Marotta On Money

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2011-08-09T10:52:00.001-07:00

David John. Marotta CFP®, AIF®, is President of Marotta Wealth Management, Inc. of Charlottesville providing fee-only financial planning and wealth management at www.emarotta.com. Subscribe to "Money Advice," our free weekly email newsletter, at www.emarotta.com/newsletter-sign-up. Questions to be answered in the column should be sent to questions at emarotta dot com or Marotta Wealth Management, Inc., One Village Green Circle, Suite 100, Charlottesville, VA 22903.

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Continue to Avoid the 'Ring of Fire' Countries

2011-08-02T05:27:00.000-07:00

Continue to Avoid the 'Ring of Fire' Countries

by David John Marotta

Americans seem to be divided on the importance of raising the U.S. debt ceiling. Regardless of your personal politics, avoid investing in countries that cavalierly allow their debt and deficit to balloon.

A year ago I wrote the column "Avoid the 'Ring-of-Fire' Countries" that suggested readers should underweight investments in countries with a high debt and deficit and low economic freedom. That recommendation has proven brilliant. Given the dangers of worldwide sovereign debt, this may be one time when investors should continue to tilt foreign and toward specific countries.

Bill Gross, cofounder of the Pacific Investment Management Company (PIMCO) and the country's most prominent bond expert, coined the term “ring of fire” to highlight the dangers associated with countries with high debt and deficit. The eight countries he identified were Japan, Italy, Greece, France, the United States, the United Kingdom, Ireland and Spain.

Last year we forecast that U.S. "GDP [gross domestic product] growth, which has historically averaged 6.5%, is liable to slow to a more European rate of 3 to 4%. Official unemployment numbers will lower but only as people drop out and are no longer counted. Real unemployment is likely to remain high for some time."

Our predictions were accurate. GDP growth is at a sluggish pace of 1.8%, and even officially, unemployment remains at 8.7%.

We also suggested "lightening up on foreign investments that primarily just follow the MSCI EAFE index." EAFE stands for Europe, Australasia and the Far East. It represents all the developed countries outside of the United States and Canada. This includes large investments in all seven of the non-U.S. ring-of-fire countries. The EAFE consists of 22% Japan, 21% United Kingdom, 10% France, 4% Spain, 3% Italy and 1% Ireland and Greece. In total, 61% of the EAFE index is invested in ring-of-fire countries.

But before you stop investing in foreign stocks altogether, remember that 100% of domestic stocks are invested in the eighth ring-of-fire country, the United States. As I wrote a year ago, "Going forward may be one of the times when a strong tilt toward specific foreign countries may provide superior long-term returns."

This past year was a dynamite period for the markets. The MSCI Net EAFE return through the end of last month was 30.7%. The seven countries in Bill Gross's ring of fire, however, averaged only 17.9%. When weighted according to their share of the EAFE index, they performed a slightly better 21.7%, pulled up by the United Kingdom and France.

Underperforming the EAFE index by a weighted average of 9% is a poor return comparison against the benchmark. The United States, now well in the ring of fire, earned 24.2% by comparison.

I advised investing more in emerging markets. They returned 28.8%, beating the United States and the ring-of-fire countries.

I also recommended emphasizing countries with economic freedom such as Hong Kong, Singapore, Australia, Switzerland and Canada. These five countries beat the EAFE index, averaging 31.7%.

And I suggested overweighting mostly free countries with lower debt such as Denmark, The Netherlands, Finland, Sweden, Austria, Germany or even Norway. These seven countries did the best, averaging 35.9%.

Investing in countries with economic freedom continues to provide gains since I first mentioned it in a column in 2004. Underweighting countries with high debt and deficit is another important screen.

Last week I wrote about the advantages of a gone-fishing portfolio. My biggest worry with such a portfolio is that for simplicity's sake it invests heavily in the EAFE index. But the global sovereign debt crisis will likely continue for another decade and drag the returns of many countries.

My first adjustment to a gone-fishing portfolio would be to replace much of the EAFE index with countries with higher economic freedom and a lower debt and deficit. Such a change adds a great deal of complexity, but the additional returns are probably worth the headache of more holdings. These countries should outperform their debt-laden counterparts.

As Gross ended his newsletter over a year ago, "Beware the ring of fire!"

Marotta Wealth Management, Inc. of Charlottesville provides fee-only financial planning and asset management. Visit www.emarotta.com for more information. Questions to be answered in the column should be sent to Marotta Wealth Management, Inc., One Village Green Circle, Suite 100, Charlottesville, VA 22903-4619.

from http://www.emarotta.com/article.php?ID=457

Where in the World Should You Invest? (2011-03-28)

2011-03-28T07:10:00.000-07:00

by David John Marotta

Finding countries where you can plant your investments in fertile soil may be one of the most important asset allocation decisions you make for the next several years.

In 2002 I coauthored a column with my father, George Marotta, entitled "Will the US Go the Way of Japan?" in the "Charlottesville Business Journal." Our answer to the question was no. We argued that when the United States has an Enron go under, there isn't a too-big-to-fail syndrome. But when a large Japanese company is in danger of failing, the government comes to the rescue. The company becomes a drag on their economy for the next decade or more.

In that column we wrote, "The ruthless culture that allows large companies to go bankrupt in the US hurts less in the long run than the Japanese style of business subsidies. In the US, the government keeps hands off business; in Japan the government interferes with the operations of business and commerce."

My, how times have changed. Now, unfortunately, the United States is going the way of Japan.

Now Japan is struggling to recover from a devastating earthquake. I was asked recently if that tragedy would stimulate its economy. Regrettably, nothing could be further from the truth.

I would suggest that everyone read Henry Hazlitt's classic "Economics in One Lesson." In Chapter 2, "The Broken Window," Hazlitt debunks the fallacy that a hoodlum throwing a brick through the window of a baker's shop is somehow good for the economy.

Certainly the baker has to pay to have his window repaired, but now he only has his window back and no money to buy a new suit. The community is poorer one new suit that could have been made and in exchange simply got its window back. But the community doesn't see what is never made.

The broken window fallacy may seem obvious, but it comes in many forms. Some pundits are mistakenly arguing that the earthquake and tsunami will be just the economic stimulus Japan needs to pull out of its malaise. This conclusion confuses need with demand.

In our country we print stimulus money and believe we have created wealth. Stimulus money may increase government spending, but the growth of government is a negative in the equation of economic prosperity. This fallacy mistakenly equates purchasing power with money.

Economic fallacies like these are "so prevalent," Hazlitt writes, "that they have almost become a new orthodoxy. . . . The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consist in tracing the consequences of that policy not merely for one group but for all groups."

The politicians in many countries focus instead on the short-run effects on a special-interest group and ignore or belittle the long-run effects on the community as a whole.

Japan wasn't the best place to invest even before March 11. Its economy is smaller now than it was in 1992. The MSCI Japan Index averaged an annual total return of -0.29% from March 1996 through February 2011. Japan dropped another 9% this month as a result of the earthquake. Most of Japan's troubles have been self-inflicted by its own government. Freedom matters.

Japan scored 72.8 out of 100 (mostly free) in the Heritage Foundation's Index of Economic Freedom. Since 1994, the Heritage Index has systematically measured economic freedom in countries worldwide. The foundation defines economic freedom as "the ability of individuals to control their own labor and property. In an economically free society, individuals are free to work, produce, consume, and invest in any way they please, with that freedom both protected by the state and unconstrained by the state."

Overall Japan is the 20th most free country, which isn't bad but is not great either. Not when 9 of the top 11 countries have large markets with easy ways to invest in them directly. In two important categories, Japan's scores are particularly poor. It ranks 145th in fiscal freedom. The top corporate income tax rate is 41%, the highest in the world. Even Japan realizes this is too steep. Next month they are cutting that rate to 36%. The U.S. top corporate tax rate is 35%, rising to 39.5% in 2013.

Japan also ranks 114th in government spending. Japan has some of the highest sovereign debt and deficit. Their ratio of outstanding gross debt to gross domestic product has risen from 68% in 1990 to about 230% in 2010.

Freedom matters. You can't afford to plant your investments in anything but fertile soil. If you simply invest in the MSCI EAFE foreign index, 22% of your investment is in Japan. What's worse, about 65% is in countries with low economic freedom and a high debt and deficit.

This isn't a reason to keep your investments here, however. Last year the United States lost its place in the list of countries with the most economic freedom for the first time in the 15-year history of the index. Part of the lower scores was a result of the U.S. debt and deficit exploding. If 65% of foreign investments are in countries with a high debt and deficit, then 100% of U.S. investments have the same problem.

Today, perhaps more than ever before, may be the time to overweight very specific foreign countries with low debt and deficit and high economic freedom. Put your investments in fertile soil where they can grow unimpeded.

I will be presenting an analysis of each country you should overweight in your portfolio at this week's NAPFA Consumer Education Foundation meeting, "Where in the World Should I Invest?" This presentation will describe what could be the most important trend to follow in today's sovereign debt investment landscape. The talk, which will take place on Tuesday, March 29, 2011, at the Charlottesville Northside Library Meeting Room from 7 to 8 p.m. with a question-and-answer session to follow, is free and open to the public.

from http://www.emarotta.com/article.php?ID=445

Save 97 Percent of Any Windfall (2011-03-21)

2011-03-22T07:48:00.000-07:00

Save 97 Percent of Any Windfall

(2011-03-21) by David John Marotta

Surprisingly, studies show that onetime windfalls can actually impoverish you. They make you feel rich, which inevitably leads to overspending. But wealth is what you save, not what you spend.

With large windfalls, people tend to spend about 40% of the money. So if you get $20,000, you might spend $8,000. But if the amount is small, you will squander a greater percentage, often more than you received. Thus if you win $75, you may actually spend an additional $125 before you stop celebrating.

Either of these scenarios will make you poorer. One goal of wealth management is to increase the amount you can spend each year rather than adopting a lavish lifestyle followed by thrift and austerity. A lifestyle is defined here as everything you can do with money, including generous donations to the charities of your choice. The goal of an ever-increasing lifestyle is not to consume more each year but rather not to allow your choices to outpace what you can continue to maintain. A year of living extravagantly is foolish if it isn't sustainable.

Consider this extreme example to see why spending even 40% of a onetime windfall breaks this principle. Imagine that instead of an annual salary you receive all your lifetime earnings in one $2 million lump sum at age 20. Spending 40% the first year is neither maintainable nor advisable. After blowing $800,000 the first year, you have reduced your potential standard of living by 40% for the rest of your life. Getting $1.2 million at age 21 is barely half as good as the original deal. Not only is your future spending severely diminished, but your expectations after a year of an $800,000 lifestyle are extremely inflated. You will struggle not to spend at least $400,000 the next year and may still feel slighted.

It is easy to expand your lifestyle and spending but very difficult to contract. Even if you give most of the $800,000 to charity, the organizations will want those funds again the following year. Prudent spending, even charitable giving, often involves continuous annual spending over a long period of time.

If your windfall is a once-in-a-lifetime event, only spend a very small percentage of it. If you are young, 3% would be reasonable and sustainable indefinitely. Saved and invested in a diversified portfolio, you should be able to earn at least 3% more than inflation.

Imagine inflation is running at about 5% and your investments are making 8%. So after a $2 million windfall, you can spend 3%, or about $60,000. Your $2 million portfolio will grow 8%, appreciating to $2,160,000. After spending $60,000, you will have $2,100,000 left. You may think you have more money, but you don't. Because this is only 5% more than you had originally, the increased amount will have the same buying power after adjusting for inflation.

The second year you can again spend 3% of the increased $2,100,000 amount, or $63,000. This will offer you the same lifestyle because prices are now 5% higher. As your portfolio increases 8% each year, you spend 3%. The other 5% simply keeps up with inflation.

Most people believe they are doing well when they save 60% of a windfall and contain their celebration to only 40%. Don't be fooled. It's like saying because it is OK to have a glass of wine every night why not just have 150 in one night and then not drink for the rest of the year. Moderation matters. You can't restrain your lifestyle and still spend 40% of a large windfall.

If you don't adjust your lifestyle spending, you will jeopardize your retirement plan. Progress toward retirement is measured by how many multiples of your standard of living you have saved. At age 40 you should have about 10 times your annual spending saved. If you spend about $60,000, you should have $600,000 saved.

You might think a windfall of $400,000 could only help your retirement plan. Now you have $1 million! Surely you should be able to spend more now that you are a millionaire.

You are better off, that's true, but only if you don't spend any of the windfall. If you do, you will have increased your lifestyle. That translates to increasing the amount you should have saved by age 40 as well as the amount you need to save each year to stay on track toward retirement.

Spend just $40,000 of your $400,000 lifestyle and your lifestyle balloons from $60,000 a year to $100,000. So by age 40 you should have ten times your standard of living or a full $1 million in savings. But because you spent $40,000, you are now $40,000 short.

Increasing your retirement goal also means increasing your annual saving toward that goal. You should be saving an additional 15% of your lifestyle each year. At $60,000, saving 15% meant saving $9,000 a year. But with your lifestyle now at $100,000, you ought to save $15,000 a year. Sustaining that increased level of savings will mean a lower standard of living in future years.

Escalating your lifestyle anything more than slightly can ruin your retirement plan. You can increase your spending each year by just 3% of any windfall. There are really few exceptions to that rule. Only a small number of families are sufficiently disciplined to rein in their celebration and save 97% of a windfall. Be one of those few. Build real wealth by saving and investing. In the end, your investments will be a dynamic engine of wealth creation and you'll enjoy financial peace of mind.

from http://www.emarotta.com/article.php?ID=444

Multiple Accounts: An Essential Management Tool (2011-03-14)

2011-03-14T09:17:00.000-07:00

Multiple Accounts: An Essential Management Tool

(2011-03-14) by David John Marotta

To build real wealth, you need specific wealth management tools. One of these is opening the right accounts and using them correctly. Most families have less than half of the accounts they really need, and young newlyweds often only have a checking account.

Here is a description of each wealth-building account, roughly in the order a young couple would need them.

Joint checking account: This account should only hold money you need to maintain your lifestyle. Keep the balance between two and three times your monthly spending. Save and invest any additional. Bank managers always encourage you to open a savings account along with your checking account. Resist. You aren't just trying to save money. You need to save and invest. Bank savings accounts are not investment accounts. Pick a bank with the lowest fees, and don't worry about the interest rate.

Taxable investment account: Many couples mistakenly believe that wealth is built only in qualified retirement accounts. But the government limits how much money you can put into retirement accounts. The excess has to go somewhere. You don't want to spend it, and accumulating cash won't grow your wealth. Saving and investing is the way to build significant wealth. This is the most important and overlooked account.

Investment accounts are best opened with a broker, not a bank. Pick a discount broker with relatively low trading fees. I've written previously about "Getting Started with Investing," available on our website.

Here is a short list of discount firms to consider: E*Trade (www.etrade.com), TD Ameritrade (www.tdameritrade.com), Scottrade (www.scottrade.com), Charles Schwab (www.schwab.com) and Fidelity (www.fidelity.com). Competition changes charges regularly. Avoid brokers with anything more than a small trading fee. Each broker has special promotions that may offer free trades, cash or electronic goods. Taking the best promotion is tempting, but first evaluate brokers without considering the promotion.

401(k) or 403(b) retirement accounts: If your employer offers a match in its retirement plan, take it. A safe-harbor match protects the plan against the claim that it only benefits the highest paid employees. With safe-harbor match your employer typically matches the first 3% you put in dollar for dollar, and the next 2% you put in is matched 50 cents on the dollar. For example, if you contribute 5% of your salary to the plan, your employer will match it with an additional 4% of your salary. This is an immediate 80% return on your money! Unfortunately, many employees fail to take advantage of this opportunity.

Your contributions always belong to you, and you can take them with you if you change employers. Sometimes what the company puts in requires you to continue working there for a number of years before you receive the full amount, which is called being vested. Learn the vesting rules, but some portion of the match will probably be yours even if you leave early, so go ahead and take advantage of the full match.

You will need two accounts, one for each spouse, through your employment. Each account can be subdivided into three subaccounts: One account is your contributions, one is the employer match that may or may not be fully vested and a third might exist for any corporate profit sharing or bonuses.

A 401(k) is more common in the private sector, whereas 403(b) accounts are for education or nonprofits. The principles are the same for each. Their names refer to the section of the IRS tax code that makes provisions for the account.

Roth IRA accounts: Unlike a traditional IRA, a Roth account does not get you a tax deduction, but there is no tax due when you take money out in retirement. Additionally, you can withdraw the amount you put in tax free after five years or more. There are limits on how much you can put into your Roth account. Put in the maximum each year.

Consider it this way. Imagine your taxable investment account has built up $100,000. Every year the government will allow each of you to move $5,000 from your taxable investment account into your Roth accounts where it will never be taxed again. Move the maximum each year. Your tax bracket will never be as low as it is right now. As you grow in wealth, your tax rate will grow considerably. Take advantage of your low rate now, and fund your Roth IRAs with the maximum allowed each year.

To fund a Roth IRA you must have earned income, but a spouse's earned income can count toward funding your own Roth. Therefore a couple needs two Roth accounts, one in each person's name.

Health Savings Account (HSA): You need health insurance to limit catastrophic medical risk, not to pool everyday expenses. This is especially true for relatively healthy young families. The best coverage to consider is a High-Deductible Health Plan (HDHP). The deductible is thousands of dollars. For everyday expenses within the deductible, consider a Health Savings Account (HSA).

An HSA is the only account where you get a tax deduction for putting the money in and you are not taxed when you use the money for a qualified medical expense. The money in the account can also be invested, and all interest, dividends and capital gains in the account are not taxed. And HSAs come complete with debit cards and checks. Your employer may provide you with an easy method of payroll deduction for your HDHP and HSA. Alternatively, you can sign up for an individual plan.

IRA rollover accounts: When you leave an employer you will want to roll your 401(k) or 403(b) accounts into an IRA rollover account where you can manage it yourself. Although the matching aspect is wonderful, a 401(k) account has limited choices and higher fees. Moving that money into an IRA is nearly always the right decision. Both you and your spouse will ultimately need IRA rollover accounts.

Living trust accounts: Estate plans can be written in many different ways. Some estate plans set up a bypass trust only after one spouse has died. Other estate plans prefer to set up a living trust each for husband and wife while they are still alive and fund it with investments. Make sure you understand your will and estate plan well enough to structure your investment accounts in accordance with your wishes.

Inherited IRA accounts: If your parents or grandparents have died they may have left you money outright or they may have left you their traditional or Roth IRA account. If they have left you an IRA account, leave the IRA account as a qualified account where the interest, dividends and capital gains grow tax deferred. Taking the money out gradually, only the amount of required minimum distributions, provides the greatest tax benefit.

Segregated Roth conversion accounts: Tax law allows you to take the money in your IRA or IRA rollover account, pay the tax and convert those assets to a Roth account. Before you pay the tax, you even have the opportunity to recharacterize and unconvert the conversion. An additional tax-planning technique suggests dividing the portion you convert into separate accounts. Segregating the assets into different accounts allows you to invest them differently, keep the one that does the best and recharacterize the ones that underperform.

Charitable gift account (or donor-advised funds): To facilitate your charitable giving, you are allowed to transfer appreciated securities to the account. As you transfer them, you receive a tax deduction for the full value. They are sold and may be reinvested in a limited number of choices. And at any time you can direct that donations be made to qualified charities. This is an easy way to get the tax write-off for donating large blocks of appreciated securities and then subsequently give smaller amounts to individual charities.

More than a dozen different accounts are listed here, but you may not have them all until you are well on your way to becoming a millionaire.

from http://www.emarotta.com/article.php?ID=443

Don't Retire: Keep Significant Goals (2011-03-07)

2011-03-07T07:47:00.000-08:00

Don't Retire: Keep Significant Goals

(2011-03-07) by David John Marotta

Most Americans fail to plan adequately for retirement and consequently miss out on opportunities to enjoy the last third of life. The best and most rewarding financial planning is not just about the numbers but rather takes place in the context of personal goals.

Retirement used to mean not only a complete withdrawal from the workforce but often a retreat from life. Even the word "retire" has the connotations of shuffling quietly off to bed.

We call that traditional concept a "cliff retirement" because it is so abrupt. One day you are working full time, and the next you are playing full time (or slumped in your chair watching TV feeling unwanted and over the hill). We all need meaning and significance in our lives. And close social relations are an intrinsic part of our humanness. For many people, work provides meaning, significance and social relationships.

Try this retirement planning exercise. Draw a large circle and write the names of 10 people inside the circle who you are genuinely close to. Don't include any relatives. They have to love us, and although our connections with our families can be very nurturing, it is friends who help validate us and widen our horizons.

Now cross out any of the 10 names you know through your work, which might eliminate half or more of the people you listed. Thus a cliff retirement can devastate not only your meaning and purpose but your social network as well. Retirees who no longer work at all say their close friends dwindle to an average of about nine people.

As a result of their isolation, people who opt for a cliff retirement often deteriorate quickly and die relatively young. Financial planning is easy when you die young, but we don't recommend it. Here are some suggestions to consider as you approach what is traditionally considered retirement age.

Consider postponing retirement. Delaying retirement until age 70 increases your Social Security benefits and also shortens the time you will be withdrawing from your portfolio. It gives you additional years to save and your portfolio more time to grow. By delaying retirement from 65 to age 70, you may have more than a 50% higher standard of living when you do stop working.

Or instead of taking a cliff retirement, think about retiring gradually. Move from full time to 30 hours a week, and then to half time. With this less hasty transition you can maintain contact with the people and purposes that give your life meaning and also have the time to develop goals and a network of relationships for your later years.

Envision your final years not as retirement but as financial independence. Now that you don't need to work exclusively for money, make a list of activities where you would like to focus your energies and use your skills and experience.

Consider developing a health and fitness routine. If work kept your mind and body engaged, you will need to replace that activity with other pursuits. Again, going part time allows you the luxury of processing the transition and adjusting to a new lifestyle.

Challenge and reexamine those stereotyped and overly rigid assumptions about retirement. Two books that may help you tailor your retirement to be a productive and satisfying time of your life are "Encore: Finding Work That Matters in the Second Half of Life" by Marc Freedman and "The New Retirementality: Planning Your Life and Living Your Dreams at Any Age You Want" by Mitch Anthony.

Of course crunching the financial numbers is critical as you begin to contemplate retirement. But your personal calling, support network and health and well-being are just as important. In the end, a holistic approach to your life is always the best starting place.

We offer just such an approach every year through the Osher Life Long Learning Institute at the University of Virginia. Beth Nedelisky and I are teaching the workshop "Planning for Success and Significance in Retirement." The course, intended for people age 50 to 70, covers cash flow projections and asset allocation as well as meaning of life issues. The three-week course begins Thursday, March 10, from 11 a.m. to 12:30 p.m. at Meadows Presbyterian Church. You may register online (virginia.edu/olliuva) or at the first class.

from http://www.emarotta.com/article.php?ID=442

Pay Yourself First

2011-02-28T06:32:00.000-08:00

Pay Yourself First
by David John Marotta | 02-28-2011

The greatest engine to generate real wealth is saving and investing. And the best way to ensure that your default is saving and investing is to automate the process. Pay yourself first, and your savings will grow exponentially.

Wealth management is based on the idea that very small changes can yield enormous gains in your family's finances. This process, both easy and simple, is worth millions. Unfortunately, only a tiny percentage of American families take advantage of the tools available to implement this automated technique.

All income should flow into your joint taxable investment account. Make saving and investing your default. Putting all of your money in this account helps ensure that you move only the money intended for some other purpose into a different account.
Automating the process of saving and investing is like damming a river to form a reservoir.

For working families this means an automatic deposit of paychecks into their joint account. Banks will try to entice you into setting up automatic payroll deposit into their checking account. They will offer you additional interest if you do so. Resist. The additional interest is not worth the failure to not only save but to save and invest. Your taxable investment account should be the default.

For retired families this means an automatic deposit of Social Security checks. It also means their required minimum distributions (RMDs) from their individual retirement accounts (IRAs) should be deposited first into this account.

From this account you can then withdraw what you need for daily expenses. Do this by setting up a regular transfer of funds from your joint investment account to your checking account. Make sure the transfer matches the amount you have allocated in your budget, ideally 65% or less of what you need to support your lifestyle. The other 35% should remain in your joint taxable account, much of it to be invested.
Gift appreciated stock from this account and leave enough cash to reinvest and replenish the value. This plants the seed for future gifting. You save on capital gains tax, and with your new purchases you can rebalance your portfolio.

Another part of what remains is the 10% you have designated for unknown unknowns. In the ideal world, this money will not be needed, but few families can anticipate every possible expense. Each stage of life presents new challenges. Having the financial margin to absorb some of life's shocks is simply wisdom and offers financial peace of mind.

Because the time horizon for this emergency money is unknown, invest it in a balanced portfolio. If unused, your emergency money will double in 7 to 10 years and provide a greater safety net for your family. If you have to dip into this fund, keep track of the amount. If it approaches the full 10% every year, you are using your emergency money to extend your budget, not simply for unanticipated expenses.
The less you use this account, the more quickly you will reach financial independence. These funds are mixed with your other taxable investment savings and continue to grow your net worth. If you are meeting all of your expenses without any major surprises, these funds can be used to purchase a home, start a business or for additional charitable giving.

Another portion of what remains in your taxable investment account will be the 5% you are specifically designating as taxable savings. Because this 5% gets mixed in with charitable giving that is being invested and your unknown expenses, the entire portfolio should be balanced. If an emergency arises, any portion of the portfolio could be sold to furnish the needed funds. Similarly, when you want to gift appreciated stock, any portion of the portfolio could be gifted.

The last portion might be the 10% for funding your retirement accounts each year. Many people put this money directly into a retirement account as part of the payroll process through a pretax deduction. If that is the situation, you don't need to flow anything through your taxable investment account. But you may want or need to fund your retirement outside of a payroll deduction. One example is funding your Roth IRA each year. In this case you may want to collect the money in your taxable investment account and then transfer it to a Roth account.

If you want to fund a Roth IRA account for the maximum $5,000 (in 2010), you could transfer the entire amount once during the year or set up a monthly transfer of $416.66. The money from your paycheck would provide the liquidity, either letting it build up throughout the year or supply the funds for each month's transfer.
Busy people forget to make the necessary transfers each year. That's why a monthly transfer is preferable. Saving and investing should be automated so it occurs regularly without any additional effort. Whatever is in your checking account you are likely to spend. Whatever is in your investments you are less likely to spend.
Automating the process of saving and investing is like damming a river to form a reservoir. The alternative is the manual process of hauling buckets of water from your stream to a water tower. You will never grow rich by hauling buckets, and it's much harder work.

No matter what income you have, you probably already have enough to grow rich. Saving and investing just $10 a day builds a million dollars over your working career at average market returns. You build wealth by what you save and invest, not by what you spend. Automating the process of saving and investing grows your wealth while you sleep.

Raising Money-Savvy Kids

2011-02-21T09:54:00.000-08:00

Raising Money-Savvy Kids
by David John Marotta | 02-21-2011

Many people lament that schools don't teach children to be financially responsible. But studies show that book learning doesn't work when trying to teach about finances. Here is a guide for what will give your children the best chance of handling their money well.

Financial responsibility is more about self-discipline than about knowledge. Think of it like dieting or staying physically fit, not solving math problems. It isn't simply information you learn from a book, it is a skill you learn by doing.
I coached soccer for many years and was assistant coach to one of the best. Excellent coaches understand how to design exciting games that teach specific skills. They are able to motivate the players about the game and at the same time teach them the skills they need to be successful.

You learned your best life lessons by experience. You cannot teach your children to live within their means if you keep supplementing their means.

Training to be financially adept requires the same three methods needed in sports: communication, example and application.

Communication alone is the least effective. Imagine I was teaching you the proper way to kick a soccer ball. In a textbook you read, "Take aim and then look back to the soccer ball as you shoot. Approach slightly from the side. Plant your non-striking foot beside the ball. Strike the middle. Keep the knee of your kicking leg over the ball. Follow through."

If that was the end of the lesson, all players would remain abysmal once they got on the field. Head knowledge isn't enough, and it doesn't help you visualize what is possible. Also, knowing how and why is very different than actually being able to do it.

Most coaching involves simply giving players an example. You do something and you say, "Kick the ball like this." Although "like this" could mean a thousand things, children are very good at abstracting what is important. Similarly, our children can learn financial perspectives and habits simply by growing up in our homes.
Our example as parents gives them a default of what to try first. But unfortunately, most families don't provide a very good model. The average family's finances are appalling. Credit card debt averages $6,500. Half of American families have no retirement accounts. The other half have only saved $35,000.

Getting your own financial house in order is half the battle. The other half is bringing your children into your circle of trust as they mature. Most children feel they are in the dark regarding family finances. My most valuable education came from my mother, who shared every aspect of her household budget with us.

Before age 10, I knew what my father's salary was, the amount of our mortgage and the interest rate we were paying. I knew how much a week's worth of groceries cost and the value of buying term life insurance and investing the difference. Parental actions can be ambiguous, but when they are accompanied with a commentary of values and decision-making skills, they offer sage mentoring.

Communication and example are important, but practice is the key to raising financially savvy children. Given enough time to practice, even children without guidance and good examples will learn from trial and error, just like young soccer players accidentally learn that spinning balls curve.

The physics that causes a lateral deflection of a spinning object are quite complex. But with some trial and error, it is much easier just to learn to do it. Even children with no knowledge of physics can ultimately bend or curve a soccer ball around a wall of players and into the corner of the net.

To raise financially savvy children, give them as much practice time with real money as you can. Encourage your children to make spending decisions as early as possible. Let them make mistakes and learn from them. Give them practice in spending, investing and earning.

They should not be asking you for money. Let them make the tough calls about needs and wants and be forced to choose. If they are not obligated to make hard decisions, you are giving them too much money or not making them pay for enough things. You learned your best life lessons by experience. You cannot teach your children to live within their means if you keep supplementing their means.

Also, they should only be paying for things you are willing for them not to purchase. For example, if you make them pay for a school trip, you must be willing for them to decide not to go. And if they have spent all of their allowance, do not loan them money. Finding that you want to buy something but you have already spent everything is a critical lesson. Make sure your children don't miss it.
Children need experience not only saving, but saving and investing. It takes a while to understand the principle of compounded interest. I thought the lesson was essential enough to cheat and shorten the time horizon. The first time my children had $100, they were allowed to invest the money for one year with an extra 100% return on their money. They could keep whatever they earned plus an additional $100. They were young, and a year was a long time for them.

As part of our firm's quarterly reporting, clients receive a chart showing the net cumulative investment versus the portfolio value, which drives home the power of investing. Even $100 invested teaches the lessons of compounded market rates of return.

Finally, children must learn how an ethic of hard work and persistence produces a financial return. Grit is a better indicator of financial success than IQ. And running a small business requires more persistence than smarts.
My children were allowed to get jobs at age 14 and were eager to do so. That year they also started funding their Roth IRAs and took over more of their everyday spending. They had been prepared and were able to assume much of their own financial independence.

At every age of your children's lives, think through how you can communicate, be an example and give them real-world practice, first at budgeting, then at investing and finally at running a business that provides real value.

If you'd like to further your children's financial education, come to this month's NAPFA Consumer Education Foundation meeting. This Wednesday, February 23, my topic will be "How to Raise Money-Savvy Kids" at the Charlottesville Northside Library Meeting Room from 7:00 to 8:00pm. The talk is intended for parents and teenage children, although younger children are welcome.

For Valentine's Day, Work on a Budget Together

2011-02-14T11:41:00.000-08:00

For Valentine's Day, Work on a Budget Together
by David John Marotta | 02-14-2011

An overwhelming number of people in failed marriages cite financial troubles as a major factor in their breakup. It's not surprising because the way we use our time and money reflects our values. Without a strong set of shared values, marriages may founder. But dealing with finances together can bring a couple closer. Developing and remaining faithful to a budget is probably the best way to build both your wealth and your marriage.

You may think financial planning is unromantic, but marriage is so much more than gazing into each other's eyes. It is as much a business merger as any corporate contract. And nothing is more romantic than planning how to realize your shared hopes and dreams for the future.

Finances tend to be a taboo subject. Often engaged couples do not know what their prospective mates earn or how much savings or debt they have accumulated. Most couples have deeply conditioned emotions and expectations about financial matters that they unconsciously project onto others. So in addition to selecting a china pattern and the floral arrangements for your big day, make sure your marriage has the financial footing and monetary habits to meet life's challenges.
Couples who have worked together on a budget already agree on the big picture. Once they make the hard decisions about what will help further the family's values, specific purchases in each category are much less critical.

Planning for financial security helps engender a loving environment of shared goals, respect and communication within which romance can flourish. If you can't share details about your finances, it doesn't bode well for your relationship. A professional may help facilitate the necessary discussions. An advisor can ask sensitive questions without judgment, listen to each person's goals and make recommendations to which the couple can respond without any hurt feelings.
I especially enjoy working with young families. Wealth management is all about small changes that produce large results over an extended period. And young couples have enough time to grow richer year by year as they age gracefully together.
Many new couples mistakenly believe they are doing well if they live within their means. This is a common misconception. Couples should keep daily expenses within 65% of take-home pay and reserve the other 35% for very specific purposes.

Ten percent should fund your retirement accounts, and an additional 5% funds your taxable savings. Set aside another 10% for large unexpected purchases. Without budgeting for these large emergencies, anything could swamp your finances. The roof might leak, the car could require major repairs or you could need to fly home for a family emergency. And finally, you may decide to put aside an additional 10% for charity and gifting.

If you add these values up, 35% of your regular take-home pay can't be spent on daily living expenses, leaving only 65% that can. Without this foresight, your finances or savings will be deluged by the regular large waves of unexpected immediate needs. This might be the single choice separating those who will grow their finances and those who won't.

Having a budget gives you more freedom, not less. Couples without one often fight about every dollar they spend. Each purchase becomes a battleground where values and priorities clash. And there are always impulsive purchases that provide fodder for an argument.

Disputes about how to spend money can be ongoing in families that are struggling to make ends meet. But a spending plan should never be exploited as a weapon. It can only be used as a tool for couples who are working together toward a common goal.
Most people occasionally buy something that their spouse considers frivolous. The way to contain the havoc these purchases wreak on a budget and a marriage is to set a boundary within which they can be enjoyed and beyond which they will not threaten other financial goals.

We recommend that couples make a line item in their budget for a husband's frivolous purchases and a wife's frivolous purchases. I suggest 1% total or half of 1% for each spouse. So long as spending stays within the budget, there should be no arguments.

Couples who have worked together on a budget already agree on the big picture. Once they make the hard decisions about what will help further the family's values, specific purchases in each category are much less critical.
When people follow a carefully constructed household budget, they do not need to worry about spending until a category exceeds the prescribed amount. Having decided how much money the family can afford to spend on clothes for him and for her, for example, it doesn't matter if he prefers lots of inexpensive clothes and she prefers a few more expensive outfits. A budget allows a certain degree of freedom that forestalls any controversy.

And when a family does overspend one category, they can decide in a monthly budget meeting how the category allocations might be adjusted going forward. There may still be disagreements, but at least with a budget there won't be petty discussions about every dollar or even an attempt to figure out where the money was spent.
As we grow older we can enjoy great peace of mind if we have resolved our money issues together. For Valentine's Day, work on a budget together. It is a calorie-free way of building lasting harmony.

Save Your Social Security Payroll Tax Cut

2011-02-07T05:38:00.000-08:00

Save Your Social Security Payroll Tax Cut
by David John Marotta | 02-07-2011

This year the government reduced Social Security taxes by 2%. More than 150 million workers will receive up to $2,136 each. The assumption is we can spend our way out of unemployment. You should boost your savings rate by 2% to ensure you don't fall behind on your retirement savings.

We can't spend our way out of economic trouble as a country any more than we can grow taller by pulling on our shoestrings. Increased spending is an indicator of economic health only when it follows increased production and earnings. Rich people generally spend more. But that certainly is not what makes them rich.

A far better scenario would be if we as a country tried to save and invest our way out of a recession. Imagine if everyone invested their rebate by creating new businesses or building factories. Then we as a nation would produce more. Increased annual production could be sold, which would increase our gross domestic product.
Consuming more goods doesn't really help our economy when half the stuff we buy comes from China anyway. In fact, deferred consumption is the definition of capital and would allow us to use that money to build more productive companies. It would lower unemployment and reduce inflation.

President Bush tried the exact same gimmick in May 2008, issuing tax rebates in the form of stimulus checks.I respondedjust as vehemently that the rebate was a cheap insult directed at the American people and free markets. Every time the government bureaucracy engages in centralized spending plans, the economy is weakened. They believe they are better off, butworkers will actually be poorerif the check increases their spending habits by even a penny.

Average workers earning about $50,000 a year will see their take-home pay rise by 2%, or $1,000. Normally their standard of living after taxes and savings might be $37,000. By age 50 they should have saved about 10 times their standard of living, or $370,000. But if they spend an additional $1,000, they increase their annual lifestyle to $38,000. They will fall $10,000 behind on funding their retirement.
The United Auto Workers supports the idea of the payroll tax cut. They claim, "Working families will likely spend this money in their local communities, creating jobs and stimulating overall growth." Anyone who spends more than 4% actually loses ground in saving toward retirement. Thwart the UAW's advice and start saving and investing an additional 2% of your income this year.

To replace your income and be financially independent at a reasonable age, you should be saving 15% of your take-home pay toward your retirement. I received the following reply to that advice from one of my readers. She wrote, "Few people I know, except for well-paid professionals, can save 15% of their income for long-term retirement goals. . . . Sorry, but most people don't live in this author's rosy world."

No matter what your salary, there are people living comfortably off 15% less money and still managing to save 15% of their smaller salary. We could easily begin to ask uncomfortable questions about this reader's lifestyle. We might find at least 15% in discretionary spending that more frugal people could easily eliminate. My reader would have made a more convincing argument if she said we are already being taxed more than 15%, which ought to be enough.
Most workers don't know how much they are taxed for Social Security. The correct figure is 12.4% for Social Security plus an additional 2.9% for Medicare, a total of 15.3%.

Of the 12.4% for Social Security, 6.2% is deducted from the employee's paycheck. The other 6.2% is withheld by the employer, who reduces salaries accordingly. In truth, without these government-imposed taxes, the labor market would settle at paying employees 15.3% higher wages. Management doesn't care whose share it comes out of. Either way employees bear the burden of the entire tax.
Saving 15.3% over a working career ought to provide all employees with a retirement income at or greater than their wage during their working years. Instead, the return on Social Security investment is minuscule if you are a rich white woman and negative if you are a poor black man. Nonworking spouses, who never contributed anything to Social Security, are the only group that can claim to have won in the exchange.

White House economic adviser Jason Furman said, "The payroll tax cut has absolutely no effect on the solvency of Social Security." Only in Washington do they pretend the emperor is clothed. How can collecting $112 billion less in Social Security taxes have no effect?

The Treasury Department has been instructed to replenish Social Security with additional borrowed money against Treasury bills. The entire Social Security fund is a stack of IOUs written against future tax collection. So I guess adding a few more without first squandering and spending revenue doesn't really change the solvency. In other words, the system is bankrupt either way.
Take ownership of your own financial securityand increase the rate you are saving and investing by at least the 2% Social Security tax cut.

Roth Recharacterization 2011 (2011-01-31)

2011-01-31T19:28:00.001-08:00

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)

2011-01-24T07:02:00.001-08:00

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)

2011-01-17T08:01:00.000-08:00

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)

2011-01-10T07:00:00.000-08:00

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)

2011-01-03T09:15:00.000-08:00

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

Seven Financial Resolutions for the New Year (2010-12-27)

2010-12-27T08:13:00.000-08:00

Seven Financial Resolutions for the New Year

(2010-12-27) by David John Marotta

Financial resolutions usually don't even last until the end of January. Making a permanent change in our behavior requires both time and a steely resolve. We can only develop financial character one action at a time. Here are seven practices to take you from pauper to prince or princess if you add one each year.

Read through the list. If you already practice the resolution, move on to the next one. Adding one behavioral change is labor enough for the next 12 months. Keep it long enough for practice to become habit, and you are on your way to developing a millionaire mindset.

Share your resolution with everyone you meet. You are 10 times more likely to act on a goal that you have articulated to someone else. Don't wait until you have everything perfect to take ownership verbally.

First, and most critical, resolve to be and stay debt free. You may have a fixed-rate fixed-year traditional mortgage on your house but nothing else. No equity line of credit on your house. No car payments. Certainly no credit card debt. You have to learn to live within your income, which sometimes means going without. Millionaires are frugal. Learn to enjoy it.

Second, automate saving enough to get the entire match that your company's 401(k) plan offers. Usually this translates to saving 5% of your salary while the company contributes a 4% match, the fastest way to get an 80% return on your money. Most Americans forgo this match, believing they need to spend 100% of their salary. But you can learn to think like a millionaire and live well on 95% of what you make.

Next, fully fund your Roth IRA ($5,000 in 2011). If you can't manage the entire amount in January, put in $416 monthly.

Automating deposits in an employer-defined contribution plan is easy. Fortunately, automating saving in a Roth IRA or a taxable savings plan is equally painless. Most brokers offer an automatic money link between your checking account and an investment account. Set your savings on autopilot.

Fourth, save an additional 5% of your salary in a taxable account. Again, set up an automated transfer. You need taxable savings for a host of financial planning opportunities as well as for a plethora of life's challenges.

By now you are saving 15% to 20% of your salary and living off the remainder. Learning to live deferring many of your wants until later is a crucial habit that millionaires have cultivated. Money makes money. And the money you need to make money is called "capital," defined in textbooks as "deferred consumption." Money spent is gone forever. Money saved and invested works for you, adding income every year.

Fifth, save an additional 10% for charitable giving. Many millionaires might suggest being generous should be number one on your list. But until you have your own financial security on track, it is difficult to help others don their own oxygen masks.

No matter where you think charity belongs in your priorities, a sensitivity to the truly needy will change your perspective about distinguishing needs and wants. Many millionaires live simply in order that others may simply live.

Save this additional 10% in your taxable account. By now you are saving 15% in a taxable account. For your charitable giving, gift the investments from the account that has appreciated the most.

No matter which worthy organizations you support, you can donate up to 20% more if you give appreciated stock instead of cash. If you sell $1,000 worth of appreciated stock, you will have to pay the capital gains tax of 20%. If most of the stock's value is appreciation, the tax owed approaches $200, leaving only $800 for charitable giving. But if you give the stock directly to the charitable organization, you can take the full $1,000 tax deduction, and the organization will not have to pay any taxes when it sells the stock.

Up until now you may have been giving cash to charities. Now that you are developing some taxable savings, run your giving through your taxable investments. For every $1,000 of appreciated investments donated, use the $1,000 in cash you would have gifted to buy additional investments. Think of this as planting the saplings you will harvest later for future gifting.

After several years, your $1,000 worth of cash should have grown to $2,000 worth of investments. Gifting a $1,000 worth of appreciated investments leaves the original $1,000 to keep increasing in value and fund future giving. This is one reason why frugal supersavers can be much more generous than those whose rich lifestyles preclude saving and investing.

Sixth, save an additional 10% in your taxable account for unknown unknowns. If your response is to ask, "Like what?" remember that you can't plan for everything. But you can save cash for the unexpected.

Families inevitably encounter cash flow problems because of unanticipated expenses. If you are living paycheck to paycheck, your budget cannot handle large unplanned outlays such as the car breaking down, the roof leaking or emergency medical bills.

When a financial crisis strikes, you will be glad to have an emergency fund. Afterward, see if you could have predicted the expense, and adjust your plan accordingly. Budget each month for the inevitable expense of buying your next car. Budget for replacing your roof. The more you can foresee these expenses, the more this category can fund discretional big purchases instead of financial emergencies.

At this point you are saving more than 35% of your salary and living on less than 65%. This is the benchmark for a millionaire mindset. As you save and invest, the appreciation on your investments can provide income that replaces your salary, bringing you closer to financial freedom. When you can replace all of your income, you are free to retire or tackle challenges that do not make you any money.

Every 25% of your salary you save replaces over 1% of your regular income in retirement. Money makes money, which then gives you the gift of financial freedom.

The seventh and final challenge is to expand this financial engine beyond 35% toward 50%. Living off half your income requires a frugal lifestyle in comparison to your income. Impossible, you say? Unless you are among the truly needy, there are families out there living comfortably on less than half of what you earn.

And if you are among the genuinely wealthy, the only obstacle standing in your way is being accustomed to an affluent lifestyle. Learn to value financial freedom over opulence. Developing an engine of wealth production takes foresight and self-restraint in addition to time and patience. But the reward is financial peace and contentment.

from http://www.emarotta.com/article.php?ID=432

The Poorhouses of "A Christmas Carol"

2010-12-20T11:48:00.000-08:00

The Poorhouses of "A Christmas Carol"

(2010-12-20) by David John Marotta

There are few better stories for talking about economics than Charles Dickens's "A Christmas Carol." Perhaps the most telling discussion in the story comes early in the first chapter when "two portly gentlemen" call on Scrooge to ask him for a donation to charity.

Dickens describes them as portly to show their affluence and success, not their weight. They were probably large and heavy in a dignified and stately way. Given that few people in those days had enough to eat, today we would probably describe them as well fed or robust. Dickens describes them as pleasant to behold.

These two portly gentlemen have made a list of establishments to visit and solicit for donations. They approach their charity work like they do their businesses, with organized efficiency. They have papers and books. They come as a team. They present their credentials. They are polite. They remove their hats.

Subsequent reinterpretations of the story often try to make capitalism Scrooge's problem and government-run social programs the answer, but that was not the case in Dickens's day or in his story. The two portly gentlemen are capitalists and entrepreneurs. Their initiative extends to good works within their community.

They are passionate about their charitable work. They assume the best about Scrooge and his former partner. Their liberality is to make slight provisions for the poor and destitute who suffer during the Winter Season. They know their efforts will not end poverty for all time. They are simply trying to spread some "Christian cheer of mind and body."

The two gentlemen focus on providing some meat, drink and means of warmth. The poor have nothing but a meager allocation of bread and gruel. They would like a little more bread. Some meat would be a great kindness. Drink and warmth are a great extravagance.

Scrooge will have none of this personal philanthropy. He argues that public entitlements are the solution. "Are there no prisons?" he asks. "And the Union workhouses? Are they still in operation? The Treadmill and the Poor Law are in full vigour, then?" After hearing these are still active, he complains, "I help to support the establishments I have mentioned: they cost enough: and those who are badly off must go there."

Dickens was very critical of the New Poor Laws passed in England in 1834 by Lord Melbourne's government. They altered the locally administered structure run by local parishes into a centralized system of workhouses. These changes cost more money and provided less relief.

The New Poor Laws were influenced by the ideas of three writers of the day. The first was Thomas Robert Malthus, who advocated limiting population growth so it wouldn't increase faster than food production. Families were split up in the workhouses into three separate barracks to discourage conception.

The second writer was David Ricardo, who argued that wages naturally tend toward a subsistence level. This view, called the "Iron Law of Wages," influenced Karl Marx's dim view of the prospects of workers benefiting from capitalism.

And the third was the philosopher Jeremy Bentham, whose idea was utilitarianism, or the idea that the moral or ethical thing to do was whatever brought the greatest happiness to the greatest number of people. Similarly, laws ought to be structured to discourage what hurts society and encourage what helps society. That these principles be put into place with draconian authoritarianism is irrelevant to his view of ethics.

That each of these thinkers was wrong was unfortunate. That the government instituted their ideas was catastrophic. One of the two portly gentlemen reminds Scrooge, "Many can't go there; and many would rather die." Scrooge's reply is Malthusian and utilitarian: "If they would rather die, they had better do it, and decrease the surplus population."

Make no mistake. Scrooge is the advocate of the sufficiency of the state to involve itself in society's welfare. Ill-conceived government programs are able to inflict misery better than any private charity. They have the force of law. How effectively the government actually does the job, Scrooge argues, is none of his business. He pays his taxes, minds his business and no additional concern is required.

Charles Dickens opposed the New Poor Laws as cruel and unchristian. He wrote "Oliver Twist" in 1837 and "A Christmas Carol" five years later partly as a response to this legislation. And in 1850 he wrote the journalistic account "A Walk in the Workhouse," in which he decried the conditions he found.

Dickens's biographer Jane Smiley described his competing philosophy this way: "It is not enough to seize power or to change wherein society power lies. With power must come an inner sense of connection to others that, in Dickens's life and work comes from the model of Jesus Christ as benevolent Savior. The truth of 'A Christmas Carol' that Dickens understood perfectly and bodied forth successfully is that life is transformed by an inner shift that is then acted upon, not by a change in circumstances."

We see that transformation in Scrooge when the nameless and faceless poor over which he has little power and means to save are replaced by his own clerk's crippled son Tiny Tim. Whereas the nameless masses might be undeserving and able bodied, Tiny Tim is both a child and disabled.

"Oh no, kind Spirit! Say he will be spared," Scrooge laments, only to hear the Ghost respond, "If he be like to die, he had better do it and decrease the surplus population." Scrooge lowers his head in shame at hearing his own words and is overcome with penitence and grief.

Mercy embodies the idea that God puts the responsibility of alleviating some of the suffering in the world on you. God doesn't charge you with all of it. And God doesn't expect you to solve the problem completely. But He does expect you to be open to being the person He chooses to use to help. This openness does not solve the problem of trying to determine where God wants you to put your resources to work. Starting a viable business and hiring people can be an act of the highest charity. So can giving to charitable causes. The principle is summarized in apostle Paul's letter to the Philippians 2:3: "Do nothing from selfishness or empty conceit, but with humility of mind regard one another as more important than yourselves."

Dickens believed in the power of a changed heart. In "The Life of Our Lord" he wrote, "people who have been wicked . . . and who are truly sorry for it, however late in their lives, and pray God to forgive them will be forgiven and will go to Heaven too."

The moment of Scrooge's redemption occurs when struggling with the final Spirit, he holds "up his hands in one last prayer to have his fate reversed." At this prayer the Phantom shrinks and dwindles down into a bedpost.

We see Scrooge's changed heart on Christmas Day. He sends the prize turkey to the Cratchit family. He raises Bob Cratchit's salary. But perhaps most convincingly for men of business is his generous giving to the two portly gentlemen including a great many back payments.

A changed heart freed from past sins is a powerful force of authentic spirituality in life. If you believe all of your time, talent and wealth belong to God, you won't make any distinction between the charitable work you do for God and the rest of your life. And you won't have any fear about doing what a benevolent God sets in your path to do.

from http://www.emarotta.com/article.php?ID=430

The Two Portly Gentlemen Are Entrepreneurial Philanthropists

2010-12-13T10:23:00.000-08:00

The Two Portly Gentlemen Are Entrepreneurial Philanthropists

(2010-12-13) by David John Marotta

As I do every December, I have been enjoying rereading "A Christmas Carol" by Charles Dickens. This year I've been thinking about Scrooge's interaction with the two portly gentlemen who stop by to collect for the poor. These entrepreneurs represent one of my favorite financial personalities.

In his book "Why Smart People Do Stupid Things with Money," Bert Whitehead describes different financial personalities. He depicts an "entrepreneur" as someone who tends toward greed rather than fear but is balanced between a propensity to save or spend.

Whitehead maps financial personality on two different scales. The first measures people's tendency toward greed or fear. As entrepreneurs, the two portly gentlemen are motivated by greed (high risk acceptance). Ebenezer Scrooge shares this same inclination. The two men see opportunities and the risk excites them. Even soliciting funds for the poor is an integral part of their entrepreneurial spirit.

When the two portly gentlemen stop by Scrooge's office soliciting charitable donations, they discover his partner Marley has been dead for seven years. One comments, "We have no doubt that Marley's liberality is well represented by his surviving partner." The narrative continues, "It certainly was; for they had been two kindred spirits."

Liberality toward others cannot come from someone motivated by fear. Distrust drives out emotions like kindness and compassion. Later in the story, Scrooge confirms this condition in Marley as he looks through his ghostly form and remembers ironically that it was said of Marley he had no bowels. Marley had no empathy for others because he was overly anxious for himself.

When fearful misers like Marley move from savings to spending, they move first to a bon vivant and then to a shopaholic personality. Their fear motivates them to spend more but only on themselves.

Scrooge, in contrast, is more of a risk taker. Thus as he shifts toward spending some of the wealth he has accumulated, he moves squarely into the entrepreneurial financial personality shared by the two portly gentlemen.

Whitehead's second scale measures an individual's tendency to save or spend. Here the two portly gentlemen are balanced between thrift and spendthrift, whereas Scrooge is a practiced saver. A risk taker who is also profligate would be considered a gambler personality. These two gentlemen are balanced between these two extremes.

Many of our clients are small business owners. They are fascinating and passionate people to work with. They are willing to take the risks required to cultivate a business, and they devote their time and effort into doing what it takes to make it succeed. Their family and friendships grow out of running their business. They employ their children.

Interestingly, their sense of mission about their companies extends to combining corporate and charitable intent. According to a 2010 Ernst and Young study, Entrepreneurs and Philanthropy, nine of ten entrepreneurs extend their personal giving practices to the corporations they run. The motivations they cited as most important were to give back to their local communities and to incorporate their personal philosophy into their corporate culture. In addition to starting their own businesses, 43% have started their own charities.

Most entrepreneurs surveyed have a quiet or passive giving style. Although their involvement may be known, they prefer not to be overtly recognized. Most have made charitable giving an essential part of their personal financial planning. They are as intentional about the causes they champion as they are about their companies.

You might think entrepreneurs possess the perfect financial personality, but they do have their weaknesses. First, they have a tendency to overwork. Perhaps this is how the two portly gentlemen acquired their girth by sitting behind their desks too long. Nesters spend less money and more time at home; travelers spend more money enjoying diverse experiences. In this regard the philanthropy of entrepreneurs is a healthy diversification of their business interests to "making mankind their business."

The second weakness is a tendency to run out of liquid assets. Entrepreneurs often sink all of their treasure as well as their time in their work. They are also much more tolerant of risk and wild swings of fortune. When times in their businesses get tough, they need to have liquid assets to survive a negative cash flow. Having a diversified base of liquid investments and lines of credit established during the good years can mean the difference between survival and bankruptcy.

Most entrepreneurs have complex finances but don't have the time to handle all the moving parts. But with great complexity comes great opportunity. Fiduciary advisors are invaluable to an entrepreneurial family. They can free them from some of the details and allow them to focus on their core business. They can also be proactive in suggesting aspects of comprehensive wealth management where small changes can have an enormous impact.

Delegating and accepting advice is the other impediment to entrepreneurs working with a financial advisor. They are accustomed to being the smartest people in the room, and a traditional commission-based agent or broker has little of value to offer. They need an expert, a savvy and reliable advisor to whom they can delegate key aspects of their financial well-being. They need a fiduciary who sits on their side of the table and has a legal obligation to act in their best interests.

The National Association of Personal Financial Advisors is the best organization I know to find such an advisor in your area. Visit www.napfa.org to find a fiduciary advisor worth trusting.

from http://www.emarotta.com/article.php?ID=429

You Deserve a Fiduciary Standard of Care

2010-12-06T11:19:00.000-08:00

You Deserve a Fiduciary Standard of Care

(2010-12-06) by David John Marotta

Most investors are not aware of a critical division of professionals in the world of financial services. This distinction lies between fee-only fiduciaries who are free to act in your best interests and commission-based agents and brokers who are required to act in the best interest of the companies that employ them. Even when people have some inkling about the differences, several important misconceptions continue about both the nature of the problem and an adequate solution.

Fiduciaries are bound by a code of ethics. They take oaths and their conduct is based on applying ethical principles. The Certified Financial Planner (CFP) Board of Standards has a published code of ethics that includes seven principles including integrity and fairness. It states, "Integrity demands honesty and candor which must not be subordinated to personal gain and advantage." And "Fairness is treating others in the same fashion that you would want to be treated."

The National Association of Personal Financial Advisors (NAPFA) offers a similar guideline in their fiduciary oath. Advisors promise to "exercise his/her best efforts to act in good faith and in the best interests of the client." These ethical guidelines imply standards of conduct far above what may be legal. They demand what is right. They require the highest obligation of care, good faith, trust and candor.

In contrast, the nonfiduciary world is based on rules rather than on principles and ethics. If an agent has followed the correct procedures, has the paperwork in order and has client signatures on the correct disclaimer forms, no rules have been broken. The behavior can be called unethical, but it is not illegal. Thus additional rules do not necessarily translate into exemplary conduct.

This is one reason why investment advisors objected to a proposal to give the Financial Industry Regulatory Authority (FINRA) oversight of fiduciary advisors. FINRA governs nonfiduciaries such as agents and brokers by means of rule-based conduct. Such an approach is diametrically opposed to being a fiduciary.

NAPFA strongly advocates a fiduciary standard. As part of the oath that NAPFA advisors sign, they pledge they will "not receive a fee or other compensation from another party based on the referral of a client or the client's business."

NAPFA also promoted the idea of a "fee-only" advisor. Their ad campaigns were largely successful at raising public awareness about the difference between advisors who are fee only and those whose compensation is based on commissions. But as if purposefully to confuse consumers, many agents and brokers introduced and started using the category "fee based," which means charging a fee as well as continuing to collect commissions.

The distinction should be easy to understand. You would object strongly if you had to ask your doctor to act in your best interests. You would never think physicians would hesitate to sign the Hippocratic Oath. Neither would you consult a pharmaceutical salesperson instead of your doctor. But the rules-based world of most financial services is like relying on a printout of a drug's potential side effects instead of on a medical degree and the responsibility to treat patients ethically.

Fee-only fiduciaries act as agents for investors. They have permission to manage your investments and make decisions in your best interests. They are held to the highest standard of fiduciary care.

In contrast, an agent or broker is an employee. They work for the mutual fund company or the life insurance company or the brokerage firm and are empowered to act only on behalf of the company they represent. So they are not allowed to make decisions without your consent. They can suggest services and products for you to purchase, but they must have your explicit permission to complete the sale. They are held to a lower standard called "suitability." They are permitted to sell you any product that is generally suitable for your class of investors.

According to FINRA, suitability means the agent or broker only must have "reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer." The more superficial the agent or broker's knowledge of the client, the better this works. The only items mentioned in FINRA's rules are the customer's financial status, tax status and investment objectives.

I've never seen a case of unsuitability or know what an unsuitable investment would look like. Selling 30-year bonds to a 90-year-old might be unsuitable. But age is not part of the information an agent or broker is supposed to elicit from a client.

The claim in any dispute will be that the salesperson explained everything and the client chose to purchase the product. All the disclosures are stated in the sales document you sign, so you have no excuse. You should have read the document. It's your mistake.

Salespeople are trained to get acquainted with their clients to make sales. They ask questions that begin, "Would you be willing to buy if . . ." and "Which of these choices would you prefer . . ." They are supposed to stop asking questions after the customer has agreed. Their lack of familiarity with a client's needs often results in substandard care.

The differences between these two worlds are seen most clearly in the decision-making process. Fiduciaries can't simply put your money into good investments. First they must understand as much as they can about you and your goals. They are required to have an undivided loyalty to help you meet those goals. Taking the time to understand your goals is simply part of their ethos.

Next, they have to strategize how to best meet those goals. They must be analytical and purposeful. They need to clearly articulate an investment strategy, which should include writing a customized investment policy statement for each client before investing. It means practicing comprehensive wealth management. It means striving to be proactive in areas of wealth management for which there will never be products and commissions.

One of the many questions we pose to potential clients is if they have made any investment mistakes in the past. A sad but common response is that they believed a friend, family member or fellow parishioner had their best interests at heart. One way of explaining the difference between a fiduciary and an agent or broker is that you do not have a legal right to trust that an agent or broker is acting in your best interests. They have no such legal responsibility. It really is your mistake.

Here are three questions you should ask any prospective financial advisor: Do you have a legal obligation to act in my best interests? Do you receive any compensation other than the fee I pay you? Do you offer comprehensive wealth management?

Don't accept anything less than a fiduciary standard of care. Your family's finances and welfare may depend on the real differences between what is in your best interests and what is just potentially suitable. You deserve better than satisfactory compliance to the rules. You deserve a firm that offers proactive comprehensive wealth management.

Don Trone, founder and executive director of the Foundation for Fiduciary Studies, describes the difference this way: "A fiduciary relationship requires a consultative, rather than sales, approach to working with the client. The question moves from, 'Is this a good investment?' to 'Is this a good investment for me (the client)?' Such a relationship, by necessity, has to be based on a much deeper understanding of the goals and objectives of the client."

Heed this important distinction between advisers who earn their living from the commissions of products and services they sell and those whose only payment comes from the client. One owes loyalty solely to serving the client. The other's interests are divided at best. NAPFA has promoted this distinction with their slogan "Truly Comprehensive, Strictly Fee-Only" and the "Fee Only" logo. Visit www.napfa.org to find an advisor in your area.

from http://www.emarotta.com/article.php?ID=428

Cyber Monday 2010

2010-11-29T08:25:00.000-08:00

Cyber Monday 2010

(2010-11-29) by David John Marotta

The retail industry has tagged today "Cyber Monday." Like the term "Black Friday," which describes the Friday after Thanksgiving, Cyber Monday refers to the Monday three days later. Just as Black Friday is considered the biggest traditional shopping day, Cyber Monday is supposed to see a significant spike in online sales.

The description "Black Friday" has been around a long time and was named to mark the day that retailers become profitable, moving on their balance sheets from the red into the black.

The National Retail Federation's Shop.org division made up the idea of Cyber Monday to generate media coverage for their online retailers. The scheme worked. The mainstream media picked up the story and reported Cyber Monday as if the name had been around for years. Retailers are often trying to create the next big thing by generating media hype and exaggerating existing trends.

Not that the trend wasn't there. The first year it was claimed that traffic was up 35% on retail websites. Since then, sales on Cyber Monday appear to be diminishing. According to comScore, a marketing research company, in 2006 online spending jumped 25%. But in 2007 it was up 21%, 2008 up 15% and last year only up 5%.

Mondays historically have been the best shopping day of the week for Internet retailers. Originally many Americans only had access to a high-speed Internet connection at work, so the Monday shopping frenzy was a wave of pent-up demand from the weekend. Now that we can shop on our smartphones waiting for our friends Thursday evening at the coffee shop, Mondays have lost their importance.

On the calendar, Cyber Monday isn't even in the top-ten online shopping days. Those occur between December 5 and 15. This year December 13 marks the start of the last week when procrastinators can still make their purchases and leave enough time for online retailers to ship the items. Shoppers keep pushing the day back as they have grown more confident their packages will arrive before Christmas. So, at least for a few more days, you can hit the snooze button on your Christmas shopping.

Cyber Monday was a brilliant idea to promote online shopping and jump-start the online shopping season by a few weeks from its actual peak. Having found that a longer holiday season translates into bigger profits, retailers like to extend every holiday season. The holiday season is now a four-month blast of marketing genius. Thanksgivoween and Hanukwansmas extend clear through the entire month of Septoctnocember.

Online sales and services will continue to compete with brick-and-mortar companies. The best firms offer both, leveraging what they have physically and multiplying it manifold through their online presence. Some sales and services can't be accomplished effectively online, but many can. A business in Charlottesville, Virginia, has lower overhead and expenses than its online competition in California or New York. And sometimes a small city like Charlottesville can only support certain businesses if they can sell to the world.

Toys and video games show the most increase in online sales during the holiday season, followed by consumer electronics, computer hardware and software, jewelry, gourmet food, furniture and home decor.

According to Experian Hitwise, an online competitive intelligence service, the top-ten retail websites are Amazon.com, Wal-Mart, Target, JC Penney, QVC.com, Sears, Macy's, BestBuy, Overstock.com and Toys 'R' Us. Amazon's share was by far the largest with 14% of the sales traffic.

You might think these Internet retailers would be great investment opportunities, and you would be right. Collectively they have been averaging 4.90% over the S&P 500 for the year ending October 31, 2010. Half have underperformed the market with the other half overperforming. But two of them have wildly overperformed, pulling the average up. Amazon.com appreciated 39.1% and Macy's appreciated 36.1% since last year. The worst performers were Overstock.com, down 13.8% and JC Penney down 12.7%.

Take advantage of their low prices, and moderate your spending this holiday season. Stay on track with your savings. Don't let the hype of the retail holiday season jeopardize the progress you've made toward reaching your financial goals.

from http://www.emarotta.com/article.php?ID=427

Should You 'Sell in May and Stay Away'? Revisited

2010-11-22T08:19:00.000-08:00

Should You 'Sell in May and Stay Away'? Revisited

(2010-11-22) by David John Marotta

Last May I wrote a column asking if you should "sell in May and stay away." I suggested it would be better simply to "rebalance in May and call it a day." Looking backward it wasn't bad advice. Looking forward, I suggest saving and investing significantly between now and next May.

The original saying began in Britain as "Sell in May and go away, stay away till St. Leger Day." The final horse race of the British equivalent of the Triple Crown takes place on St. Leger Day, in the second week of September. In the United States, September and October historically are considered dangerous months to invest. In addition, St. Leger Day is unknown here. So the date of reentering the markets has been pushed to the end of October, causing the rule to also be known as the "Halloween indicator."

Since 1950, September has been the only month averaging a negative return, due to severe losses in 1974 and 2002. This year September was the best month for the S&P 500, which appreciated 8.92%.

October, contrary to popular opinion, is a typical month with an average return of +0.82%, despite the 21.5% loss in 1987 (Black Friday) and the 16.8% loss in 2008. This year October had a nice gain of 3.8% for the S&P 500.

The traditional wisdom suggests selling on May 1. But since 1950, May has performed well with an average return of 0.80%. This year May was terrible, dropping 7.98% on the S&P 500. Selling on May 1 would have avoided the worst month for the year.

My own study shows that since 1950, May through October has contributed a 3.16% return; November through April has contributed 8.44% for an annual return of 11.60%. If you sell in May, you have to be able to get a six-month Treasury return better than 3.16%. Considering trading costs and capital gains taxes, that's difficult.

This year the S&P 500 only appreciated 0.74% in May through October, underperforming the historical averages. You could not have done better in Treasury bills or money market. You would only have earned 0.06%.

Although the S&P 500 did not do very well over the summer months, other indexes performed better. After dropping 11.37% in May, the MSCI EAFE Foreign Index regained all that and more, ending the period up 5.97%. Despite the meltdown of the euro in May, foreign investments have still outperformed U.S. stocks. Emerging markets have performed even better. Between May and October they were up 10.15%.

Although the return of the S&P 500 has been disappointing, a more broadly diversified portfolio fared better. Year to date through the end of October, the S&P 500 is up 7.84%, the MSCI EAFE Foreign Index is up 5.12% and the MSCI Emerging Markets Index is up 14.24%. A diversified portfolio of half U.S. stock, a third foreign and a sixth emerging markets averaged 8.00% for the year on a buy-and-hold strategy. But rebalancing once at the end of May boosted your return to a whopping 13.94%. The reason is that these three indexes have not moved in sync this year. The S&P 500 did the best for the first four months, appreciating 7.05%. Even in May the S&P 500 did not drop as much as foreign investments. Rebalancings at the end of May meant selling out of the U.S. stock, which was only down 1.50%, and buying into the EAFE Index, which was down 12.08%, and the Emerging Market Index, which was down 5.36%. These foreign indexes rebounded heartily. Asset allocation means always having something to complain about. This past summer it was the S&P 500. Meanwhile your rebalanced portfolio allocated more to foreign stocks.

When the markets are volatile, the bonus on account of rebalancing is greater. Rebalancing every month does not produce the greatest bonus. Rather the greatest bonus is produced by rebalancing just after large movements, such as the foreign meltdown in May. And then the bonus is only gained by diehard contrarians eager to buy what everyone else is selling.

Rebalancing is not a magic bullet. Rebalancing at the beginning of May was 0.45% worse than the 8.00% buy-and-hold strategy, but rebalancing at the end of May was 5.94% better. On average, rebalancing boosts returns by about 1.6% annually.

If a seasonal ebb and flow to market returns really exists, it may be as simple as observing when cash is tight and not flowing into the markets. In February bills from the holidays arrive, and many people are gathering cash to pay their taxes. Summer vacations strap many families, resulting in high expenses in September. Only after bills are paid can money flow back into the markets.

In contrast, December sees large profit-sharing bonuses put into the markets, and pension funds are often invested in January. In the early spring, people are funding their retirement accounts.

Whatever the reasoning, this is the season to be invested. Returns from November through April are historically more than twice those of May through October.

The lessons are clear. Save. Invest. And rebalance regularly.

from http://www.emarotta.com/article.php?ID=426

Coping with College Expenses (2010-11-15)

2010-11-15T06:07:00.000-08:00

Coping with College Expenses

(2010-11-15) by Matthew Illian & David John Marotta

An old axiom states that nothing is certain except death and taxes. But now we have to add the skyrocketing costs of a college education.

According to the most recent College Board Annual Survey of Colleges, the sticker price of a college education keeps rising, faster than the price of groceries, health care and almost everything else in the basket of goods used to determine the Consumer Price Index (CPI). In the last 10 years, in-state tuition and fees at public four-year colleges increased 5.6% annually on top of a CPI growth of 2%. The average estimated total expenses for a current public in-state four-year student are an astounding $81,356.

If you were blessed with the birth of a child recently, you will need to save $430 monthly to pay for in-state college tuition, fees, room and board. Double this rate to cover the full costs at the average private institution. And this doesn't even include money for a cell phone, pizza, room decor or other stuff that college students deem "necessities."

Most students don't pay full price for college. In 2009-10, undergraduate students received an average of $12,894 in financial aid, split almost equally between loans and grants. Grants are the most attractive because students are not saddled with a repayment plan after college. Federal grants make up 26% of total aid. Institutional college grants account for 17%, state grants for 6% and private and employer grants (scholarships) for 4%.

Students are graduating with larger debt loads than they were 10 years ago. Public four-year college borrowers graduate with an average of $19,800 in debt; their nonprofit private college counterparts graduate owing $26,100. This private college debt is 17% more than it was 10 years earlier, even after accounting for inflation. In addition, a growing percentage of all college debt is unsubsidized and begins accruing interest immediately.

Our experience suggests not all college degrees are created equal. In May, the New York Times profiled a recent graduate of New York University who majored in women's and religious studies. With more than $100,000 in debt, she is struggling to repay her loans, meet her living expenses and regretting her selection of an expensive private school.

Students will have to make more astute education choices. Today's global marketplace places more value on hard skills such as engineering, computer technology, teaching and finance. Technical degrees and certificate programs will become commonplace. A liberal arts education will likely diminish in popularity and become more focused at the elite institutions. More students are likely to begin their education at lower cost community colleges and complete a four-year degree at schools that specialize in their concentration.

Parents may feel overwhelmed about the amount they need to save for college. But college education is one of the two lifetime investments for which we approve borrowing money (the other is a home mortgage). Students should plan to graduate with a debt load no higher than half of what they can reasonably expect from their first year's salary. For example, those with a starting salary of $40,000 should keep their debt at or below $20,000. Thus graduates can dedicate 10% of their annual salary to school debt and pay it off in five years.

New parents should immediately begin saving $430 a month for college. Alternatively, a onetime $50,000 investment should cover tuition, fees, room and board at an in-state college 18 years from now.

Giving a child the gift of a college education and a debt-free start to adulthood is one choice. Other parents believe their children should participate in financing their college education and can apply the 50/50 savings approach. Parents commit to saving half of the money needed, and their children commit to the other half. Students participate by working hard in high school, applying for scholarships, taking summer jobs, seeking out work study opportunities and accepting reasonable loan levels.

The support of grandparents can help tremendously. The vast majority of the college accounts that we manage are owned and funded by grandparents. Instead of buying the latest gadgets for their grandchildren, they make annual contributions to a college savings account. If the grandparents own the account, it has the added advantage of not being included as a resource on the student's financial aid forms.

The 529 plans are still the most cost-efficient way to save for college expenses. If the grandparents are Virginia residents, they are entitled to a $4,000 state tax deduction, which saves them $230 each year per account. Or they could each open one account for their grandchild and double the savings. This money grows tax deferred and is tax free when withdrawn, akin to a Roth IRA. The 529 plans have the additional benefit of an upfront state tax deduction.

Virginia has the largest 529 plan in the country, perennially ranked in the top five across the country. VEST, the Virginia Education Savings Trust, is marketed directly to the public. Another plan, CollegeAmerica, is offered through financial advisors. It has different share classes, some of which have loads that make them unattractive. But no-load shares are available through fee-only financial advisors. CollegeAmerica allows advisors to create their own asset allocation mix from a few dozen different funds.

We do not recommend prepaid college tuition plans. At best, they match college inflation, and if used at an out-of-state institution, returns are based on money market rates, which are abysmally low right now.

The plethora of decisions can be intimidating. The nonprofit NAPFA Consumer Education Foundation is offering a helpful presentation titled "Advantages of College 529 Plans for You and Your Grandchildren" at the Charlottesville Senior Center at 1180 Pepsi Place on Thursday, November 18, from 5:30 to 6:30 p.m. with a question-and-answer session to follow. The talk is free and open to the public. Bring your questions!

from http://www.emarotta.com/article.php?ID=424

When Donating a Dollar Only Costs Five Cents (2010-11-08)

2010-11-08T06:07:00.000-08:00

When Donating a Dollar Only Costs Five Cents

(2010-11-08) by Beth Nedelisky & David John Marotta

According to a poll published last month by Fidelity Investments, Americans are likely to give the same amount or less to charity in 2010. But Virginians are fortunate to have a reason to donate 23 times more to charity this year.

Virginia offers tax credits in exchange for donations to nonprofit organizations serving the truly needy. More than 200 charities have been designated Neighborhood Assistance Programs (NAPs).

Donors to these approved charities are eligible to receive a Virginia tax credit for 40% of the value of their total contribution. Thus a gift of $1,000 to a NAP qualifies for a $400 Virginia tax credit. For some taxpayers, a donation to a NAP may yield total federal and state tax savings worth nearly 96 cents for every dollar they give away.

NAPs provide health care, education, housing, job training and food to the poorest people in our communities. Included in the list are large organizations such as the Virginia chapters of Habitat for Humanity, Boys & Girls Clubs, and The Salvation Army, as well as smaller ones like the Soho Center for Arts and Education.

To be eligible for the 40% Virginia credit, individuals must contribute a minimum of $500. A $500 gift to a NAP is eligible for a $200 Virginia tax credit. Donors may give cash or marketable securities. Gifts of merchandise, services or real estate are not eligible.

Remember that a tax credit is far more valuable than a deduction because it reduces your total tax bill dollar for dollar.

Businesses are also encouraged to donate. They can receive tax credits for professional services donated to an eligible charity as well as for real estate, materials, cash and stock donations. Businesses must donate $1,000 or more to be eligible for the 40% credit. They cannot receive more than $175,000 in tax credits per year.

The beauty of the Neighborhood Assistance Program is that it allows Virginians to give even more generously to help their communities. Virginians in the top federal tax bracket can donate $1,000 to a NAP and receive the equivalent of $957.50 in total federal and state tax savings. With such significant tax savings, people can give 10 or 20 times more than they had planned.

Let's assume Mr. Monopoly has a share of highly appreciated stock worth $1,000. Instead of selling the stock and paying the capital gains tax, he decides to give the stock directly to charity. By transferring the stock to a NAP, Mr. Monopoly avoids federal capital gains taxes of $150. He can take a deduction of $1,000 against his income, saving him $350 on his federal income taxes. Thus far his tax savings are $500, but they don't stop there. On his state return, Mr. Monopoly's gift yields savings of $57.50. Plus he received a $400 tax credit from the NAP. In all, Mr. Monopoly receives a total of $957.50 in tax savings. What began as a $1,000 stock gift actually cost him only $42.50.

The big tax savings allow donors to give more to charity. Instead of donating a stock worth $1,000, Mr. Monopoly could consider giving stock valued at $23,529, a donation worth more than 23 times his original gift. Assuming the stock had a low cost basis, the real personal cost of such a gift would be closer to his original gift amount of $1,000.

Even if you are in a lower federal tax bracket, your tax savings may still be significant. For many middle-class Virginians, the total tax savings generated through a gift to a NAP is likely to be worth 60% of the gift amount.

To receive tax credits for your donation, first contact the charitable organization and determine if it has any remaining tax credits to allocate to your gift. If tax credits are still available, fill out the Contribution Notification Form and send it to the organization. The charity will orchestrate the transfer of the tax credits to you. After submitting the paperwork, you will receive a tax credit certificate. At tax time, attach the certificate to your return.

The Department of Social Services and the Department of Education manage the transfer of the credits. Each qualifying charity is assigned a set number of credits annually. Your donation might not receive a credit if the charity has already given away its share. But if you receive more tax credits than you need this year, you can carry them forward to future years.

If you want to make charitable donations to a NAP, don't wait until the end of the year. Applying for the tax credits does require some extra effort. Your gift and the corresponding paperwork must be complete by year-end to receive the credit for 2010.

Links to the charities that qualify as NAPs are available on our website at www.emarotta.com/nap. Give generously this year to help Virginians in need. The dollars you donate will only cost you pennies.

As part of the nonprofit NAPFA Consumer Education Foundation, we are offering a presentation titled "Philanthropy Isn't Just for the Rich" at the Charlottesville Northside Library at 300 Albemarle Square on Thursday, November 10, from 7:00 to 8:00 p.m. with a question-and-answer session to follow. The talk is free and open to the public.

from http://www.emarotta.com/article.php?ID=423

Wealth Management Is In Your Control (2010-11-01)

2010-11-01T08:28:00.000-07:00

Wealth Management Is In Your Control

(2010-11-01) by David John Marotta

For many people, tomorrow's midterm elections feel like a political struggle over which they have very little control. It seems as though the outcome will determine the economics of the country for many years to come. Many feel similarly helpless to direct their own success. Nothing, however, could be further from the truth.

Even the smallest changes you make can have a significant impact on your future. Applying the principles of wealth management depends on exercising what psychologists call an "internal locus of control." In other words, through your own behavior and actions, you can take charge of your financial life.

Successful wealth management depends almost entirely on your choices, habits and hard work. It's based on the principle that very small changes can have a very large effect over either a 45-year working career or a 30-year retirement.

For example, pricey lattes have garnered a bad reputation in financial presentations. They have come to symbolize the fact that Americans should be saving and investing instead of spending mindlessly and spiraling ever deeper into debt. The budget-busting reputation of the caffeine habit is well deserved. My wife uses a cold brew Toddy coffee system. It produces a less bitter coffee concentrate that keeps fresh for a week. Mixed with milk, syrups or just plain water saves $4.75 per serving.

It may seem insignificant at first glance, but saving $4.75 is one of those small changes that have a large effect over time. If you save $4.75 early in your working career, you can invest it. Averaging an 11% return, that $4.75 will grow 100-fold to more than $475 between ages 20 and 65. In this case the effect of saving money when you are young removes the decimal and gains 100-fold.

Saving and investing the cost of a latte every day adds up to even more impressive numbers. Investing $4.75 every day between ages 20 and 65 grows to $475,000. That's a half a million dollar latte habit. Small daily efforts to save have large cumulative effects.

A slight increase in your investment return has a similarly large impact on your retirement savings.

In the financial world, a single percentage point is broken into hundredths of a percent. Each hundredth is called a "basis point." Basis points are abbreviated "bps," which is then shortened into the financial slang "bips." Some in the financial world will kill for 10 bps. That's how important they are.

For every additional 1% you earn over your working career, you can retire 7 years earlier or 50% richer. That is a huge effect for just 100 basis points. Every extra basis point of return over your working career allows you to retire 25 days earlier. The slightest rate of return can save you 142 hours of extra work.

Extra basis points can be found everywhere. The average portfolio's expense ratio can be reduced by about 80 basis points. Rebalancing your portfolio annually adds 160 basis points. Putting the right investments in the right investment vehicles is worth 100 basis points each year. Roth conversions, tax management and asset allocation are all worth hundreds of basis points.

In his book "Why Smart People Do Stupid Things with Money," financial advisor Bert Whitehead asks readers to identify factors that will have an impact on their financial future. In each case, the item under your control is the one that will have the greatest influence on your financial well-being. These variables include taxes, diversifying your investments across all asset classes, being a savvy shopper, how much you earn, the stability of your relationships, the house you purchase and the percentage of your income you allocate to permanent savings.

Small changes in each of these have exceptionally large effects on net worth. Saving for college in a 529 plan can provide half of a college education in appreciation. Foreign investments can boost your returns a few percent each year. Countries with the most economic freedom and emerging market countries can boost your returns a few more percent. The proper insurance coverage can save you from being wiped out financially. Tax Management can reduce the head wind of growth on your net worth. And estate planning can avoid the 55% estate tax on millions of dollars.

So by all means vote wisely in tomorrow's election. But learn to live wisely too so you can achieve your life goals. To find a fee-only advisor to help you define the changes you need to make in your personal finances and help support you in the process, visit the National Association of Personal Financial Advisors at www.napfa.org.

from http://www.emarotta.com/article.php?ID=422

Liberals Get Basic Economics Wrong (2010-10-25)

2010-10-25T08:06:00.000-07:00

Liberals Get Basic Economics Wrong

(2010-10-25) by David John Marotta

Economics 101 is based on facts, not opinions. In a study by Zogby International, liberals and progressives would fail the class. They answered incorrectly to more than half of the basic questions. No wonder a liberal administration working with a liberal legislature has turned an economic downturn into a more permanent malaise.

The survey asked participants their opinion on eight statements. They could respond "strongly agree," "somewhat agree," "somewhat disagree," "strongly disagree" or are "not sure." But these questions were not really a matter of opinion. They were objective statements. Any college student in an economics class could have easily labeled them as either true or false.

The survey counted any statement of agreement or disagreement as correct or incorrect. Then it only used the number of incorrect responses. An answer of "not sure" was considered correct. Given how badly people did on the survey, more liberals need to move from "strongly agreeing" with the wrong answer to the humility inherent in being a little more "not sure."

As a true-or-false test in Economics 101, none of the questions would raise an eyebrow. "Minimum wage laws raise unemployment" or "Mandatory licensing of professional services increases the prices of those services" are both statements straight from a textbook. But asked as a personal opinion, many people felt remarkably free to disagree with economic fact. Our website has a link to all eight questions and the original study. You can take the test yourself or quibble with the answer key.

The average number of wrong answers was 2.98 for a score of 63%. That's a poor result, given that answering "not sure" on each question would have received a perfect score.

Participants were asked to self-identify as progressive/very liberal, liberal, moderate, conservative, very conservative or libertarian. Self-described progressives fared the worst. They missed an average 5.26 questions for a score of 34%. Liberals' economic opinions were also more wrong than right, missing 4.69 for a score of 41%. Even moderates scored worse than average, getting 3.67 wrong for a score of 54%.

About half those surveyed described themselves as progressive, liberal or moderate. The other half said they were conservative, very conservative or libertarian. These last three groups scored much better. Conservatives received a score of 78%. Very conservatives did the best with a score of 84%. Libertarians scored 83%.

The variation within these two camps was even smaller than the divide between moderates and conservatives. It reflects the polarized mood of the country. But the most interesting conclusion is that the debate is not debatable. There really is a right answer. For the economically aware, these issues are no more subject to compromise than the laws of gravity for a team of aircraft designers.

Progressives and liberals find this certainty maddening. Often they respond with invective and name calling but little content or economic dialogue. This disconnect is that what appears to be opinion for many liberals and progressives is not a matter of debate. They are simply wrong.

The authors of the Zogby study suggested their own explanation. "We think that, for many respondents, economic understanding takes a vacation when economic enlightenment conflicts with establishment political sensibilities."

A few other interesting insights can be gleaned from this study.

First, moderates are economic liberals. Moderates scored worse than average on each of the eight questions. Their scores were closer to progressive/very liberal than they were to conservatives. Liberals marvel that conservatives are actively trying to cleanse the GOP of moderates. They assume moderates are halfway between liberals and conservatives. But really they lean heavily liberal in the way they get economics wrong.

Second, a college education did not correlate either positively or negatively with correct responses. Perhaps the school of getting a job is as good a teacher as the modern university. Or perhaps the utopian environment of academia negates the positive effects of what students learn in their few classes in economics. Studying economics in college has been shown to move students in a slightly more conservative/libertarian direction.

It is interesting to see what did correlate with higher economic enlightenment. Voters for Obama and Democrats got 4.6 incorrect (43%). McCain voters missed only 1.6 (80%). African Americans (47%) scored lower than whites (63%). Asians/Pacific Islanders (68%) scored higher. Hispanics (59%) scored slightly less than the average (63%). Women (55%) scored worse than men (68%).

Other correlations included not living in a large city (60%) but in the suburbs (66%). Protestants did better (70%) than those claiming no religious affiliation (50%). But evangelicals or fundamentalists scored even higher (75%). Atheist/realist/humanists did even better (76%), probably due to the wide influence of Ayn Rand, author of "Atlas Shrugged" and the founder of objectivism.

Having a family member in a union hurt (55%), but a relative in the armed forces helped (67%). Not surprisingly, being an investor (70%) helped even more than earning more than $100,000 (67%). But even better was being a NASCAR fan (70%) or a weekly shopper at Wal-Mart (72%).

Although all of these correlations are associated with self-identified political ideologies, they break many liberal biases of who understands economic principles correctly. This administration and this Congress have shown an amazing ignorance of economic principles. Much of the legislation passed by this Congress and signed by this president has been shown to do more harm than good.

For example, the Cash for Clunkers program was a complete waste of money. It moved the purchase of 360,000 cars ahead just seven months. And then it paid $3 billion to destroy perfectly good automobiles.

Extending unemployment benefits from 26 to 99 weeks also revealed a basic ignorance of economics. Paying people not to work for so long has increased and lengthened unemployment. It has kept the cost of hiring high. Many potential workers have opted to keep receiving benefits rather than take a full-time job paying slightly more than unemployment. While on the dole a mom can save money being a full-time homemaker. Or a couple could start a business and only report the income to the working spouse. To keep benefits going for nearly two years, people need only feign looking for a job.

The headwind of expiring, new and proposed taxes has created an economic environment that threatens to truncate productivity at $250,000 per year. This group earns a quarter of the reported income and pays half the federal tax. Thus changes in their marginal tax rate will have a significant effect.

The list of economic fallacies is as long as the list of liberal accomplishments. People currently in power talk about "fair share" and "spreading the wealth." But their policies impoverish everyone. Liberals simply get basic economic principles wrong. And when they legislate, they do more harm than good.

Obama declared last week that voters are turning conservative because they are scared and not thinking clearly. He claimed that facts, science and argument do not seem to be winning the day. The Zogby poll suggests exactly the opposite. Having been drunk on "hope and change," voters have now sobered up to the economic reality that socialism impoverishes us all.

Like physicians whose guiding tenet is "first do no harm," the first principle of good government should be a president of one political persuasion and a Congress of another. Thus a Democratic president and a Republican Congress will provide the best chances of creating deadlock that a libertarian can hope for next week.

from http://www.emarotta.com/article.php?ID=421

Seventy-Five Days Left for Tax Management (2010-10-18)

2010-10-18T10:06:00.000-07:00

Seventy-Five Days Left for Tax Management

(2010-10-18) by David John Marotta

In just 75 more days the largest dollar-denominated tax hike in U.S. history will take effect. If you have been focusing more on the political solution on Election Day than your personal finances, you have work to do before the end of the year.

As a percentage of Gross Domestic Product (GDP), the Revenue Acts of 1941 and 1942 during wartime win the award for the biggest tax increase. Although the upcoming tax increases are not the biggest as a percentage of GDP, they will have an enormous impact on everyone.

On January 1, 2011, the 2001 and 2003 Tax Relief expires. Those across-the-board tax cuts lowered rates for investors, small business owners and people at every level of income. Undoing those tax reductions raises nearly every federal income tax bracket. The 10% bracket and 0% capital gains tax bracket will disappear. The lowest tax bracket will return to 15%, the 25% bracket to 28%, 28% to 31%, 33% to 36%, and 35% to 39.6%.

The only people who won't experience a tax hike are the 47% of households that pay no federal income tax at all.

Itemized deductions and personal exemptions will again be phased out. The math is complicated, but for higher income taxpayers it equates to increasing the top marginal rate from 39.6% to 41.6%.

Married couples and parents will get tax increases. The marriage penalty returns on the first dollar of spousal income. These narrower brackets virtually chastise people for marrying instead of just living together. The standard deduction for couples will no longer be double the single deduction. The child tax credit will be cut 50% from $1,000 per child to $500. Dependent care and adoption tax credits will be cut.

Last year the inheritance tax was capped at 45% and excluded for estates up to $3.5 million. This year it was repealed entirely. So far four billionaires have died owing nothing. Next year we will see the inheritance tax return at 55% for everything over $1 million. So a family that wants to pass on an illiquid farm or business worth $3.5 million, who would have been taxed nothing in the last two years, will be taxed $1.4 million in 2011. Forcing family farms or businesses to liquidate simply to pay inheritance tax is unfair and shortsighted.

These new policies will cast a pall on saving and investing. The tax on capital gains rises from 15% to 20% next year and to 23.8% two years later. The double taxation on dividends rises from 15% to 39.6% next year and up to 43.4% in 2013.

The Patient Protection and Affordable Care Act (Obamacare) further limits how Americans can spend their own pre-tax health-care dollars. Nonprescription over-the-counter medicine will no longer be covered using your health savings account (HSA), flexible spending account (FSA) or health reimbursement account (HRA).

After 2012, a cap of $2,500 will be imposed on health FSAs. Families with staggering medical expenses because of children with special needs will bear the brunt of this new policy. Rather than being able to pay with pretax dollars, their excessive medical spending will be subject to their top marginal rate, and they will have to use whatever is left over.

These tax rates will impact negatively on the country's success. But you do have control on how you manage your personal taxes. With legislation coming and going and rates rising or unstable, you should consider ways to shelter wealth from the government.

You can implement two essential strategies between now and the end of the year. First, accelerate income into 2010 and delay deductions until 2011. Second, structure your finances to reduce taxable interest and dividends until we see more favorable legislation.

Of the many ways to accelerate income into 2010, the largest and most effective is a Roth conversion, which I've written about extensively. But now there is a new and equally great opportunity.

Just three weeks ago, the president signed a provision of the Small Business Jobs Act that allows participants in 401(k) plans to roll over a portion or all of their account balance into a Roth 401(k) plan offered by their employers. Plans must be amended by the end of the year.

The ability to convert your 401(k) to a Roth 401(k) can have a considerable effect on retirement benefits. The new provision is especially advantageous for people at the upper income levels. This opportunity deserves its own article, but the details are still being released. It is important to start the process of amending your plan now.

There are many ways to put off deductions until 2011. Business owners could delay significant purchases or expenses until January 2011. Bonuses could be paid in January 2011 instead of December 2010. Additional hiring could be deferred too.

End-of-year charitable giving can also be postponed until next year. Giving in January 2011 instead of December 2010 makes little difference to the charities involved but may save you significantly by doubling your charitable deduction next year when rates are higher.

This method also works any year for families who don't have a home mortgage and therefore can't itemize their deductions. Normally they are only allowed their standard deduction each year because without the addition of home mortgage interest, their charitable giving is slightly less than their standard deduction. But twice their annual charitable giving could add up to more than their standard deduction.

One year they should take the standard deduction, and then the next combine two years of charitable giving, allowing them to take more than the standard deduction. One year they give in January and December. The next year they give nothing. Their average annual giving is the same, but every other year they can take more than the standard deduction.

Get your asset allocation and investment mix structured to avoid capital gains and dividends in your taxable accounts. Change your taxable account so it uses mostly exchange-traded funds (ETFs). These investment vehicles are tax efficient and won't kick off capital gains until you decide to sell them. Invest them so you won't need to make changes for several years.

Put investments paying interest or dividends in traditional or Roth accounts, respectively. These accounts can defer or avoid taxes until a more favorable administration.

A dollar saved on taxes is better than a dollar earned. If you save a dollar on taxes, you can keep all 100 pennies. But if you earn a dollar, the government will tax it at your marginal rate. Going forward, tax management will be as significant as investment management in a comprehensive wealth management plan.

As part of the nonprofit NAPFA Consumer Education Foundation, we are offering a presentation titled "Tax Management: Pay Less, Keep More" at the Charlottesville Senior Center at 1180 Pepsi Place on Thursday, October 21, from 5:30 to 6:30 p.m. The talk is free and open to the public. Bring your questions!

from http://www.emarotta.com/article.php?ID=420

Getting the Most from Your 401(k) or 403(b) (2010-10-11)

2010-10-11T09:05:00.000-07:00

Getting the Most from Your 401(k) or 403(b)

(2010-10-11) by David John Marotta

For many workers, their retirement account is their largest asset. Having so much of your nest egg in one place means you should watch carefully how it is invested and monitor it regularly. Unfortunately, the average family spends more time planning their annual vacation.

The secret of making it financially used to be joining the right company, earning big bonuses and promotions and letting the firm provide for you in retirement through its defined benefit program. Your benefit in retirement was typically defined by your earnings over the course of your career. But as we all know, those days are over.

Today's average worker will have a dozen employers and work at each job for less than four years. Your career is now your responsibility, and so is your retirement plan.

Instead of a defined benefit program, most companies have defined contribution programs such as a 401(k) or a 403(b). In these you reap what you sow and the growth is subject to the weather of the markets. Nothing is defined.

A 401(k) and a 403(b) are virtually indistinguishable, named after the sections of the IRS tax code that define them. Businesses use a 401(k); schools and nonprofits use a 403(b). Most of the principles for evaluating and managing them are identical.

Some 403(b) plans and many 401(k) plans offer an employer match. Formulas vary, but the most common is to match the first 3% of your salary that you contribute at 100% and the next 2% of your salary at 50%. So if you put 5% of your salary into the company's plan, your employer will give you an additional 4% of your salary.

This is easily the fastest 80% return on your money. No one should pass up an employer match. If you are in the 25% tax bracket, each dollar you contribute will only cost you 75 cents. If you earn $50,000 and contribute $3,000, it will reduce your paycheck by only $2,250, and you may receive an employer match of $2,500. In other words, for $2,250 less in your paycheck, you can get $5,500 more in your retirement account.

Everyone should take advantage of matching plans and contribute at least the minimum amount required to receive a full match into the company plan. Unfortunately, many workers don't. In our example, between age 20 and age 72 at 6.5% return above inflation, the match would grow to more than a million dollars. Your first priority in saving should be to get the entire match.

The next step would be to fund your Roth account, make sure you are growing your taxable savings, and then return to contribute more to your company's retirement account. As we will see, there are good reasons not to contribute everything to your company plan.

The advantage of contributing to a Roth account is that your income (and therefore your tax rate) is probably increasing over the course of your working life. I've written extensively on the benefits of a Roth conversion this year, and that same reasoning makes funding a Roth IRA a good idea.

Many employers allow contributions to a 401(k) or 403(b) Roth. The more common pre-tax contributions are called a "traditional" 401(k) or 403(b) to distinguish them from Roth contributions. You should consider designating the portion you contribute toward a Roth. The portion your employer contributes, either matching or profit sharing, is always put into a traditional account.

If your income is significant, consider maximizing your contribution. The limit for 2010 is $16,500 a year. If you are older than 50, the limit rises to $22,000 to help you catch up on your retirement savings. In addition to your contributions and your employer match, companies sometimes pay bonuses or offer profit sharing as an additional pre-tax contribution. The total allowable contribution for 2010 is $49,000.

Given the amounts of money in retirement funds, it is important to invest them wisely. Every additional 0.01% return lets you retire nearly a month earlier. Thus fees matter, especially the expense ratio of your plan's fund choices. Most plans have funds laden with fees. Some share this revenue with plan sponsors, enticing them to pick more expensive funds to subsidize the costs of the plan or even make a profit.

But after you retire or leave that company's employment, you should almost always roll your 401(k) into an IRA for better investment choices and lower fees. Few plans have choices in every asset class and subsector.

When trying to craft an allocation when the choices are anemic, start by looking at your top-level asset allocation before selecting specific funds. For example, imagine you have decided on an asset allocation of 8% U.S. bonds, 7% foreign bonds, 34% U.S. stocks, 38% foreign stocks and 13% hard asset stocks. The next step is to look at the choices your plan offers.

You may find three U.S. bond funds and no foreign bond funds. One might be inflation protected, one might be intermediate-term treasuries and the other might be high-yield with a higher than normal expense ratio. You might combine the allocation to U.S. and foreign bonds and then split that amount between the first two bond funds, avoiding the third altogether.

There might be a dozen U.S. stock funds and only two foreign funds. The bulk of your asset allocation may fall in one or both of the foreign funds. And you may have to split the allocation to hard asset stocks between the U.S. and foreign choices. Your financial advisor can help you integrate your 401(k) selections with the rest of your portfolio. And as always, you want to evaluate each choice, looking closely at fees and expenses.

As part of the nonprofit NAPFA Consumer Education Foundation, we are offering a presentation titled "Get the Most Out of Your 401(k) or 403(b)" at the Charlottesville Northside Library at 300 Albemarle Square on Thursday, October 13, from 7:00 to 8:30 p.m. The talk is free and open to the public. We will be building ideal allocations and distributing sample portfolios for the University of Virginia's 403(b) options. Bring your plan's options and your questions!

from http://www.emarotta.com/article.php?ID=419

Umbrella Insurance Is Always the Right Answer (2010-10-04)

2010-10-04T08:04:00.000-07:00

Umbrella Insurance Is Always the Right Answer

(2010-10-04) by David John Marotta

If you have a personal umbrella insurance policy, congratulations. If you don't, you must not have a lot to lose. This important insurance can extend your liability coverage beyond your home and auto insurance by millions of dollars.

We live in a litigious society. Anyone can sue you for any reason. Those with money are targets simply because suing someone without assets is pointless.

Car and home insurance are required, but even $300,000 liability coverage won't protect you in the event of a catastrophe. Your teenage driver is at fault and young people in both cars are seriously injured. Your dog bites a child. You chaperon a class trip and are judged negligent when one of the students tragically dies. You cause an accident on the freeway and a truck filled with expensive cargo is involved. A neighbor slips on your steps and sues you. You write something reckless and unwarranted on the Internet about a certain financial columnist, and he sues you for slander and libel.

The good news is that these events are relatively unlikely. The bad news is that any one of them could result in a judgment well in excess of your liability limits. Your insurance company will just pay their $300,000 share and leave you to defend yourself in court for the remainder. If the judgment doesn't ruin your finances, the legal fees will.

If you receive a judgment for more than your net worth, you could lose everything. Your taxable investments and savings may be subject to the claim. The equity in your house may be at risk. A large judgment can also garnish 2.5% of your wages for the next 10 years and/or any current or future inheritance you receive. Any inheritance left in a generation-skipping trust offers protection against creditors and failed marriages, but many families leave an inheritance outright instead.

You don't want a single accident to wipe out your life savings. Umbrella insurance helps protect you against that possibility.

Personal umbrella insurance sits on top of your auto and homeowners insurance. To get umbrella coverage you must first increase your home and auto insurance liability coverage to where the umbrella policy begins, usually $300,000. Only then can you get additional coverage of $1 million or more. If you get sued for $1.3 million, you would first pay your $1,000 deductible. Your home or auto insurance would pay $299,000 to reach the $300,000 liability on the policy. The umbrella insurance would pay the final $1 million. You would pay nothing more than the initial $1,000.

Being sued for more than $300,000 is not a remote possibility. For example, with today's more effective air bags, surviving an auto accident even with serious injuries is much more likely. As a result, the cost of life insurance policies is decreasing while medical expenses continue to accelerate. We've made cars safer and more people survive the accident. They survive, and then they sue for damages.

Anyone with assets they don't want to lose will benefit from umbrella insurance. Many accidents are the fault of someone with no assets to lose. Unfortunately they can simply not pay or at worst declare bankruptcy and lose nothing. If you are saving and investing, you have something to lose. It isn't clear at what level of assets you should get protective umbrella coverage, but financial pundit Dave Ramsey recommends it for families who have more than $200,000. It certainly isn't just for the ultra rich.

Consider buying more than $1 million in coverage. Getting the same amount of coverage as you have assets won't protect the assets you have. For example, if you have $1 million in assets and you purchase $1 million of coverage, you will lose all of your savings in a $2 million judgment. Thus you need to have enough coverage to satisfy the worst judgment you might receive. Coverage of $2 to $4 million will suffice for most of today's lawsuits.

I am usually not an advocate of insurance products. Umbrella insurance is the exception. It is designed to cover very unlikely but very costly events, exactly what insurance is supposed to do, at a reasonable price. In review courses for the certified financial planner (CFP) exam, prospective advisors are told, "Umbrella insurance is always the right answer."

About 12% of homeowners purchase umbrella insurance. For the wealthy, that number grows to about 50%. The tragedy is that half of wealthy homeowners are betting their entire net worth against the odds of a freak accident, which unfortunately do happen.

Insurance companies will only write an umbrella policy if they also provide your home and auto insurance. They want to know if the underlying coverage gets cancelled for any reason, and they don't trust another insurance company to defend their interests.

Another excellent feature of an umbrella policy is that the insurance company is obligated to provide your legal defense, and the legal costs are paid in addition to your coverage.

The first million dollars of coverage usually costs the most. A typical annual premium might be $150. Subsequent costs are about 65% of the first million for each subsequent million. So $2 million of coverage would cost about $248, and $4 million would cost $443.

Premium costs vary and are subject to a host of issues. When you apply for an umbrella policy, your answers to a number of questions may raise your rates or even disqualify you. Own a Rottweiler or a have been recently convicted of reckless driving and you may not be able to get umbrella coverage. If you serve on a board, you may not be able to get coverage for more than the board's coverage. And if you have a driver younger than age 25 or have a very poor driving record, coverage may cost a $100 more per million. Even if you don't plan on getting umbrella insurance, you might want to apply just so you know what behaviors may limit your likelihood of being sued.

Remember, personal umbrella liability insurance covers only nonbusiness activities. Umbrella policies are also available for businesses and well worth the money. Any umbrella insurance won't cover intentional acts or punitive damages.

For the cost of a splurge on a not particularly memorable restaurant meal, you can enjoy the protection of a $1 million umbrella policy. Insurance agents don't make much commission on an umbrella policy. So you have to call them. Just do it.

from http://www.emarotta.com/article.php?ID=418

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

2010-09-28T19:26:00.000-07:00

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)

2010-09-21T05:51:00.000-07:00

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)

2010-09-14T06:08:00.000-07:00

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)

2010-09-07T06:31:00.001-07:00

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

Gold May Drop If Political Winds Change (2010-08-30)

2010-08-31T08:06:00.003-07:00

Gold May Drop If Political Winds Change

(2010-08-30) by David John Marotta

Gold recently hit a high of over $1,250 an ounce. Gold advertisers and gold investment newsletters continue touting their wares as though gold only goes up in value. Commercials are promising cash for gold, and people who normally don't concern themselves with investments are asking if they should buy gold. But now may not be the best time to buy gold.

Gold tends to maintain its value. It doesn't go up; it doesn't go down. It just holds its purchasing power and keeps pace with inflation. On average it stays constant, but only on average. In the short term, gold fluctuates wildly, at times even more than the stock market.

In January 1980, gold reached its high of $850 an ounce on the expectation of rampant inflation. But such inflation did not follow the doomsday predictions of straight-line projections. In fact, gold prices reversed and began dropping as chairman of the Federal Reserve Paul Volcker took action to strengthen the dollar and broke the back of inflation.

Under a sounder monetary policy, gold continued to drop from $850 in 1980 all the way down to $260 in 2001. It lost 69% of its value over a 21-year period for a consistent annualized loss of 5.5%. It didn't return to $850 until 2008, 28 years later. You can't afford nearly three decades of no return while inflation eats away your buying power.

That $850 in 1980 had the same buying power as $2,249 in today's dollars. Gold trading at $850 an ounce then was like gold trading at $1,000 more than its current price. Those people who purchased gold in 1980 have lost over half their buying power during a 30-year investment.

Had they invested $850 in the S&P 500, their investment would have grown not merely to $1,250 but to $17,261. Which investment would you rather have chosen in 1980: gold that is up 47% while inflation has been up 166% or the S&P 500 that is up 1,931% and averaging 10.8% a year?

In his book "Stocks for the Long Run," Jeremy Siegel analyzes investments over the past 200 years. Gold typically just maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation it would be worth about a dollar today. Because of inflation, a dollar today would only have had the buying power of about 7 cents back then! However, the stock market, on average, has been appreciating about 6.5% above inflation.

Inflation has been running at about 4.5% and equities have been averaging 10.8% over the last 30 years. You need to exceed inflation to grow the purchasing power of your portfolio and fund a long and successful retirement. Holding gold may help you sleep well tonight, but you won't eat well 10 years from now.

Although gold generally holds its purchasing value, it can fluctuate wildly based on other factors. The price of gold generally rises with expectations of inflation or worries about economic or political security. The recent appreciation of gold stems from an expectation that prolific and wanton spending by the federal government will excessively devalue the dollar and run up deficits that will lead to a catastrophic financial meltdown as well as worries that Iranian president Ahmadinejad is determined to nuke Israel and America.

Perhaps such dire predictions are correct and we are headed to Armageddon. If so, gold should not be your first purchase. First you should stock a year's supply of food. Then buy a gun to protect it. Only after you've purchased plenty of seed corn should you think about buying gold. Even then I would think that gold isn't a liquid asset at the end of the world as we know it. At that point a loaf of bread will buy a bag of gold. If you want liquid assets in such a catastrophic situation, try buying cases of Jack Daniels. It is cheaper, keeps just as well and will fetch more in trading value.

Perhaps we are rushing toward the meltdown of society as we know it. But perhaps not.

As strongly as I believe in the foolishness of government-created solutions to solve government-created crises, I believe even more strongly in the fickleness of the American voter. Who would have thought a Republican would be elected to Ted Kennedy's Senate seat?

Perhaps the pendulum is swinging back and reckless governmental socialism and spending will be repudiated in the midterm elections. If that happens, all the dire expectations that worried individualists have priced into the gold market will evaporate along with some of the value of gold investments.

We don't recommend holding more than 3% to 5% of your net worth in gold coins. You don't need any Eagles or Krugerrands to reach your financial objectives. Hard asset stocks do better than simply buying the underlying commodities. Holding diversified foreign equities protects against government monetary folly and would have protected even the citizens of Zimbabwe. Emphasizing those countries with a sound monetary policy is even better.

Having said all that, holding a few gold coins has had its benefits historically.

Some of our clients are old enough to remember Franklin D. Roosevelt's Executive Order 6102 in 1933 that restricted gold ownership. Owning gold was illegal until the early 1970s when Richard Nixon abandoned the gold standard for our currency and Gerald Ford signed a bill that legalized private ownership of gold.

Having gold during World War II was the only way to get family members safely out of Nazi Germany using bribery. Owning gold coins can provide some flexibility in dark and uncertain political times.

Although holding a small number of gold coins won't jeopardize your financial objectives, be prepared for their value to decline if the world's debt, deficit, socialist tendencies and Armageddon start looking a little less bleak.

from http://www.emarotta.com/article.php?ID=412

Dodd-Frank Bill Concentrates Financial Power (2010-08-23)

2010-08-24T08:06:00.000-07:00

Dodd-Frank Bill Concentrates Financial Power

(2010-08-23) by David John Marotta

Congress recently passed the Dodd-Frank bill. At the signing, President Obama claimed, "Because of this law, the American people will never again be asked to foot the bill for Wall Street's mistakes. There will be no more tax-funded bailouts . . . period."

Washington excels at blame shifting. The financial crisis began and ended with the exercise of political privilege and power. Fannie Mae and Freddie Mac were given a lending environment superior to the private sector while the latter was forced to loosen lending requirements beyond reason. The blame for the financial meltdown belongs on federal regulators, not on a lack of regulation.

But beyond all this blame mongering is the assumption that the current legislation can bestow enough power in the hands of a few to steer the course of global finance for the better. As William F. Buckley, Jr. has often remarked, "Idealism is fine, but as it approaches reality, the costs become prohibitive."

The bill mostly just asks federal agencies to make sure that nothing bad happens in the future. It doesn't really tell them how to do that. But it does make it clear they will be held accountable. And they can't complain they didn't have the needed authority or clout. In the bill they are given a wide range of new and unchecked powers to do whatever it might take to make sure bad things don't happen.

Unfortunately, we now have to fear their exercise of these powers. Only if you swear by the genius of Caesar, trust in his altruism and believe in his divinity is this bill a cause for celebration.

For example, the bill creates a Financial Stability Oversight Council. The ten regulators in this group have the task of monitoring any systemwide risks in our financial system. They have also been given nearly unlimited power to address these risks by forcing financial firms to sell assets or close a portion of their business.

The utopian hubris of believing such a group will do more good than harm is unfounded by human history and experience. And the assumption that such a council will be untouched by self-interest is naive beyond belief.

In the chapter on politics in his book "The Blank Slate," Harvard psychologist Steven Pinker says, "We are all members of the same flawed species. Putting our moral vision into practice means imposing our will on others. The human lust for power and esteem, coupled with its vulnerability to self-deception and self-righteousness, makes that an invitation to a calamity, all the worse when that power is directed at a goal as quixotic as eradicating human self-interest."

Congressmen Christopher Dodd and Barney Frank themselves were given the simpler task of overseeing Fannie Mae and Freddie Mac. Their own self-deception and self-righteousness led them to defend and even praise Countrywide's reckless lending practices. In the meantime, they accepted more than $2 million in campaign donations from Countrywide, Fannie Mae and Freddie Mac.

The new bill is ripe for lobbying by special-interest groups. Almost all of the actual rule writing has been delegated to regulators. The legislation will be revised endlessly for decades, and all the power players with a stake in the game will be able through their contributions and lobbying efforts to leave their fingerprints on the rules.

Such concentrated power will be used to benefit one firm at the expense of another. The winners will be the most powerful financial firms, lobbyists and legislators. The losers will be smaller banks and financial firms, fee-only fiduciaries and consumers. Anyone who doesn't have millions of dollars at stake will not be a big enough stakeholder to bother gaming the system.

According to the Washington Post, "Some liberals have criticized the bill for failing to more aggressively alter the structure of Wall Street and for leaving so many critical decisions to federal regulators, who missed many of the warning signs before the crisis."

"'It's the dumbest argument I've ever heard,' Dodd countered. 'What do they expect me to write, a 100,000-page bill? This is far beyond the capacity, the expertise, the knowledge of a Congress to detail every new regulation,' he said."

Truer words could not have been spoken. Such work is also far beyond the agencies to which Congress has delegated the task. The bill is 2,319 pages long. It establishes 355 potential new agency rules. It mandates funding 47 studies. And it requires 74 different reports.

It will probably create more jobs than any of the bailouts efforts. But none of those hires will be working for consumers. Their number-one priority will be their personal reputation and power. Only tangentially will any of their interests align with yours.

None of this work will encourage competitiveness. No one will manufacture products for sale. These efforts will produce no real wealth. And hundreds of the potential new rules have nothing to do with financial stability.

The report has thousands of potential unintended and unanticipated consequences. For example, the Federal Reserve will now be authorized to limit the swipe fee that credit card companies charge merchants for debit card transactions. Such price controls have popular support. After all, who wants credit card companies to rake in high fees? But price controls are never good economics.

How will they decide what the limit should be? If limiting the fees to $6 is good, is limiting the fee to $3 even better? Why stop there? Why not limit the fee to $1? What are those fees for anyway?

Currently there isn't a limit on the fee because the fee can be a percentage of the total transaction amount. Part of the reasoning is that such a transaction may be fraudulent identity theft and the money transferred could be unrecoverable. Because the fee serves as insurance against this possibility, it is a percentage of the transaction. If the Fed limits the fee, such transactions could be eliminated as well. Alternatively, banks could simply charge the maximum and allow smaller transactions to subsidize the risks of larger transactions. None of this is good economics.

This is a consequence of price controls. Transactions that all parties would otherwise want to make become illegal. Either the price control is set too high and has no effect or it is set below the equilibrium and upsets the balance, making the service disappear altogether.

Maybe the genius of the Fed will set the swipe fee limit high enough so it will have no unintended consequences. But Fannie Mae and Freddie Mac should have been able to set lending requirements high enough to avoid the financial crisis in the first place. If politics did not allow something that simple, we certainly won't avoid mistakes with regulations as complex as this bill invites.

The Dodd-Frank bill can be likened to giving the government unlimited powers and asking them to eliminate evil. It sounds like a good idea in theory, but the task is impossible, and the means by which they will make the attempt is dangerous to life, liberty and the pursuit of happiness. Libertarians can't tell you exactly why the bill is a bad idea. No one can understand the complex interaction of our financial systems that well. And that is exactly why we know the bill will do more harm than good.

from http://www.emarotta.com/article.php?ID=411

Saving: The Most Fundamental Element of Wealth (2010-08-16)

2010-08-16T08:05:00.000-07:00

Saving: The Most Fundamental Element of Wealth

(2010-08-16) by David John Marotta

Everything in wealth management begins with savings. All wealth comes from producing more than you consume. Unfortunately, most Americans are better at consuming than producing.

Have you ever met people who always have enough money to do what they want? Their peace of mind and confidence is no accident. Nor is it luck. It comes by carefully planning their spending and savings. They deny themselves some desires now in order to enjoy financial security later.

The character Mr. Micawber from Charles Dickens's novel "David Copperfield" offered a kernel of wisdom learned the hard way, now popularly known as the Micawber principle. He said (numbers updated), "Annual income $50,000, annual expenditure $48,750, result happiness. Annual income $50,000, annual expenditure $51,250, result misery."

Surplus income is wealth. Deferred consumption is the textbook definition of wealth, which can be used as a capital investment to produce additional wealth. Although by itself money certainly does not guarantee happiness, wealth can enable us to accomplish many goals in life. Without such a surplus we experience Micawber's misery.

Mr. Micawber is memorable for trusting that "something would turn up" to solve his financial problems. Americans are perennial Micawbers. The savings rate in America is abysmally low, and those who do try to acquire wealth are chastised by a punitive tax code. Micawberism, in contrast, has been rewarded so much, it is considered patriotic to shop until you drop simply to boost the economy.

Unfortunately, economics doesn't really work that way.

Most families who become mired in credit card debt do so because they fail to plan for emergencies. These unexpected events swamp their cash flow, and they have to resort to plastic. But cars break down. Roofs leak. And children need braces. We recommend saving 10% of your take-home pay just to meet these unanticipated expenses.

Saving fuels the financial engine that makes the rest of wealth management possible. Whatever your life goals, saving is most likely required to achieve them.

Saving is the logical choice if you have upcoming major expenses. Some families need to save small amounts to meet modest needs. Others have elaborate and expensive plans that require more complicated strategies.

One of the most important purposes of saving is financial independence or retirement. There isn't a simple dollar amount that will be sufficient. What matters is that you have saved enough to support your lifestyle. Having $1 million at retirement doesn't help if your lifestyle requires $200,000 per year. Dying young is never a good retirement plan.

Saving too little or too late requires more extreme adjustments in savings or lifestyle later in life. Worrying about how to meet your financial objectives should not haunt you. You will know if you are on track only if you know what that track looks like and you adjust your course regularly as needed.

Saving is powerful, but it is only half the story. If you do not invest your savings, inflation will erode your purchasing power every year. In contrast, savings that are invested grow and appreciate.

You should know how much to save today to exceed the needs and priorities of tomorrow. At a 10% rate of return, your savings will double every seven years. So for every seven years you delay saving, you are cutting your ultimate lifestyle and net worth in half.

All of this wisdom about saving can be summed up by the suggestion to "Start saving now." Beginning early in life is certainly the most significant factor in building real wealth.

Saving a million dollars isn't so difficult. Investing just $16.20 a day at a 10% rate of return grows to $1 million in 30 years. This phenomenal rate of growth comes simply by having $16.20 more in income than spending each day. By saving $162 a day, you could accrue $10 million after 30 years.

The most successful way to save is to automate your saving plan. Make savings your default setting. Establish an automatic electronic funds transfer from your checking account to your investment account the day after each paycheck is deposited. You won't miss what you don't see.

Making these decisions explicitly is much better than failing to plan and then being forced to take whatever options are still available late in the game with little time left for course corrections.

Comprehensive wealth management comprises many different elements. But saving is the most fundamental. It is like hydrogen, the first and most basic element. By its energy the sun gives us light and warmth, making all life on earth possible. Harness the energy of saving and put it to use for your life goals.

Most families with significant investments are simply the millionaire next door. They live well below their means and save and invest the difference. They grow rich slowly and steadily. Wealth is what you save, not what you spend.

Take control of your savings today. It is the cornerstone of your wealth management plan.

from http://www.emarotta.com/article.php?ID=410

Second Quarter of 2010 in Review (2010-08-09)

2010-08-09T05:47:00.000-07:00

Second Quarter of 2010 in Review

(2010-08-09) by David John Marotta

The market fell to its lowest point this year on the last day of June, closing the quarter and the first half of 2010 with some significant losses. Short-term trends can signal or counter longer term trends. Distinguishing which is which can be difficult.

About 96% of market movements are noise. Even long-term trends are three steps forward and two steps back. That makes it challenging to distinguish short-term changes from long-term trends. Reviewing the market movements from last quarter is useful only to the extent that such distinctions can be made.

Aim to structure portfolio allocations for 3- to 5-year trends, not for monthly fluctuations. Some of the investments that will do well--if the dollar weakens or if we have inflation--are the same investments that did not make money this last quarter. Other investments that did better are part of longer term trends that should signal you to adjust your asset allocation.

Stocks fell during the second quarter of 2010 as government debt in Europe and malaise at home slowed hopes of an economic recovery anytime soon. Over the quarter, the S&P 500 was -11.43%; the EAFE foreign index, -13.97%, emerging markets, -8.37%; and the Goldman Sachs Natural Resources Index, -9.76%.

The EAFE foreign index was down 2.54% more than the S&P 500. The prospects of bailing out Greek budget deficits devalued the euro against the U.S. dollar. Much of the movement in foreign stocks was due to currency exchange. The euro dropped 11% over the second quarter from $1.35 US to $1.20. As a result, the dollar strengthened, but we don't expect this trend to continue.

Bill Gross, cofounder of the Pacific Investment Management Company (PIMCO) and the country's most prominent bond expert, recently evaluated countries based on their total public sector debt as a percentage of gross domestic product (GDP) as well as their annual deficit, which is making matters worse. Gross singled out seven foreign nations that are heaping significant deficits on their mountain of debt and called them "The Ring of Fire." These countries comprise significant percentages of the EAFE foreign index: Japan 22%, United Kingdom 21%, France 10%, Spain 4%, Italy 3% and Ireland and Greece 1%. In total, 61% of the EAFE index is invested in the ring-of-fire countries.

But Gross included an eighth country in the ring of fire: the United States. He also warned, "Once a country's public debt exceeds 90% of GDP, its economic growth rate slows by 1%." Gross is probably underestimating the drag that public debt puts on economic growth. Rising public debt in the United States has been at the expense of economic freedom.

For the first time in the Heritage Foundation's Index of Economic Freedom, the United States was moved from the list of "free" countries to the second tier of "mostly free" countries. Investors seeking to avoid the European malaise by not investing in foreign stocks will find themselves 100% in the eighth ring-of-fire country, the United States. The phrase "American level of growth" used to describe something significantly higher than a "European level of growth." Now the distinction may have been removed.

This may be a unique time in investment history. Tilting toward mostly foreign but specific countries with low debt and deficit and high economic freedom may produce superior investment returns.

Countries that still rank as free according to the Heritage Foundation include Hong Kong, Singapore, Australia, Switzerland and Canada. These five countries already have an average five-year return of 8.04% versus the S&P 500's five-year return of -0.79%. Economic freedom is significant both to investors and to the welfare of their citizens. Debt and deficit also matter.

Going forward, you should continue to emphasize foreign developed countries with lower debt and deficits as well as the emerging market economies.

The 2010 World Economic Database of the International Monetary Fund (IMF) reports that while the United States and most other developed nations are experiencing increasing budget deficits, a select group of countries have been able to run a surplus. Norway (+9.67%), Switzerland (+1.37%) and Hong Kong (+.81%) are three such examples of fiscal health. Norway is blessed with an abundance of natural resources that make it the world's fifth largest exporter of oil and gas. Soaring public debt in the 1990s prompted Swiss voters to approve a constitutional amendment requiring revenue and expenses to balance over an entire economic cycle. Hong Kong's government has been a beacon of fiscal prudence as evidenced by its number-one ranking in the Heritage Foundation's index for 15 consecutive years. We believe that on average, businesses run within these fiscally responsible economies will outperform companies in countries with high debt or government intervention.

According to the IMF, emerging and developing economies will experience 6.6% GDP annual growth during the next two years while the advanced economies will only experience 2.5%. Perhaps "Emerging market level of growth" has replaced America as the land of opportunity. The emerging market index has averaged 12.73% over the last five years versus the -0.79% return of the S&P 500.

Average investors have nearly all of their assets in U.S. large-cap stocks and U.S. bonds. This represents one and a half of the six asset classes we recommend. We believe that adding any of the other asset classes may both boost returns and decrease volatility.

Regarding U.S. bonds, municipal bonds (or "munis") are becoming more popular. We do not recommend this strategy. Although a tax tsunami is coming at the end of this year, trying to avoid taxes by investing in muni bonds has its own pitfalls. With municipal debt rising, the risk of credit downgrades and insolvency threatens these investments.

Municipal revenue tends to trail economic recoveries by the year it takes for higher income and property taxes to be assessed and collected. Aid to municipalities from the $787 billion stimulus package is starting to wind down. Some municipalities are looking at deficits requiring tremendous reductions in spending. Warren Buffett, whose Berkshire Hathaway Inc. has been paring down its municipal bond portfolio, predicted a “terrible problem” for state and local government debt in his June 2 testimony to the U.S. Financial Crisis Inquiry Commission in New York.

Not all municipal debt is created equal. California's replacement of paychecks with IOUs is one example. Current-day financial stresses are highlighting the divide between those municipalities that have been spending beyond their means and those that have acted prudently. Reviewing your municipal portfolios is more important now than ever before.

Rebalancing after market declines on average provides a better return than a buy-and-hold strategy. Exiting the markets after declines is the worst of all possible strategies because it abandons a wise asset allocation simply because of short-term market fluctuations. But before rebalancing, make certain you have set a wise asset allocation in the first place.

from http://www.emarotta.com/article.php?ID=408

The Summer of Our Employment Discontent (2010-08-02)

2010-08-02T08:47:00.000-07:00

The Summer of Our Employment Discontent

(2010-08-02) by David John Marotta

The economy in the first half of 2010 has been disappointing, especially to investors and job seekers. High unemployment, market drops and less-than-stellar hopes for the future regarding taxes and regulation have all added to the general displeasure with our market environment. Now economists are generally predicting "more of the same" for the rest of 2010 at least. Evidently hope of a quick recovery was overly optimistic.

According to the Bureau of Labor and Statistics, the unemployment rate fell from a high of 10.1% last October to 9.5% in June. The decrease is hardly good news. More than 650,000 people are no longer counted as "unemployed" only because they are assumed to have given up even trying to look for work. The Bureau of Labor and Statistics U-6, a more comprehensive measure of employment underutilization, is currently at a seasonally adjusted 16.5%. Even this number excludes "part-time for noneconomic reasons." A survey by "Investor's Business Daily" suggests the number of people desiring more employment may be as high as 24%.

What little job growth is included in the statistics is mostly artificial stimulation from the government. Over a half million people were hired into temporary jobs as U.S. Census workers. As these temporary workers are let go, employment numbers are expected to remain sluggish through the remainder of the summer.

About 8 million jobs have been lost in the private sector since the start of the recession. About 2.7 million of those have been lost since the passage of the recovery act. But we need to add more than 100,000 jobs a month just to keep pace with population growth.

This worrisome shift from private sector jobs to public sector jobs has been measurable. In December 2007, 44.6% of personal income came from private sector jobs. By the first quarter of 2010, however, this number had decreased to 41.9%. Income from government programs rose from 14.2% to 17.9%. If every worker were paid the same, then for every 1,000 workers in America, 27 lost their job in the private sector and 37 of them were hired to work for the government. The remaining workers in the private sector paid an extra 9.8% of personal income to shoulder their increased burden.

Government assistance has taken what might have been a simple recession and turned it into a more lingering malaise. First we spent trillions bailing out corporations that should have just been allowed to fail. It would have looked worse, but it would not have really been worse. Banks would have failed, but the smaller bailout of those banks would have been less expensive and left the financial sector in the hands of those companies that practiced responsibility.

Then we tried simultaneously to juice the economy by spending like a drunken sailor and collect more revenue by raising taxes on sailors. Programs popularly described as "shovel ready," "homebuyer credit" and "cash for clunkers" wasted what could have been spent relieving the private sector from the coming tax tsunami. This reveille of utopia culminated in the health-care reform bill. It removed any limits on the increasing costs of health care other than government inefficiencies and rationing. It also laid the financial burden for those burgeoning costs squarely on the back of small business owners and investors by increasing taxes and capital gains on those with adjusted gross incomes (AGIs) of over $250,000.

Remember, although small business owners can have an AGI of $250,000, they only pocket take-home pay of $75,000 or less. They are heavily taxed on whatever they try to roll back into the business or when they expand their workforce. All this uncertainty is made even more dire with a tax time bomb set to explode in less than 200 days when the Bush tax cuts expire at the end of this year.

This bleak economic outlook sent the markets into a second dip for this recession. Over the second quarter the S&P 500 was down 11.43%. And from the peak on April 23 to the trough on the last day of the quarter, the S&P 500 was down 15.3%.

You might think all of this negative news would be a good reason to get out of the markets entirely. Many investors would agree and have done just that. But we believe that moving with the herd will underperform a more contrarian rebalancing strategy for four reasons.

First, all of this negative news has already been priced into the markets. The economy looks bleak, but it would have to look worse for the price to be driven lower. Second, many investors have already taken their money out of the markets. That is what drives the market lower. They can't drive the market any lower by staying out of the markets. Therefore a bottom often occurs when most investors are out of the markets. Whenever they move back in, they will drive stock prices higher.

Third, hundreds of millions of Americans work for publicly traded companies. Their very livelihood depends on them making those companies profitable for shareholders. I believe in the ingenuity of the American worker. I don't think all those American workers can be held back, not even by millions of new government hires.

And finally, I believe in the fickleness of American voters. They are willing to give new ideas about hope and change a chance. But they are also quick to reject those new ideas when they turn out to be nothing more than misguided and failed government intervention.

The Republicans proved they could spend like drunken sailors. Ultimately they were voted out of office. Now the Democrats have proven they can spend like drunken Republicans, and the electorate is taking note.

A full 59% of the electorate now describes themselves as "fiscally conservative and socially liberal." But only 26% would describe themselves as "libertarian." These changing winds will have their political effect in November. Even today more moderate Democrats are trying to break rank with Obama and Pelosi and extend the Bush tax cuts for the higher income tax brackets.

The economy will recover. Employment will rise. The ship of state will right itself. And even the American stock market will once again continue to advance and enrich its shareholders.

from http://www.emarotta.com/article.php?ID=407

Invest in All Six Asset Classes (2010-07-26)

2010-07-26T09:58:00.001-07:00

Invest in All Six Asset Classes

(2010-07-26) by David John Marotta

Investors are challenged these days to know where to put their money. Everyone wants to know which asset class will perform the best and help them meet their retirement goals.

We use six different asset classes: three for stability and three for appreciation. In the stable asset classes, you loan a company money to be paid back at a fixed rate of interest. Examples include money market, certificates of deposit (CDs) and bonds. These asset classes are like the iron rods that support a sailing ship. They don't make the ship go faster, but they do keep it from capsizing in a storm.

Investors approaching retirement should have at least five to seven years of their safe spending rate allocated to stability. For them, replenishing their allocation to stability when stocks are appreciating helps secure future years of spending.

In the appreciation asset classes, you own a piece of a company and share in its earnings. Examples include shares of individual companies or the mutual funds or exchange-traded funds that invest in equities.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). These decisions are the most critical in determining the overall behavior of your portfolio returns.

We divide the asset classes for stability into short money, U.S. bonds and foreign bonds.

Short money includes any fixed-income investment with a maturity date of two years or less, which includes money market accounts and many CDs. Short money investments are not paying a great rate of interest right now. But when interest rates rise, they will adjust quickly and be among the first investments to gain from the higher rates.

Many risk-averse investors put their money in a bank account or invest in CDs. But like any other investment, cash has its own set of risks. It is dangerous because the dollar can be devalued so the same number of dollars won't buy as much as they used to. There are good reasons to hold cash, but holding too much for too long makes it harder to grow your assets and can jeopardize your financial goals.

The second asset class, U.S. bonds, generally pays a higher interest rate the longer their duration and the worse their credit quality. But longer term bonds drop more in value when interest rates rise. And bonds whose credit rating drops lose value too because of the chance of default.

Putting money in stable instruments because you want to reduce risk only to invest in high-yield junk bonds is counterproductive. So is increasing the term of a bond when interest rates are very low. We recommend higher quality short- and intermediate-term bonds. Invest a portion of your assets in stable investments, and if you want a higher return, put the money into appreciating assets.

Foreign bonds are the third stable asset class. They can balance domestic currency values and interest rates with what's happening in the rest of the world. And they sometimes pay a higher interest rate. Foreign bonds also appreciate when the U.S. dollar is declining in value. Foreign bonds are subdivided into bonds in developed countries and bonds in the emerging markets. Like U.S. bonds, foreign bonds are categorized by quality and duration.

Appreciating assets are essential to your portfolio. They are the engine of your retirement savings. Even in retirement, you will need enough appreciation to keep up with inflation, pay the taxes and still have some real return left over.

We divide appreciation into U.S. stocks, foreign stocks and hard asset stocks. Most investors have primarily U.S. large-cap stocks, mimicking the S&P 500. They buy mostly large-cap growth stocks in the industry that did well last year with a high price-per-earnings (P/E) ratio. We don't recommend such portfolios.

On average, small cap outperforms large, and value outperforms growth. Although we recommend overweighting smaller companies with low P/E ratios, your portfolio should include a broad spectrum of stocks, including a generous helping of growth-oriented stocks. There may be times to overweight or underweight specific industries such as technology or health care.

The second appreciation asset class is foreign stocks. Diversification abroad can both boost returns and decrease volatility. Some people try to diversify internationally by investing in U.S. companies that gain a significant portion of their revenue from overseas. But these multinational companies still track fairly closely with other domestic companies, and they don't offer the same benefits as investing in foreign stocks.

Overweighting specific countries can be advantageous too. We use the Heritage Foundation's ratings to select countries that combine the greatest economic freedom with large investable markets. One yardstick of economic freedom favors countries with a low public debt and deficit and therefore a more stable monetary policy.

We recommend investing in the fastest growing countries. These emerging economies provide even greater diversification and returns. However, emerging markets are inherently volatile, so it is important to find the right balance and make adjustments as needed.

Finally, hard asset investments include companies that own and produce an underlying natural resource. These include oil, natural gas, precious and base metals, and resources like real estate, diamonds, coal, lumber and even water. We suggest diversifying hard asset stocks by resource type, geographic location of a company's reserves and company size.

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 in raw commodities or their volatility. But buying a gold mining company is a hard asset stock investment.

Over time, dollars lose their buying power, and the goods and services we buy cost more. Commodities generally maintain their buying power in dollar terms. But investing in hard asset stocks generally appreciates at a rate much higher than inflation.

Hard asset stocks have a distinct set of characteristics and are categorized separately. Their movement is generally less correlated with that of other asset classes. They have a unique (and positive) reaction to inflationary pressures. And at certain periods in the longer term economic cycle, including hard assets helps boost returns.

Many advisors don't have an asset class for natural resource stocks. They select one portion of the category instead, typically real estate, and make that the asset class. This can be a good idea. Real estate indexes have correlations as low as 0.49 against the S&P 500. We use real estate as a subclass within the natural resources category because at times it has a low correlation with energy and other commodity movements.

Natural resource stocks have an even lower correlation to U.S. bonds. Natural resources (commodities) often exhibit a negative correlation to fixed-income investments due to their inverse relationship to inflation. So their optimum allocation depends on both the amount designated to stocks and the amount designated to bonds.

Many U.S. investors crowd their assets into a combination of large-cap U.S. stocks and U.S. bonds. This allocation represents only one and a half of the six asset classes described here.

Asset allocation means always having something to complain about. Investors are continually looking for the safe investment. But inflation, sovereign debt, globalization and diminishing U.S. economic freedom make a clear choice difficult. Thus we advise a diversified portfolio that overweights certain subcategories.

If you have set such an asset allocation, what did poorly this past quarter may be poised to do better in the coming year. If your asset allocation is wrong, change it. But if it is right, don't abandon a brilliant allocation simply because of short-term returns.

Finally, rebalance regularly. Without rebalancing, those categories that do well may continue to grow as a percentage of your portfolio until they significantly underperform the markets. The ones that do the best often bubble and finally burst.

from http://www.emarotta.com/article.php?ID=406

Life Planning Part 3: Twenty-Four Hours to Go (2010-07-19)

2010-07-21T04:31:00.000-07:00

Life Planning Part 3: Twenty-Four Hours to Go (2010-07-19)

by David John Marotta

Life planning peels back the layers of our soul, seeking the best and highest calling for our existence. Seek out a financial advisor who understands what you truly value and structures your finances accordingly to best support your life's mission.

The idea is simple yet ingenious. Begin with the end in mind.

Let's take another look at George Kinder's well-known "three questions" that seek to uncover those goals and values most central in our lives. Number one is "If you had all the time or money you needed, what would you do?"

The response to this question typically provokes a long list of everything we want that money can buy. But with reflection, it goes deeper, stirring the longings of our heart.

The second question aims at these deeper desires. "What do you want to do or be so in the end you will feel that you've lived fully?"

These values most commonly revolve around three different realms. First, we yearn for meaningful connections with others starting with our immediate families and extending into our communities and the world at large. Second, we seek authentic spirituality, an odyssey that shapes and renews our very identity. And third, we revere beauty, creativity, nature and special locations. These three realms, righteousness, truth and beauty, are the areas where most of us find meaning and significance.

Kinder's third question can be encapsulated by the phrase "Twenty-four hours to go." It probes beyond our relationships and activities into the sum of our very existence. "Imagine that your doctor shocks you with the news that you only have 24 hours to live. Notice what feelings arise as you confront your very real mortality. Ask yourself: What did you miss? Who did you not get to be? What did you not get to do?"

This is a daunting question for many of us to even contemplate. Every day we get up preoccupied only with our to-do list, assuming we always have tomorrow. One day we won't have tomorrow. We all know intellectually that day will come, but we don't want to make our plans in light of it.

It is especially difficult to face our own mortality if we have not taken the time to deal openly and honestly with the issues in the first two questions. These three questions must be taken in order. We all want to perceive our lives as successful and significant. But justifying our existence is a daunting challenge.

Every day we face the dual desire to improve the world or to enjoy it. One requires judgment; the other, contentment. We struggle between the duty to do what we should and the passion to do what we love. The first structures our lives and the second strengthens and nurtures us. The consequences of these decisions are not always easy to understand because we must live our lives going forward. Kinder's third question gives us the opportunity to stop and look back, to assess how our decisions have changed the course of our life if our life were to end tomorrow.

How do you want to be remembered by your friends and family? Author Samuel Butler wrote, "Life is like playing a violin in public and learning the instrument as one goes on." Our faults are often embarrassingly obvious and humbling. First we have to learn to play the instrument. Then we need to learn to make our own music. At every moment we can confront our own mortality and reflect on the progress we have made.

Surveys have found that people regret what they didn't do more often than what they did. And when people express remorse about having done something wrong, it was usually what I call a "life buster"--one of those decisions that can greatly compromise your life.

Serious life regrets include marrying someone you knew wasn't right for you, getting hooked on drugs or breaking the law. You can recover from these, but you will lament the spiritual death and wasted opportunities along the way. A good rule of thumb is always to ask, "What's the worst that could happen?" If it might destroy your life, hesitancy is indeed a virtue.

Regrets about things we didn't do are more subtle. Our lives can change course dramatically and be filled with serendipity all because of some small decision on our part. How many times have we heard the story of how a happily married couple met, only to be surprised that it almost didn't happen? If the worst outcome of a decision is a little embarrassment, perhaps the chance is worth taking.

We each long to participate in something significant. And that requires foresight, planning and forgoing our momentary desires in order to work toward realizing our greater passions. The choices we make each day determine the ones we will have the opportunity to make in the future. Without those hesitant, often stumbling first steps, we can't complete the journey.

The Latin phrase "Audaces fortuna iuvat" translates as "Fortune favors the bold." We commonly use a milder version of it in our family: "You do not have because you do not ask." Often our hopes and dreams are unrealized because they are left unmentioned.

Voicing what we are passionate about can be scary. Beginning to act on our ideas can feel overwhelming. But courage isn't a lack of fear, it's action in spite of fear. And our fear may an indication that we are on the quest of our lives.

For entrepreneurs, overcoming fear is a regular occurrence. Many, perhaps even most, multimillionaires have at least one if not more failed businesses in their past. That's because only those willing to risk failure--and the lessons learned from it--have the grit to achieve success.

Entrepreneurship, or its equivalent, is a form of proactive living. You don't necessarily have to start a business, but you do have to begin the journey toward your life's goal. When you take ownership of your life, you can do what you think is best, go where you think you are called and be who you believe you should be. Life can have fewer compromises and therefore fewer regrets.

I asked Kinder why he championed his three questions among financial advisors. He answered, "Money is the facilitator of what is most meaningful for us in the world. When we understand this, everything about money becomes clear and falls into place. We don't hire a financial advisor just because they're a nice person, they show us interesting spreadsheets, and they seem pretty much on the ball. We hire them so that with their professional financial expertise they can best deliver our brilliance into the world. Without being crystal clear what our most profound goals are, we can't begin that process."

A violin resonates because of the laws of physics. But virtuosos have to feel the music in their souls. Only after we know what we are striving to do with our lives can we make financial choices that enable and reflect our own special music.

from http://www.emarotta.com/article.php?ID=403

Life Planning Part 2: Just a Few Years Left (2010-07-12)

2010-07-14T08:34:00.000-07:00

Life Planning Part 2: Just a Few Years Left

(2010-07-12) by David John Marotta

George Kinder, a member of the National Association of Personal Financial Advisors and a fee-only financial planner, founded the Kinder Institute of Life Planning. He helped popularize the concept of financial life planning, which begins with the idea that financial advisors should understand their clients' life purpose and structure their finances accordingly. In other words, they should begin with the end in mind. This is both obvious and genius.

Kinder is probably best known for his now famous "three questions" that seek to uncover those goals and values most central in our lives. Number one is "If you had all the time or money you needed, what would you do?"

The response to this question typically provokes a long list of all our desires that money can buy. But with reflection it goes deeper, stirring the longings of our heart. As C.S. Lewis wrote, "One of the dangers of having a lot of money is that you may be quite satisfied with the kinds of happiness money can give."

Our materialistic culture seduces us into believing happiness can be packaged as a commodity and taken home in a shopping bag. As a result, we spend money on goods and services that at best provide fleeting satisfaction and may jeopardize long-term goals that could have brought us real fulfillment.

We may be tempted to judge our well-being not by the quality of our lives but by how we compare with others. Today's borderline poor live as well as the upper middle class did a few decades ago. But they still feel deprived. As we become accustomed to a higher standard of living, luxury quickly loses its luster. We always want more. Kinder's first question gets all these desires out on the table, at least partially, so we can move past them.

Kinder's second question, which can be encapsulated by the phrase "Just a Few Years Left," probes those values that money can't buy. "Imagine that you visit your doctor, who tells you that you have only 5-10 years to live. You won’t ever feel sick, but you will have no notice of the moment of your death. What will you do in the time you have remaining? Will you change your life and how will you do it? (Note that this question does not assume unlimited funds.)"

Take the time to explore this question periodically. A personal five-year plan isn't the sign of an obsessive-compulsive personality disorder. Systematically moving toward our goals is simply living intentionally.

If you have young children, your answer may focus almost exclusively on them and include few, if any, of your own personal goals. Certainly parenthood is a consuming responsibility. But it is only for a season of our lives. And even during that time, parents can often integrate some of their own dreams.

Kinder unfolds all of these ideas in his book "The Seven Stages of Money Maturity: Understanding the Spirit and Value of Money in Your Life." Many of us hesitate to take this personal journey. I regularly get letters questioning what spirituality and values have to do with financial planning. I believe these detractors miss the whole point.

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. A few participants are disappointed that they have to wait until later for the spreadsheets and income projections. But most are glad to talk about why a complete retreat from the working world followed by 24/7 recreation and a shrinking social circle is an impoverished environment for our souls.

We shouldn't shortchange the process of wrestling with the meaning of our lives at any age. Deep down many of us probably know what would be a more satisfying life, but we are afraid to contemplate the implications. Change can be intimidating. The alternative, however, is to keep living a life that in our own eyes may seem unimportant.

Even without small children, significance stems heavily from family and other close relationships. Loving others demands risking and being willing to change and adapt in order to connect deeply. At the end of life, people often regret the risks they didn't take. For many of us, it takes something drastic, like a serious medical prognosis or a near accident, to push us out of our comfort zone.

Often it requires getting older to find the wisdom and the grace to accept people as they are. The virtues of forgiveness and forbearance are necessary to live harmoniously. Relationships can be messy, but they are generally worth the effort. And it helps to remember that what is most important is being the right person, not finding the right person. We can learn to accept people without necessarily approving of their choices.

Once our personal relationships are healthy, many of us want to connect with the outside world and give back to others. Even small efforts to help others can make a significant impact on our communities and change the course of people's lives.

A second realm where people find significance is authentic spirituality. This is more than simply being religious, which is often expressed through practicing a specific tradition. Authentic spirituality often involves the totality of our life in which we seek to have our very identity renewed and shaped.

Compartmentalizing spiritual considerations into a small subset of our lives lacks authenticity. We long for a more meaningful life. At times these issues demand our attention and contemplation. We can start by relying on our spiritual traditions, but outward practices can only take us so far. Authentic spirituality is an odyssey of discovery and personal growth such that the truths learned change the way we live each day.

The third sphere where people seek a deeper and richer life is in the arena of beauty. Many people enjoy exploring their creativity, perhaps through music, the visual arts, or personal writing.

For others this sense of beauty is found in a reverence for nature. Places in the world like the redwood forests of California have a magical quality. Or we may find a special connection with urban locales like Central Park or the back alleys of Venice.

These three realms, righteousness, truth and beauty, are the three areas where most people find meaning and significance. They categorize what is most important to many of us.

I asked George Kinder about people's life goals and he said, "Sometimes I wonder why it is that so many of us make foolish decisions around money. Even with good advisors at our side, it seems. And then I reflect that perhaps the reason is that we have never really figured out what money is and what it's about. We think it's about spreadsheets and bank balances and rates of return and stock markets and buying things and getting into debt. Or at least those are some of the categories that might come up for us.

"But money really is the great facilitator of what is most meaningful for us in the world. It's meant to help us put together a life that best expresses our own individual genius, our brilliance, our creativity, our compassion, our values, our integrity, our spirit, our mission in life, what is most important of all that we realize and become."

Some thoughtful responses to these life planning exercises can help us set goals that are both meaningful and deeply personal and help us truly value our lives. Take the time to reflect on what you would like to do or be to live life to its fullest. Next week we will move on to the third life planning exercise.

from http://www.emarotta.com/article.php?ID=402

Life Planning Part 1: Plenty of Money (2010-07-05)

2010-07-07T09:07:00.000-07:00

Life Planning Part 1: Plenty of Money

(2010-07-05) by David John Marotta

Thoughtful wealth management is more than just maximizing net worth. It also gives us the best chance of meeting our life goals. Wealth is only valuable because it helps us make a significant impact on our world. It doesn't give us meaning.

Life planning takes a holistic look at what you truly value. And for most people, their life is more important than their money. Only after exploring your life goals can you structure your finances to help you realize your dreams.

A fee-only fiduciary wealth manager sits on the clients' side of the table. With a deep understanding of clients' goals, the professional can manage their money just as the clients would if they had the same expertise.

We begin the process with a preliminary questionnaire that poses a series of easy questions to help us learn about a client's goals and values. We ask, "What charitable and/or professional organizations do you support? What interest/hobbies do you enjoy? What gets you out of bed in the morning? What would you like to be doing five years from now?"

This allows us to begin to know our clients at a deeper and more revealing level than what we learn from a tax return and net worth statement. It is difficult to write about life planning without sounding religious or moralistic, which is the point. Ultimately, our financial decisions are spiritually based. The process of financial planning pushes us to articulate which values we want to live by and motivates us to adjust our daily monetary decisions to fit those values.

Spiritually sensitive financial advisors, regardless of their specific perspective, ask astute questions that reveal these values. Christians, Zen Buddhists and many other perspectives share this common framework that spiritual concerns are critical. For example, George Kinder , author of " The Seven Stages of Money Maturity: Understanding the Spirit and Value of Money in Your Life," approaches life planning from such a perspective. He uses a series of three exercises to help people sort out when they might need to change direction. Each one is an experiment in which you ponder one potential scenario and imagine all the possible ways you might react.

The first one, called "Plenty of Money," starts with one of Kinder's famous "three questions":

"Imagine you are financially secure, that you have enough money to take care of your needs, now and in the future. How would you live your life? Would you change anything? Let yourself go. Don't hold back on your dreams. Describe a life that is completely and richly yours."

This scenario is playful and fun as well as revealing. I've seen several variations, such as "What would you do if you won the lottery?" or "What would you do if you had a million dollars that you couldn't spend on yourself?" But Kinder's format is probably the better one because it purposefully focuses not on the money but on your life's calling.

Like Eric Liddell in the film "Chariots of Fire," we are searching for meaning in our lives. He says, "I believe God made me for a purpose, but he also made me fast. And when I run I feel His pleasure." We are looking for a life so completely and richly ours that we feel God's pleasure. This is our area of genius. This is our calling.

This exercise may not result in a practical life change when you are done. But it will begin to uncover some of your inner longings that currently may be eluding you.

Another excellent way to explore this process is Barbara Sher's book " I Could Do Anything If I Only Knew What It Was: How to Discover What You Really Want and How to Get It." Subtitled "How to Discover What You Really Want and How to Get It," it offers practical ways to expand on Kinder's scenario and find your heart's desire.

You've probably heard the saying "Find a job you love and you will never work a day in your life." Studies show that deep joy comes from knowing exactly what you want and feeling like you are moving toward getting it.

Sher suggests the next time you are with a group of strangers, tell them the most offbeat idea you can think of. Say your dream is to raise Dalmatians in the Himalayas, but you have no contacts in Tibet.

People's interest perks up. They may even try to solve your problems. Some may react negatively, but most suggest ideas. But describe the same scenario to your family or friends, and they will try to save you from your folly. And that is one reason why we find it so difficult to dream long enough to determine what our dreams really are.

Another of my favorite exercises in the book comes after you create an ideal scenario. Sher then asks you to act on it for only an hour: Get the application. Find out about the job. Call some contacts. Make an appointment.

She says that planning is mostly science fiction, just a hopeful prediction. But following a plan gets us out into the world where something can happen. Anything that moves us toward what we want makes room for serendipitous events. It also forces us to confront any hidden resistance within us.

Finding our life's goals requires quiet times of thought and reflection over a long period to learn about ourselves and our place in the world. And often it takes experiences we can only have by trying a number of different endeavors.

All of this may sound too fuzzy or creative, but nothing is more important in the wealth management process. Balancing a family's financial goals and making financial choices according to those values is at the heart of comprehensive financial planning. Financial woes often come not from a lack of income, but from our failure to live according to our true values.

Take some time to imagine how you would live your life if you had plenty of money. Next week we will discuss the second life planning exercise.

from http://www.emarotta.com/article.php?ID=400

Virginia Land Preservation Tax Credits (2010-06-28)

2010-07-01T05:37:00.000-07:00

Virginia Land Preservation Tax Credits

(2010-06-28) by David John Marotta

A dollar saved on your taxes is more valuable than a taxable dollar you earn from your salary. The Virginia land preservation tax credit can reduce your state taxable income by 16%. For example, if you owe $3,000 of Virginia state tax, it will save you $480. If you owe $30,000, it will save you $4,800. Other states have similar programs, but the details vary.

Every Virginia taxpayer can profit from this technique. The process begins with landowners who donate a conservation easement against their land. In this legal document, owners of private property give up some of their development rights. Usually they donate them to a conservation nonprofit. Because development rights are valuable, their donation is tax deductible.

These donations preserve and encourage permanent open and undeveloped land while keeping the ownership of that land private. For those concerned that land lost is land lost forever, conservation easements are a way to reverse that trend. Land restricted by a conservation easement is preserved in perpetuity. In Virginia, currently 6% of the land not owned by the federal government is subject to permanent conservation easements.

Advocates suggest that conservation easements do permanently what taxation based on land use assessment tries to accomplish every year. That is, they keep open spaces, improving the quality of our air, water and food. To their way of thinking, tax incentives are better spent on land conservation easements than other more temporary methods of land preservation.

To encourage such preservation, the Virginia Land Conservation Incentives Act of 1999 offered strong tax incentives. It allowed a landowner to claim 40% of the value of the easement as tax credits. So if the easement was worth $1 million, the land owner received $400,000 in state tax credits.

Tax credits are much more valuable than tax deductions that only reduce the amount you are taxed on. For example, a dollar of deduction might only be worth 35 cents. In contrast, tax credits are a dollar-for-dollar reduction in your tax bill. And a refundable tax credit could mean the government will owe you money you never paid in the first place.

Land preservation tax credits are not refundable, however, which left some philanthropic families with thousands of dollars of unusable tax credits they could only roll forward for 10 years. So in 2002 the legislation was amended to allow the credits to be transferable.

Now generous donors could sell their $400,000 worth of credits to taxpayers at some negotiated discount. Willing taxpayers could either pay their $10,000 of Virginia state tax or buy credits to pay their tax at a discount. Donors are paid something for credits they can't use. And taxpayers get a discount on paying their taxes.

This scenario may sound too good to be true or even illegal. But Virginia budgets up to $100 million for qualified land preservation tax credits.

Advocates of smaller government argue that first the state reduces the value of the land it is taxing and then gives that value back in tax credits. All of these shenanigans further the goals of conservationists by burdening commercial land owners. Conservationists don't care about the lost revenue. They argue that Virginia spends the least on land conservation among the states and continue to push for a vastly increased budget to support these efforts.

We shouldn't moralize too much when engaging in tax management. If the tax code permits a huge deduction for brushing your teeth with your left hand while standing on one foot, it is still worth doing. The burden is light and the gain is great. Vote your conviction at the polls, but take the benefit.

In this case the benefit can be significant. In 2009, land preservation tax credits were sold at about a 16% discount. Each year this discount is subject to supply and demand. Sellers got about 73% of the value. Of the remaining 11%, 5% went to state transfer fees and 6% to the brokers who put the deals together.

Consider an example. If your income is $200,000 and your deductions are about $25,000, your taxable income of $175,000 means you owe Virginia $10,000. If you purchase credits at 84 cents on the dollar, you save $1,600. That's a significant savings for filling out a little paperwork.

Brokers do suggest you have at least a $2,000 tax liability before you decide to take advantage of these credits, which would save you $320. Obviously those with a $50,000 tax liability save a whopping $8,000 just for complying with the required clerical work.

The risks are small but do exist. Good brokers weed out questionable credits. They also ensure that sellers provide legal guarantees to protect buyers. In the worst case scenario, the credits are disallowed, the seller refunds your purchase of the credits and you have to pay the full tax you owed.

You must purchase the credits before the end of the year to use them to pay your tax in April. Each taxpayer can use up to $50,000 of credits per year, so a husband and wife could each buy their own and use $100,000. Unused credits can be carried forward for up to 10 years.

Purchasing credits in December at a 16% discount to pay a tax liability in April is an excellent short-term return. But it is even better when you consider that you can avoid paying any quarterly Virginia estimated tax payments throughout the year. Per state regulations, you will owe no tax because of the tax credits you have purchased.

Proactive certified public accountants or financial planners who review your finances and suggest ways to save thousands of dollars are worth their weight in tax credits. Ask your advisor about using this technique to save you money.

from http://www.emarotta.com/article.php?ID=397

Dorothy in Taxland: Tax Credits (2010-06-21)

2010-06-22T08:06:00.000-07:00

Dorothy in Taxland: Tax Credits

(2010-06-21) by David John Marotta

Tax credits are much more valuable than tax deductions. Deductions only reduce the amount you are taxed on. One dollar of deduction might only be worth 35 cents. In contrast, tax credits are a dollar-for-dollar reduction in your tax bill. And a refundable tax credit could mean the government will owe you money you never paid in the first place.

The final tax formula is "Total tax minus payments equals the amount you owe or have overpaid." The critical part of this formula is that payments include not only the money you have given the government but also any tax credits you are eligible to receive.

But most people fail to claim all their legal tax credits and miss opportunities to gain some real wealth redistribution.

For example, if college students have earned income, they can receive the Making Work Pay tax credit. It's a refundable tax credit worth 6.2% of earned income with a maximum of $400 per person. This credit is phased out for middle-income families but not for their children. They are eligible as long as their parents don't claim them as dependents.

Even if these students pay no tax, they will still receive a check from the IRS for $400. That's the beauty of a refundable tax credit. Students who file a tax return can take advantage of several other tax credits.

As a parent of a college student, you could receive a Hope tax credit. Usually this is a $1,800 credit for the first $2,400 spent on a college education during the first two years. But for the past two years it has been enhanced for students in the Midwestern disaster area to be $3,600 on the first $4,800 spent. If you have saved in a College 529 plan, you cannot receive this credit for money disbursed from the 529.

But if you spend $24,800 on the University of Chicago, for example, you can reimburse yourself $20,000 from the 529 and still receive the full $3,600 Hope tax credit for having spent $4,800 out of pocket. Spending $1,200 outside the 529 allows you to keep an extra $3,600 inside the plan.

Alternatively you can get the American Opportunity credit, which gives you up to $2,500 on the first $4,000 of educational expenses. It isn't limited to the first two years of college and is partially refundable. You can also take advantage of the Lifetime Learning credit and get $2,000 on the first $10,000 spent. Even part-time students who only took a single class are eligible.

This year many adult children of millionaires will receive an $8,000 First-Time Home Buyer tax credit. Many wealthy families will receive a $6,500 Move-Up/Repeat Home Buyer tax credit. These credits were available for couples with incomes under $225,000 who purchased homes priced at $800,000 or less. It's good to know we are using our tax credits to support the truly needy.

In many very rich families, everyone got a new home this year. Money is being given to each child to help him or her buy a home and make payments. In three years all the homes can be sold for a profit. In the meantime everyone gets an $8,000 refundable tax credit.

If you install a new air conditioner, windows, doors, roofing, furnace or water heater, you can also qualify for tax credits. The replacements have to be more energy efficient. Nearly everything new qualifies. Even those with enough discretionary income to make improvements without any governmental incentives can get a $1,500 tax credit.

According to the IRS regulations, nearly every window sold today will qualify as more energy efficient than the older windows being replaced. But the window companies have lobbied for taxpayers who can't afford to replace their windows to subsidize wealthier individuals who can. Nearly anything can be justified these days by calling it green.

The geothermal heat pump manufacturers must have had an especially adept lobbyist. Their merchandise isn't subject to the $1,500 cap and is worth 30% of the cost. So are solar energy systems or small wind energy systems.

There's even a tax credit for contributing to your retirement account. Couples earning less than $50,000 can get a tax credit up to $2,000. They can get a tax deduction for the contribution and still receive the credit. Even students can qualify if they are part time and not claimed as a dependent.

Probably the largest of all is the Earned Income tax credit. It is intended as the primary way to help the working poor, defined as a family of four with an income less than $45,295. The maximum credit is $5,028 with two children.

If you choose to take your children as dependents, you may also qualify for the child tax credit. It provides a $1,000 tax credit for each child as long as couples earn less than $110,000.

Finally, there is still a federal energy tax credit if you buy a hybrid electric vehicle. Incredibly, the IRS has ruled that even golf carts qualify under the rules of the $700 billion bank bailout. Every golf cart manufacturer has applied to become a licensed motor vehicle dealer and modified its carts to be street legal and plug into the wall. Getting a $5,900 tax credit on buying a golf cart can't possibly be what legislators intended.

Most of these tax credits are just a percentage of what you have to spend to qualify. Because the poor don't have much discretionary income, these tax credits do not help them at all. Mostly they subsidize the upper middle class and the businesses in specific industries who have lobbied to qualify.

I've personally taken advantage of nearly every tax credit available. In fact, this year each of my children got refundable credits giving them thousands of dollars more than they actually paid. Tax planning and management is increasingly a crucial part of wealth management. But it is terrible public policy. I think it is every citizen's civic duty to vote against the hands that try to bribe special interest groups with tax credits.

Hundreds of other federal tax credits and a host of state tax credits are available as well. Simplifying the tax code is the easiest way to reduce or eliminate loopholes and bring sanity back to the process.

As always, the tax code is as easy to understand as a flying monkey. Perhaps this is another reason why most people leave hundreds or even thousands of dollars of refundable tax credits unclaimed. This is especially true of the poor who don't have tax professionals to help them decipher and access the multiple forms required.

The moral failing belongs to voters and politicians who support nearly every proposed tax credit and then are surprised at the consequences. Until our country comes to its senses, tax management will remain a way to build and protect your family's hard-earned wealth.

from http://www.emarotta.com/article.php?ID=396

Dorothy in Taxland: Overview (2010-06-14)

2010-06-15T13:05:00.000-07:00

Dorothy in Taxland: Overview

(2010-06-14) by David John Marotta

Many people who use tax computation software don't understand the changing structure of the U.S. tax code. They fill in the blanks, click Compute and pay the tax. Then they forget about the torture until next year.

Into this dark forest of the tax code, we throw college students and recent graduates. It is almost a rite of passage, better likened to a fraternity hazing than a step into adulthood.

The byzantine rules and regulations of the tax code are carefully crafted to cover up just how much we pay each year. In other words, tax laws are obscure by design. While you are busy trying to translate word problems written in Taxglish, you don't realize the IRS is asking all the wrong questions. Like Dorothy in the field of poppies, you can't seem to stay awake long enough to realize the danger.

A professional tax expert can help you get the correct deductions. But he or she likely won't motivate you to keep the right records unless you understand the benefits for yourself.

The three basic ways to reduce your tax burden are above-the-line deductions, below-the-line deductions and credits. The line in this case is your adjusted gross income (AGI).

Each method is used in one of the four general formulas on the 1040 tax form.

The first formula is "Gross income minus above-the-line deductions equals your adjusted gross income (AGI)."

Above-the-line deductions are subtracted from your gross income to compute your AGI. Therefore, they reduce your AGI, which also lowers your taxable income.

Above-the-line deductions are more common if you are self-employed. But if you are not a small business owner, there are still above-the-line deductions you can take such as stock losses up to $3,000, IRA contributions, student loan interest, moving expenses, alimony and several other items.

Payments to your Health Savings Account (HSA) can also be deducted above the line. In 2010, the family limit is $6,150 in tax-free contributions. One of every 10 patients consumes 69% of health-care costs. The other nine would benefit from an HSA.

The second formula is "AGI minus deductions equals your taxable income."

Below-the-line deductions are more uncertain. Like many items in the tax code, whether they will reduce your taxes depends on many factors.

You can either itemize your deductions or you can take the standard deduction, whichever is greater. For 2010 the standard deduction is $5,700 if you are single and $11,400 if you are married. And whether you itemize or not, you can take additional personal exemptions of $3,650 each.

Home ownership is the most common way to boost your deductions above the standard deduction. The IRS allows home owners to deduct their interest payments each year. If your home mortgage is at 6% and your payments are mostly interest, most of your mortgage is tax deductible. If your marginal tax rate is near a third, the government is paying 2% of your interest, and you are only paying 4% of your interest. For most middle-class families that results in a large tax savings.

If home ownership alone doesn't make itemizing worthwhile, your state and local taxes (including personal property taxes) along with any charitable deductions may push you over the top. Alternatively, if you have high medical expenses that exceed 7.5% of your AGI, you can deduct them as well.

In the third formula, after looking up your taxable income, you compute your total tax. Two different methods are used, and the higher of the two must be paid.

The first method uses the traditional tax tables. The second uses the Alternative Minimum Tax (AMT).

The AMT method of computing tax owed undoes many of the deductions you took in previous steps and turns much of traditional tax planning upside down. Increasingly middle-class families are hit by the AMT, whereas upper-class families pay such a high tax rate already, they are unaffected.

The fourth and final formula is "Total tax minus payments equals the amount you owe or have overpaid."

The critical part of this formula is that payments include not only the money you have given the government but also any tax credits you are eligible to receive.

Deductions only reduce the amount you are taxed on. One dollar of deduction might only be worth 35 cents in tax savings. In contrast, tax credits are a dollar-for-dollar reduction in your tax bill. And some tax credits are refundable. That could mean the government ends up owing you money you never paid in the first place!

Thus tax credits are much more valuable than tax deductions. But most people fail to claim all their legal tax credits and miss opportunities to gain some real wealth redistribution.

Investment management is central to building wealth. But comprehensive wealth management includes tax management as well. A proactive CPA is another essential component of the team. CPAs do more than just fill out your taxes. They may charge a little more, but they can earn their fee multiple times over.

from http://www.emarotta.com/article.php?ID=395

Regular Adjustments Maximize Retirement Success (2010-06-07)

2010-06-10T06:16:00.001-07:00

Regular Adjustments Maximize Retirement Success

(2010-06-07) by David John Marotta

Retirement planning consists of a wild scatter plot of potential projections. Navigating successfully through possible outcomes requires regular corrections and adjustments.

Most retirement software runs hundreds of possible retirement scenarios, called a Monte Carlo analysis. Success is defined as achieving 80% or more of investment outcomes where blindly following your planned strategy means staying solvent until you die. Keeping an 80% success rate ensures that your average is much higher than depleting your portfolio. You are prepared to deplete the portfolio, but over half the time you will leave a significant legacy.

Although these projections are useful, they are seriously limited.

One software vendor includes wild stock returns, often called black swan events, that might swamp your portfolio. So the allocation recommendation given the best chance of success for long periods of time is an all-bond portfolio, exactly the opposite of what you would expect.

I pressed the software makers to explain why their program gave such a strange result. They had tried to simulate black swan events in the stock markets. But they admitted they hadn't included any unforeseen bond or inflation events.

They did not consider a possible excessive bond default. And they simply assumed constant straight-line inflation at whatever input was provided. Muni bonds may default en masse. In fact, the United States may go the way of Greece. Alternatively, hyperinflation may return. In any of these scenarios, the all-bond portfolio doesn't seem so attractive for long-term investing.

At age 65, retirement projections are like Lewis and Clark leaving St. Louis heading for the Pacific. They start out due west but know they will need to alter their route as they navigate the terrain. And they can also rely on their Native American interpreter and guide.

Straight-line projections don't work within Monte Carlo. And you can't anticipate every unexpected event. The best approach is to diversify your portfolio to reduce the risks associated with one type of investment and to make continual course corrections.

We recommend a safe withdrawal rate based on age. At age 65 that rate is 4.36%, assuming portfolios with sufficient appreciation and projections adjusted regularly.

Assume you have a million-dollar portfolio as you retire at age 65. Your safe withdrawal rate is 4.36%, or $43,600 for the first year. Inflation averages about 4.5%. A balanced portfolio might earn 5% over inflation, or 9.5% total. So in an average year you would spend $43,600. The remainder of your portfolio would gain $90,858 for an end value of $1,047,258.

Our safe spending rate at age 66 increases from 4.36% to 4.43%. If you'd only earned 3% over inflation, you would receive an approximately 4.5% cost-of-living increase at $45,562 per year. Because you earned 5% over inflation, your safe spending rate increases to $46,394 annually. The extra $832 a year is available because 80% of the time the average return for your portfolio is above our planning.

The market typically appreciates more than planned and you get an increase greater than inflation. But some years the market drops significantly. You then have to hold your spending constant, waiting for your portfolio to catch back up with average market returns.

Our minimal expectation is 3% over inflation. That is the average return of a bond portfolio. When inflation is running at 4.5%, a bond portfolio offers about a 7.5% return. Investing everything in bonds, however, is a poor idea. It gives your portfolio no average excess return to come back from bad bond markets or hyperinflation. With all bonds, your failure rate is 50% or more, too high for a safe retirement plan.

Adding stocks to your portfolio will boost your average return. If bonds earn on average 3% over inflation, stocks earn 6.5% over inflation (11% if inflation is 4.5%). Adding stocks provides an engine of appreciation over 30 years of retirement.

A million-dollar portfolio at age 65 with average returns from a 30-70 tilt toward bonds will produce $4.0 million in spending through age 100. But tilting 70-30 toward stocks will produce $6.1 million. The decision to tilt toward stocks produces over $2 million more lifestyle spending over 35 years.

Investing in fixed income gives you peace of mind. You know your lifestyle for the next few years will be relatively stable and not depend on the whims of an inherently volatile market. Investing in stocks is appropriate when your time horizon is at least five years or longer. Being overly fearful of the markets may jeopardize your retirement lifestyle.

To balance your asset allocation, we recommend keeping the next six years of spending in fixed-income investments and the remainder in stocks. You can keep five years of spending in fixed income if you are aggressive and seven years if you are conservative.

Now your retirement spending is relatively secure for the next six years. We suggest putting the remainder of your portfolio into more volatile stock investments to achieve a better long-term rate of return. Not only do you have a maximum safe withdrawal, you also have a suggested allocation to fixed income to balance the need for six years of stable spending with the need for appreciation to cover the seventh year and beyond.

Thus at age 65, 25% of your portfolio should be in fixed income. This gives you six years of safe spending. Your fixed income allocation could range from a more aggressive 20% to a more conservative 30%. Outside of this range gives you a smaller chance of maximizing your lifetime retirement spending.

Outside of this range you must reduce your withdrawal rate. If you reduce your spending, you can afford to allocate more to fixed income because you don't need the growth. You can also allocate more to appreciation because the investments are really being managed for the next generation. If the markets drop significantly, you won't need the money to meet your lifestyle needs.

Small adjustments in asset allocation and withdrawals provide the constant course corrections necessary to reach your goals. And these regular adjustments give your retirement plan the greatest chance of maximizing total retirement lifestyle spending and the smallest chance of depleting your assets prematurely.

from http://www.emarotta.com/article.php?ID=394

Spending Retirement Income Can Be Risky (2010-05-31)

2010-06-01T20:06:00.001-07:00

Spending Retirement Income Can Be Risky

(2010-05-31) by David John Marotta

Calculating safe spending rates in retirement is challenging. Everyone wants to be conservative and be sure they will have enough money. But understanding what numbers to use is not simple.

The most common request we get is for a back-of-the-napkin calculation of future yield, interest or income. People assume they can safely spend the income and thus refrain from touching the principal. But rather than being conservative, this strategy may actually lead people to spend too much.

Consider Michael and Jennifer Madison, a newly retired 65-year-old couple who want to play it safe. They have $1 million that they invest entirely in bonds paying 6%. They believe if they can live off the interest, they won't need any of the principal. Every year they spend $60,000, confident about their conservative choices. But after several years, they begin to feel strapped for cash. They have not provided for the inevitable increase in the cost of living. Too late they realize that inflation is eroding their buying power. The idea of leaving their principal intact is not working.

In just 10 years, the couple's $60,000 only has the purchasing power of $36,000. Their lifestyle has dwindled to 60% of what it used to be. With inflation averaging 4.5% over long periods of time, they need their principal to appreciate. Each year their dollars stay constant, they lose their buying power.

Additionally, although their bond portfolio was getting a 6% return when they started the process, bond yields fluctuate as much as stocks do. When the Madisons find themselves in a low-yield environment like today, they don't know what to do. Inflation has eaten the principal. The Fed has swallowed the yields.

Leaving the principal untouched is even more difficult to interpret when you consider the difference between stocks and bonds. If your investments are in bonds, your principal has no growth to help keep up with inflation. But the interest payment may be higher than you should be spending.

If your investments are in growth-oriented stocks, however, they may pay no dividend at all even if they double in value. Without a dividend it isn't clear what keeping the principal intact means. We don't distinguish between more value from income and more value from appreciation. In either case, spending all of your growth leaves nothing to keep up with inflation.

From an investment point of view, a stock that appreciates 6%, a stock that provides a 6% dividend and a bond that pays 6% interest are equal. Some companies provide a better return by reinvesting earnings in the business. For others it is better to distribute those earnings to shareholders. Attempting to live off the income and preserve the principal often leads people to create asset allocations that are all income and no appreciation. They mistakenly believe this is the best of all worlds. It seems like both overly conservative investing and overly conservative withdrawal rates, when in fact it is neither.

Because retirement may last more than 35 years, you need significant appreciation just to keep pace with rising costs. With inflation averaging 4.5%, spending at age 100 will be more than 4.5 times what it is at 65. So if you get no interest or appreciation on your portfolio, you can spend only a tiny fraction the first year. You will have to save 4.5 times the dollar amount to have the same lifestyle your final year.

Put another way, if Michael and Jennifer stuff their million dollars in the mattress, they will only be able to spend 1.16%, or $11,606, the first year. They must save the remainder for the $54,168 that same standard of living will cost if they live to 100.

Note that because no interest is paid in your mattress, even this ultraconservative 1.16% withdrawal rate is depleting the principal. And any higher withdrawal rate depends on some level of income or appreciation.

Also bear in mind that any specific asset allocation including an allocation entirely to U.S. Treasuries will produce fluctuating returns. Sometimes even bonds drop in value. Long-term government bonds lost 7.03% in 1994 and another 8.6% in 1999. Even short-term Treasuries lost 0.58% in 1994.

Given these shifting returns, the rate of return we assume for our projections is critical. Even if you are ultraconservative, put no money at risk and have a withdrawal rate of 1.16%, you may still run out of money. You may live to be 101 or older. And inflation may exceed 4.5%. There is always a chance of failure in the infinite combinations and permutations of returns, inflation and longevity.

For this reason, financial planning doesn't guarantee with 100% certainty that you can withdraw a certain amount of purchasing power for 35 years and not outlive your money. Instead, astute financial planning seeks an 80% chance and then relies on annual course corrections over the next 35 years to adjust your spending to cover the remaining 20%.

This is an excellent approach. First, keeping 80% of the wild scatterplot of returns exceeding your safe withdrawal needs means the average is much higher than you need. Most of the time, returns that fall in the bottom 20% are more than compensated by the 80% that do not. And because the average return is higher than you need, your portfolio will most often be able to make up for poor returns early in retirement.

Second, if 80% exceeds the needs of your safe withdrawal rate, it produces a lot of excess returns. So although you are planning to deplete the portfolio, 80% of the time you will leave a significant legacy. What you are trying to accomplish is your best chance at enjoying your preferred lifestyle. And your best chance of achieving it is aiming to deplete the portfolio in less than 20% of the wild scatterplot of returns.

This 80% success rate sounds more threatening than it actually is. In truth, it means you will be able to increase your spending rate by more than inflation 80% of the time. But 20% of the time, you will have to defer any spending rate increases by inflation until excess returns have helped your portfolio rebound. These annual adjustments allow a near 100% success rate by adjusting your standard of living by a small amount based on how your portfolio has actually performed.

At age 65 the safe withdrawal rates using this method are 4.36%, or about $43,600 for a million-dollar portfolio.

from http://www.emarotta.com/article.php?ID=393

Avoid the "Ring-of-Fire" Countries (2010-05-24)

2010-06-01T20:04:00.000-07:00

Avoid the "Ring-of-Fire" Countries

(2010-05-24) by David John Marotta

A few months ago Bill Gross, co-founder of PIMCO and the country's most prominent bond expert, wrote a provocative monthly newsletter. He evaluated countries based on their total public sector debt as a percentage of gross domestic product (GDP) as well as their annual deficit, which is making matters worse. Gross singled out those countries heaping significant deficits on their mountain of debt and called them "The Ring of Fire."

The eight countries he identified were Japan, Italy, Greece, France, the United States, the United Kingdom, Ireland and Spain. The International Monetary Fund (IMF) cautioned that rising government debt has replaced financial industry stress as the biggest threat to the global economy. Gross warned his readers to watch "the U.S. with its large deficits and exploding entitlements." We recommend that you reduce your investments in these countries.

Our own government spending spree was not necessary. A Heritage Foundation study concluded that the stimulus money spent by countries had a negative short-term correlation with that country's GDP. In other words, stimulus money may even have had a slight negative short-term effect as well as a stronger negative longer term effect.

The IMF study agreed, stating, "Longer-run solvency concerns could translate into short-term strains in funding markets as investors require higher yields to compensate for future risks." In other words, we've taken short-term financial illiquidity and turned it into a long-term government deficit, which in turn raises the cost of short-term liquidity.

If you've lost your job or are struggling to live within your budget, running up your credit card never helps. It may make you feel better momentarily, but it doesn't even really help your situation in the short term. Spending beyond your means only makes matters worse. And government spending is making everyone miserable.

A small amount of government spending is necessary for infrastructure, which appears to boost economic activity. Successfully funding the rule of law provides the economic freedom necessary for economic activity. The optimum amount of spending appears to be relatively small, perhaps about 18% of GDP.

In every economic analysis, greater government spending is associated with weaker economic growth. The Keynesian views of economic stimulus have been largely discredited, although its ideas continue to be misused politically to support massive government-spending programs.

Government intervention continues to do more harm than good. This past year it took a common recession and prolonged it into a more permanent malaise. GDP growth, which has historically averaged 6.5%, is liable to slow to a more European rate of 3 to 4%. Official unemployment numbers will lower but only as people drop out and are no longer counted. Real unemployment is likely to remain high for some time.

Lest you think these policies don't affect you, they do. Part of Greece's austerity measures include raising the retirement age 14 years. Lower U.S. stock returns could have the same impact on your ability to leave the workplace. For each 1% less in return over your working career, you will have to retire seven years later to achieve the same retirement lifestyle.

Countries obligated to impose austerity measures illustrate the natural consequences of spending money you don't have while taxing and regulating wealth creation. Politicians take the credit for enacting feel-good programs they can't pay for, and then they scapegoat private enterprise to cover their misguided thinking.

Reduce your investment in these countries. Put your money where the entrepreneurial spirit is rewarded and the welfare state is discouraged, not the other way around. We suggest lightening up on foreign investments that primarily just follow the MSCI EAFE index.

EAFE stands for Europe, Australasia and the Far East. It represents all the developed countries outside of the United States and Canada. This includes large investments in all seven of the non-U.S. ring-of-fire countries. The EAFE consists of 22% Japan, 21% United Kingdom, 10% France, 4% Spain, 3% Italy and 1% Ireland and Greece. In total, 61% of the EAFE index is invested in ring-of-fire countries.

But before you stop investing in foreign stocks altogether, remember that 100% of domestic stocks are invested in the eighth ring-of-fire country, the United States. And we need our own austerity measures. The total compensation package for federal workers in the United States is $108,476--a full 55% higher than workers in private industry whose total compensation amounts to only $69,928. Going forward may be one of the times when a strong tilt toward specific foreign countries may provide superior long-term returns.

Gross advises seeking return where "national debt levels are low, where reserves are high, and where trade surpluses promise to generate additional reserves for years to come." This suggests investing more in emerging markets such as Chile, China, India and Brazil.

It also includes emphasizing countries with economic freedom such as Hong Kong, Singapore, Australia, Switzerland and Canada. Or mostly free countries with lower debt such as Denmark, The Netherlands, Finland, Sweden, Austria, Germany or even Norway. These countries should outperform their debt-laden counterparts.

As Gross ended his newsletter, "Beware the ring of fire!"

from http://www.emarotta.com/article.php?ID=391

Should you invest IRA Funds in Real Estate? (2010-05-21)

2010-06-01T20:03:00.000-07:00

Should you invest IRA Funds in Real Estate?

(2010-05-21) by Matthew Illian

Q: I am looking for a way to get into the distressed real estate market. What do you know about using the money in my IRA or 401(k) money to invest in real estate?

Sincerely, Cash Poor and IRA Rich

Dear Cash Poor,

You have good financial instincts. Real estate could be a great investment right now, and we are currently increasing exposure to this sector. But the risks and accounting red tape when making direct investments using IRA or 401(k) money should be avoided.

Cashing out a traditional individual retirement account (IRA) or 401(k) will trigger a taxable distribution and usually an additional 10% early-withdrawal penalty for people younger than 59 1/2. I don’t recommend this approach because the penalty is high and the investment results unpredictable. One recent belief that I hope has been forever scorched from the American consciousness by the recent recession is the idea that real estate investments always increase in value.

Another ill-advised option would be to transfer your IRA to a self directed custodian that allows for real estate purchases. These transactions have been gaining popularity, but I believe most investors should avoid these complex techniques. You will likely lose the power of leverage because few banks lend money to an IRA. Additionally, you can’t deduct property taxes and you can’t use depreciation. When an IRA holds the property, an individual is not allowed to cover an expense--like buying paint or new granite countertops-- out of personal funds or it will likely be deemed a prohibited transaction in the eyes of the IRS and could cause your entire IRA to be taxed.

Many 401(k) plans allow you to take a loan of 50% of the vested account balance up to $50,000. Borrowing from your 401(k) is penalty free, unless you don’t pay the money back. Then the usual early withdrawal penalties apply. You are charged interest on the loan because your 401(k) is the bank, and the interest gets added to your account. Most plans also require you to repay the loan within five years and definitely before you change employers. I would suggest not tapping your 401(k) plan.

Don’t get me wrong. I believe this is a good time to invest a portion of your portfolio in real estate. In fact, after being out of the real estate markets for several years, our firm is now recommending a 4% allocation in diversified portfolios. If you don’t have the cash or financing available to purchase directly, consider investing your IRA or 401(k) money in a real estate investment trust (REIT). These investment pools are typically publicly traded and run by real estate investment professionals. You can invest directly in specific REITs or indirectly through diversified mutual funds and exchange-traded funds (ETFs). If you are looking for an easy recommendation for an investment vehicle, try the Vanguard REIT ETF (symbol is VNQ). The expense ratio is only 0.15%, and the effective yield is 3.5%. This is by far the simplest and most cost effective way to take advantage of this trend. If you do invest in real estate, remember it is a long-term investment, and like all such investments, you will have to give it time.

from http://www.emarotta.com/article.php?ID=392

Stop-Loss Orders Can Lose Money Quickly (2010-05-17)

2010-05-18T08:17:00.001-07:00

Stop-Loss Orders Can Lose Money Quickly

(2010-05-17) by David John Marotta

After investors and their advisors experienced the precipitous market drop during the fall of 2008, many people searched for ways to protect their assets. After a year-long review of possible ideas, I decided to stay the course and not change our investment strategy. Every technique I reviewed would have put such a drag on portfolios as to erase gains over the last 10 years.

Although the S&P 500 had a flat or down decade, even my simple gone-fishing portfolio had satisfying gains over that same time period. I write every year or so about how this diversified portfolio is doing. Although they aren't even the best funds to select today, they remain popular funds with low expense ratios.

The portfolio consists of 20% Vanguard Total Bond Index (VBMFX), 21% Vanguard 500 Index (VFINX), 10% Vanguard Small Cap Index (NAESX), 21% Vanguard Total International Stock (VGTSX), 10% Vanguard Emerging Market Index (VEIEX) and the final 18% in T. Rowe Price New Era Fund (PRNEX).

Through the end of April 2010, that portfolio has a 6.05% 10-year annual return versus 0.19% for the S&P 500 alone. Over 10 years, that's the difference between being up 79.93% and down 1.88%. Diversification over the last decade boosted returns significantly. It doesn't always safeguard you from market losses, but as I said, anything you do to protect yourself from losses can weigh down portfolio returns significantly.

My favorite quote last year was from former Fed chairman Paul Volcker: "You can't hedge the world." If you try too hard to avoid volatility, you will probably just dampen your returns and may still experience some other unexpected event (the so-called black swan), like the defaulting of municipal bonds you thought were secured.

One strategy we rejected as a hedge against a precipitous market drop is a technique called a stop-loss order. After purchasing a stock or exchange-traded fund (ETF), an investor can place an additional order with instructions on when to stop holding the security and sell it. Stop orders are triggered when the security reaches a specific price.

Sell limit orders are placed above the current market and execute when the security reaches that price. Sell stop orders are placed below the current market with the objective of limiting losses if the market value drops.

We recommend avoiding these types of orders for downside protection. Getting out of the markets at a 15% loss doesn't help you know when to get back in. Most investors who get out remain there until the markets rise well above the triggering values. Getting out is also the exact opposite of rebalancing. When the market drops, rebalancing your portfolio would mean selling bonds and investing more in the markets, not getting out of the market.

We think these are good reasons to avoid stop-loss orders, but many others disagreed. Thousands of investment advisors recommended this technique to their clients. Now it looks like this advice may have been the cause of the market plummet.

For example, take Vanguard Value ETF (VTV), which was trading at around $50 per share on May 6. Investors or advisors who wanted to protect their investment from a catastrophic drop in the markets may have wanted to sell if the markets dropped by 15%. This would mean placing a stop-loss order that would be triggered at $42.50.

Just because a market move sets off a stop-loss order doesn't mean the investor will get the trigger price. The trigger submits the sell order as a market order, meaning it gets whatever the next market price is. Under normal conditions this might mean the stock would be sold at most for a nickel below the trigger price (i.e., $42.45).

Unfortunately, May 6 wasn't normal conditions.

Possibly some large sale of Procter & Gamble caused a drop in the Dow. That may have triggered some automatic stop-loss orders in Dow index funds, which may then have caused other Dow stocks to drop in value.

The drop in Dow stocks could easily have triggered additional stop-loss orders. Each sell pushed stock values lower, triggering more stop-loss orders set at even lower levels. This cascade of stop-loss orders caused the May 6 free fall.

But it gets worse. The stock exchange has speed bumps in place to slow the market when it appears to be moving too fast. These curbs limited transactions from market makers at exactly the time when higher liquidity was needed. A market maker is a firm that stands ready to buy or sell a particular stock on a regular and continuous basis at a publicly quoted price. Market makers move that price gradually, which keeps the market orderly.

Without market makers, when there are more sellers than buyers, a stock has no price. Some of these market orders got picked up by exchanges linked to the New York Stock Exchange. Others got picked up by stub orders for a penny a share.

Between 2:40 pm and 3:00 pm, at some points no one knew what certain stocks or ETFs were worth. Consequently, the value of many ETFs hit virtual zero. Stop-loss orders for VTV set at $42.50 got executed for $0.10 a share. Then after every stop-loss order was finally triggered, the plunge came to a halt.

After the last of the stop-loss orders was cleared for pennies a share, the automatic selling stopped. At that point many institutional investors or their automated systems stepped in to bargain hunt and pick up shares for fractions of what they were worth. The market quickly rebounded, recovering most of its value in the next 20 minutes.

You can see this effect on Google finance, where it looks like the stock price for VTV bounces off zero that day at 2:52 pm. These trades were not an isolated event. Many stocks sold for just a penny per share. These trades show a market in free fall with a snowball of cascading stop orders and no market makers stepping in to set a reasonable price.

The statistics are already being cleaned up to erase this trading anomaly. Some sites still show the year low of these ETFs as $0.10 or even $0.00. But other sites now have the edited low of VTV as $18.58 or $19.32 that day.

After the close of trading on May 6 and numerous investor and advisor inquiries, the NASDAQ mandated canceling these clearly erroneous trades. But they insisted these were legitimate market orders executed in a reasonable manner and were not aberrations or mistakes in the system. In other words, you have been warned that the events of May 6 were a natural consequence of using stop-loss orders during a market free fall.

Thus the stop-loss order technique failed at the very moment it was supposed to save the average investor. It tried to sell in a free-falling market and only succeeded in dumping valuable stocks on a dime and for a dime. Even after adjustment, some investors lost 63% on a day where the stock market only closed down 3.62%. I doubt investors or financial advisors will be advocating the widespread use of stop-loss orders again in the near future.

But if they do, I suggest putting in a series of limit orders to buy stocks or ETFs at half their current value. If investors ever want to dump their shares for half their value, I'm more than willing to buy at that price.

Be a contrarian. Buy when people are selling. Especially when they have automated their panic with stop-loss orders.

from http://www.emarotta.com/article.php?ID=390

Now's Still the Time to Buy a House (2010-05-10)

2010-05-11T10:33:00.001-07:00

Now's Still the Time to Buy a House

(2010-05-10) by David John Marotta

Between 2005 and 2009 I annoyed local realtors by claiming that real estate values were headed lower. Then in a column in July 2009, I said it was the time to buy a house. And now in the spring of 2010, it is still the time to buy a house.

Early in 2005 my father George Marotta and I explained the coming subprime debacle and predicted "the bubble, if it is a bubble, could pop as late as 2006 or 2007." Our projection was accurate. Real estate continued to rise that year. But it was relatively flat in 2006, underperforming the markets that appreciated over 15%.

Two years later, I wrote, "Many homeowners with adjustable rate mortgages have seen their monthly payments increase 50%, due to the higher rates. With the sudden jump in monthly mortgage payments, many are finding they can no longer afford to stay in their homes. The rate of late payments and foreclosures has continued to rise, leaving many lenders on the brink of bankruptcy themselves."

Again, the prediction was accurate. In 2007 the Cohen & Steers Realty Majors Index turned negative, losing 18.03%. Residential real estate did even worse. Apartments suffered one of the largest declines, down 25.4%. In February 2008 in my column "For Now, Avoid Real Estate Investment Trusts," I warned again to stay out.

It wasn't until well after the financial implosion that I suggested to readers it was the time to buy a house. I said, "Nathan Rothschild offered the contrarian advice to 'Buy when there's blood in the streets and sell to the sound of trumpets.' It is time to consider buying residential real estate. The bottom is forming, although it may continue to do so through early 2011."

I believe that advice will also prove accurate. Comparing last month's statistics from the Charlottesville Area Association of Realtors, the median home price has dropped from $247,000 last July to $238,000, but the rate of decline has slowed. The average days on the market have risen from 125 to 153. And although the number of active listings is still high at 3,312, the number of houses actually selling has started to pick up.

Home prices are well below 2005 averages, and time on the market is well above the healthy market average of 90 days. Sellers have been slow to realize that their home isn't necessarily worth the appraised value or what they paid for it or even what they owe. Houses are simply worth whatever the market will bear, which is a lot less than it was at the peak of the market three years ago. National trends have followed a similar cycle.

Half the advisors at our firm have purchased real estate in the last year, and I'm personally still looking for investment opportunities. It isn't too late because the recession has been prolonged and the recovery delayed.

Investment real estate isn't for everyone. You shouldn't have more than a third of your net worth bound up in real estate. For many families the home they live in provides them with more than enough real estate exposure.

Also, you don't need to buy and manage individual properties to get an exposure to real estate. Publicly priced and traded real estate investment trusts (REITs) offer an easy way to get in and out of real estate for the average investor. In a favorable climate, up to 8% of your portfolio might be invested in REITs this way.

We got out of REITs entirely and are only looking to get back in recently. My father would always say, "Make half a mistake," which suggests putting perhaps 4% of your portfolio back in REITs now and waiting until early 2011 for the other half.

If you are looking for an easy recommendation for an investment vehicle, try the Vanguard REIT exchange-traded fund (symbol is VNQ). The expense ratio is only 0.15%, and the yield is 7.8%. This is by far the simplest way to take advantage of this trend.

Specific individual real estate holdings offer investors the opportunity to leverage their investments by holding a mortgage on the property. Lending requirements are very tight right now, so for investors who can still get credit, there is real opportunity.

Investors could invest $1 million in appreciating securities, or they could invest $700,000 in appreciating securities and put $300,000 down on a $1 million commercial real estate holding. Assuming normal conditions, the second arrangement will produce a better return. The danger is that you do not want to be highly leveraged in a falling real estate market. Borrowing the money you are investing amplifies the gains, but it also amplifies the losses.

I've heard a number of bleak predictions for the housing market recently. Everyone is expecting real estate to underperform the stock market for many years going forward. Maybe they are right.

With the $8,000 first-time homebuyer tax credit expiring, demand may shrink. Starting your search now may be the perfect time. And there will be another opportunity at the end of the summer when buyers shrink even further. But maybe they are wrong. By this time next year, I expect the markets to turn positive. And I think it is time to make half a mistake and invest a little back into real estate.

It was only a few years ago that everyone was boasting about how real estate was appreciating by 1% every month. They made us feel like fools to be out of the market. With only a handful of listings out there, we were told that even if a glut of houses came on the market it would take years to satisfy the demand. But markets can turn quickly. Now we are contrarians again, looking at the trends and trying to gauge if there will be a second precipitous drop before the bottom. I don't think so. I think that we are near the bottom and brighter days lie ahead.

In the meantime, there's still blood in the street. Don't miss this opportunity to look for a great real estate deal.

from http://www.emarotta.com/article.php?ID=389

Should You "Sell in May and Stay Away"? (2010-05-03)

2010-05-11T10:32:00.001-07:00

Should You "Sell in May and Stay Away"?

(2010-05-03) by David John Marotta

The old stock market adage "Sell in May and stay away" suggests you can avoid risk and increase return by getting out of the markets during the summer.

This advice appears this time of year whenever the markets have appreciated over the previous six months. Sometimes it's right, adding anecdotal evidence that you ignore the advice only at the risk of your equity.

But it's a slippery claim to evaluate and consequently a difficult trend to capitalize on. Let's begin by pinning down the exact days you would exit and then reenter the market.

The saying originated in Britain as "Sell in May and go away, stay away till St. Leger Day." The final horse race of the British equivalent of the Triple Crown takes place on St. Leger Day, in the second week of September. In the United States, September and October historically are considered dangerous months to invest. In addition, St. Leger Day is unknown here. So the date of reentering the markets has been pushed to the end of October, causing the rule to also be known as the "Halloween indicator."

Buying in mid-September or at the end of October is a significant choice. Since 1950, September has been the only month averaging a negative return. The S&P 500 has appreciated an average of 0.97% each month. But the September average is -0.37%, due to severe losses in 1974 and 2002.

October, contrary to popular opinion, is a typical month with an average return of +0.82%, despite the 21.5% loss in 1987 (Black Friday) and the 16.8% loss in 2008. Prior to two years ago, the average for October was 1.17, well above the 0.97% monthly average.

Mark Twain commented wryly on October, saying, "This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February."

For the purposes of our analysis, I will use October 31, Halloween, as the day we would buy back into the markets.

The date to sell stocks is equally challenging. The traditional wisdom suggests selling May 1. But since 1950, May has performed well with an average return of 0.80%.

The problem with the data is what time period you use to back-test it. My data are from 1950 through the end of last month. But when the saying first circulated, May was flat. Since 1987, however, May has done phenomenally well, averaging 2.11%. May's recent streak of luck has raised its average substantially.

Yale Hirsch popularized this approach of investing in his "Stock Trader's Almanac" starting in 1986. He found that investing in November through April produced better returns than May through October.

Mark Vakkur refined Hirsch's approach to cherry-pick the best months. He suggested alternating between being fully invested, half invested, and out of the markets entirely depending on the month. September has the worst returns, but February has the second worst.

Historical patterns can be correlated to an infinite number of future predictions. Others would suggest that price per earnings ratios or the yield spread between long- and short-term bonds are a better indicator of stock returns. To suggest that each month is a reliable indicator of future results requires more than past statistical anomalies. Even if those statistics are taken from 60 years, they still represent a limited data sample.

I tried a simple thought experiment taking 720 imaginary pennies and flipping groups of 60 in 12 different categories, each labeled with a different month. In total I flipped 40 more tails than heads. But one month alone contributed 24 of the extra tails. Flipping 42 tails and only 18 heads in one month certainly seems meaningful. Simulating penny flips with a spreadsheet, I repeated the experiment multiple times. Each time at least one random month produced an anomalous result.

Here's another saying I like better: "Stocks go up and stocks go down." The markets are inherently volatile. Sometimes most of the tails can land in one month over a 60-year sample.

Seasonal investing hit the height of its support in Sven Bouman and Ben Jacobsen's 2002 study. The drop in the markets that summer heavily contributed to the trend. Between 1950 and 2002, returns for November through March averaged 9.06% versus only 3.18% between May and October.

Since 2002, however, the trend has been much more muted. The recent difference between these numbers is statistically small for the wide range of returns.

In 2009 May through October went against the trend and was up 20.10%. But in 2008 that same time period was down 25.84%. The past five months, November through March, are following the trend and up 13.87. But a year ago, November through April was down 8.53%.

Even in the last two years, this volatility can be made to fit the trend. Adding the two years together, November through April was more up, and May through October was more down. Although the markets have gone nowhere, blindly following the strategy would have produced a 5.74% gain.

As this column has repeatedly advised, rebalancing and diversification are clearly a better long-term approach.

Larry Swedroe of Bogleheads.org, an indexing discussion site, did an analysis starting in 1926 that switched to U.S. Treasuries every May 1 and moved back into the S&P 500 on November 1. The strategy produced an annualized return of 8.3% versus 10.25% for just holding the S&P 500.

By cherry-picking the right years, he found periods when the strategy might outperform a buy-and-hold strategy. This held true specifically for 1987 through 2002, the very period in which the saying received national attention.

Given the volatility of the markets and the strength of seasonal psychology, there may be a period of months when markets will perform better. But that doesn't mean Treasuries can outperform May through October.

In contrast, December sees large profit-sharing bonuses put into the markets, and pension funds are often invested in January. In the early spring, people are funding their retirement accounts.

These are just speculations. It could just as easily be the amount of sun in the Northern Hemisphere affecting people's emotions. Or it could just be that a lot of random tails fell in the September portion of the carpet.

Thus we provide a thoughtful compromise between jumping in and out of the markets and ignoring the seasonal effect entirely. If the markets are up, as they are now, and we are approaching the summer months, it is a good time to take some profits off the table. I'd like to replace the adage with the following advice: "Rebalance in May and call it a day."

from http://www.emarotta.com/article.php?ID=388

Appreciating Assets Part 2: Other Investments

2010-04-26T13:36:00.002-07:00

Appreciating Assets Part 2: Other Investments

(2010-04-26) by David John Marotta

Your top-level asset allocation determines both the ultimate return you will receive and the volatility you will experience. Your investments should be working for you, appreciating more than inflation to become an engine of growth that pays you money and provides some measure of financial freedom. A combination of stocks and bonds with low expense ratios and a tilt toward stocks provides the best tuned engine of growth.

Stocks average 6.5% over inflation. Bonds average 3% over inflation. Thus after 25 years, $100,000 invested in stocks will have a buying power of $483,000. And $100,000 invested in bonds will have a buying power of $209,000.

Many other assets fare worse than these two categories. Understanding the average appreciation of these assets can help you model retirement projections and decide to invest or not.

Commercial real estate barely appreciates at the rate of inflation. Actually, it depreciates against inflation by about 1% a year. Fortunately, it should produce enough income to overcome this depreciation and produce a real return of about 4.9% over inflation. We invest in Real Estate Investment Trusts (REITs) that are publicly priced and traded as equities on the stock exchanges.

Handling a private commercial real estate requires more work. If private commercial real estate isn't generating a lot more income than it costs to maintain it--including depreciation--it isn't pulling its weight. Only if it can produce significant income and grow at a real return of 4.9% over inflation will a $100,000 investment in real estate grow to $331,000 after 25 years.

Similar equations can be used for residential real estate. On average it produces slightly less income, giving a real return of 4.1% and growing to have a buying power of $273,000. Obviously all real estate is subject to the increasing desirability of the area where it is located. Some excellent school districts have experienced appreciation significantly greater than inflation. But many rural communities have barely kept up.

A few years ago real estate was the darling that appreciated at over 1% a month. Now in parts of Michigan, Florida and California, those same homes are going for 20 cents on the dollar in foreclosure sales.

Remember that the house you are living in is an expense, not an investment. An investment pays you money. Although the principal portion of your mortgage payment is forced savings that will nearly keep up with inflation, it doesn't grow and work for you. Because you are occupying the house, you forgo the rental income that would provide the real return above inflation.

Gold is even worse than real estate. There is never any possible income from gold, so it just holds its value. And gold can be extremely volatile, losing 69% of its value in a 21-year decline from $850 an ounce in 1980 to $260 an ounce in 2001.

At least gold holds its value. Cash loses its buying power by the rate of inflation. After 25 years, although you might still have $100,000 in cash, it will only have the buying power of about $32,000. An inflation rate of 4.5% is devastating over the long term.

Fixed annuities act like cash. They lose their buying power quickly over time. Even if you could get an immediate annuity paying 7% at age 65, it would still be a bad deal. Seven percent sounds good only because you fail to take into account the immediate loss of 100% of your principal. If you die any time during the first 14 years, your return would be zero. You would only have received your own money back.

Assuming you live an average lifespan, your return would be 3.06%, not even keeping up with inflation. And even if you and your spouse both lived to be 100, your annual return would only reach 6.35% or a 1.85% real return, which is worse than an all-bond portfolio.

Immediate annuities initially seem like sufficient spending money, but that's only because they are front-loaded with buying power. If you want to maintain a certain standard of living, you should save some of the initial payout to supplement purchasing power at the end.

Even if you could purchase a $100,000 fixed annuity paying 7%, or $7,000 a year, you should only spend half of that amount. You would need to save the other half to supplement your spending later when you need more money to keep the same lifestyle.

Social Security is a little like a fixed annuity. Because it is indexed to the government's official inflation numbers, it doesn't keep up with real inflation. As a result, Social Security has a real return of about -2%

At this rate, over 25 years your Social Security payments will drop to about 60% of their initial purchasing power. Consequently, at the full retirement age of 66, we recommend only spending 84% of your Social Security income on your standard of living. Save the other 16% and invest it in equities to supplement your lifestyle later when the buying power of your Social Security payment dwindles because of inflation.

No one should count on Social Security. Had the money we've paid into Social Security been saved and invested in almost anything, every senior would be retiring as a multimillionaire. Until our Social Security system is privatized--like the one in Chile--it is not an investment you own. It is completely subject to the political risk of the next stroke of the pen. Inevitably Social Security benefits will be means tested so that people with more than a certain amount of assets, say a half million dollars, will no longer receive benefits.

We pencil Social Security payments into retirement equations tentatively and then see where we are without considering them. The younger the client, the less chance of collecting even the smallest fraction of what was contributed.

Many other expensive items should not be considered an investment. Just because it costs a lot doesn't mean it is an investment. For example, art is not an investment. Neither is furniture or a new roof. Neither is installing solar or geothermal. It may save you money, but that doesn't make it an investment. If it saves you money, you should be able to reduce your standard of living accordingly and put more money into your real investments. If that is the case, I would call putting more money into your real investments the "savings" and not consider the energy efficiency an investment.

If you can't put more money into your savings, then your purchase simply allowed you to increase your spending someplace else and was neither an investment nor did it save you any money. This principle should be applied toward anything that salespeople are apt to call an "investment," such as energy-efficient cars or time-share rental property.

Just calling something an investment doesn't make it so. Investments should appreciate at a rate that grows faster than inflation and gains purchasing power. And spending your money on non-investments can jeopardize a plan to reach your goals of financial freedom. Investments should work for you, paying you money that you can spend or reinvest elsewhere.

from http://www.emarotta.com/article.php?ID=387

The Fragility of Freedom at 60%

2010-04-26T13:36:00.001-07:00

The Fragility of Freedom at 60%

(2010-04-19) by David John Marotta

In 1977 economist Milton Friedman wrote an article "The Line We Dare Not Cross: The Fragility of Freedom at '60%.'"

He predicted that as the percentage of society that owes a portion of their livelihood to government spending increases, the ability to limit the growth of government will decrease. At some tipping point, attempts to reduce the size and scope of government become too difficult. Welfare statism sets in as a permanent malaise and drags on the growth of the economy.

Friedman said, "We still have some ruin in us, but pretty soon we are going to be forced to face up to the issue." We did a good job of keeping government spending relatively constant as a percentage of gross domestic product (GDP) for the next 30 years. Total government spending was at 33% in 1977 and had risen to only 35% by 2007. But since 2007 we've expanded the scope of government from 35% of GDP to 45%.

This overspending is certainly severe, but the cumulative deficit spending is even more critical. When Friedman warned us about the fragility of freedom, the gross public debt was at 47% of GDP. After three decades of deficits it had risen to 81%. Today it is at 120%. In just three short years we've added more to the deficit as a percentage of GDP than in the three decades before.

We don't have much ruin left. We have to face up to the issue. We are in danger of crossing a line we dare not cross.

Every time government spends money to provide security to a few, it destabilizes the rest of society. Shore up one sector and you risk impoverishing other sectors. Soon catastrophes in those sectors that are left free of government support are perceived as further evidence of the failure of the free market. Each crisis becomes an opportunity to expand the scope and power of government.

Most government spending consists of benefits given to the few while the costs are borne by the many. Thus a small minority has a large vested interest in seeing the legislation passed, and for the large majority it isn't worth the time and effort to try and defeat it.

Imagine there are 100 people in society and each earns $100 a day. Now imagine for just $5 a day from each person you could support five people so their income was secure and they could do public good. For the five people involved, it is a great deal. Everyone else is too busy to organize and fight against funding them. After all, it is only worth $5 to fight against it, but it is worth $100 each for those five to organize and agitate for it.

Perhaps there are another 10 people who benefit most from the good being done. It will only cost them $5 a day, and they might get $20 a day worth of benefit. Under the free market they could have purchased the benefit directly, but it would have cost them more. Never mind that they are middle class and could have afforded it. Why should they be obliged to pay when they can vote for the government to provide it for "free"?

The other 85 people only get $1 worth of benefit and it costs them $5 in taxes, but it isn't worth fighting, so they end up paying it. The cost to society is $500, and the benefit to society is only $285. The rest is lost opportunity costs. Most people, had they kept their $5, would have spent it on exactly what they valued at $5, and there would have been no waste. But because society pooled its money, few got what they really wanted.

And now that everyone only has $95 left to spend, everyone's businesses will collect 5% less in revenue. Society as a whole will be poorer as a result. In our example the level of missed opportunity costs was only 40% of what was collected plus an additional 5% less in GDP. In reality, the level of waste is much higher. Compliance and collection are costly. Federal monopolies are rife with enormous inefficiencies.

Ultimately the five individuals who are on public support have secure jobs, better pay, superior benefits and guaranteed pensions. In fact, we are there already. A Bureau of Labor Statistics study this month showed that federal jobs paid better than the exact same job in the private sector 83% of the time.

The difference is striking. The average salary in the private sector is $60,046, whereas the average federal worker earns $67,691. That's 12.7% more pay for the public servant. And the difference was even more pronounced in benefits. Health, pension and other benefits total $40,785 per federal worker but only $9,882 per private worker. So the total compensation package for the federal worker is $108,476--a full 55% higher than the worker in private industry whose total compensation amounts to only $69,928.

There is also the inevitable building of government fiefdoms and use it or lose it budgeting. Government bureaucrats each serve their own private interests. Many are seeking to further their careers or salaries. Others are seeking to extend their power and prestige. The legislation and regulations they put in place uses force to implement their interests.

An example from Friedman describes the problem succinctly. In a political decision, if 51% vote for red neckties and 49% vote for green, 100% of the people get red neckties. Each individual vote counts for very little in the political process. Contrast that with the free market where every vote counts and people get exactly the color they want.

The strategy for building a politically powerful coalition is to find a dozen such minorities who are willing to support you if you vote for their pet project regardless of what else you may do. This aggregate spending may be burdensome to society as a whole, but each item by itself will have a strong advocate. Although there may be popular support for cutting government spending in general, people will be reluctant to cut any specific programs because of the vehement support by an emotionally vested minority.

Friedman asked this very important question: Is there anybody in the vast American electorate who would take his or her vote away from a representative because that person voted to keep some small special-interest project? We need people like that. We need people who are against society specifying tie color even if they want red ties.

We need government employees who are willing to vote for limited government. We need middle-class families who are willing to let entitlement programs stop after funding the truly needy. And we need liberals who are willing to join with libertarians to say "Enough."

Holding the line on the growth of government is challenging, but there is a line we dare not cross. Just because something is good for most people doesn't mean it is good for everyone. Society is interconnected. We must cooperate in nearly every component of the economy.

We can either allow that cooperation to be voluntary or coerce behaviors through force. The first spreads a multitude of small benefits over many people. The second gives larger benefits to a privileged minority. One leads to freedom and prosperity. The other leads to tyranny and misery.

from http://www.emarotta.com/article.php?ID=386

Social Security Loopholes (2010-04-12)

2010-04-12T15:14:00.000-07:00

Social Security Loopholes

(2010-04-12) by David John Marotta and Matthew Illian

Had you simply saved and invested, you would probably be retiring as a multimillionaire. But because you were required to pay into Social Security, now you have to figure out how best to get back some of your money. Being aware of some Social Security loopholes will help you choose between options that differ by as much as a quarter of a million dollars.

Like all government law, Social Security is not a simple piece of legislation. Since the Social Security Act became law in 1935, hundreds of amendments have been added. A worker's Social Security contributions can total up to $440,000. So you want to make sure you have done your homework when beginning to pull this money out. And to make the best decision, you must consider health, income before retirement, income during retirement and taxes. By learning about three Social Security loopholes, you may be able to recoup thousands of dollars.

Three strategies for maximizing your Social Security dollars are available to married couples. You won't find them by reading the government's printed literature or general web pages. And in a time when many families are stretching to make every dollar count, the extra income can go a long way.

The first loophole comes in the form of an interest-free loan provided by Uncle Sam. Many retirees are not aware that they are eligible to repay their Social Security benefits at any time and for any reason in order to claim a higher deferred benefit and at no interest. This ability to undo your selection will raise your monthly payment by 33% at full retirement age and by 76% at age 70. As you can imagine, this payment can be quite hefty if you've waited years before repaying and refiling your benefits. Some savvy retirees have found a benefit by claiming Social Security early and stashing this money in a CD or other fixed-income account. That way they can earn eight years of interest on the money.

Those unsure of Social Security's viability and solvency can use this method to play both options. If benefits are reduced, you will be happy to have filed early. If not, just repay and refile.

This money may be free, but it's not easy. This "File, Repay and Refile" strategy requires you to amend each year of tax filings to recoup the extra taxes and lost interest applied to those earnings. Interested retirees will need to fill out a Withdrawal of Application to begin the repayment process.

The Senior Citizens' Freedom to Work Act of 2000 provides a second loophole that can boost total benefits payments for retirees by as much as 15%. This option is called "File and Suspend." It works well for couples who have a large disparity in their earnings history.

Consider the dilemma of James and Susan who are fast approaching their retirement. James is coming to the end of a long career as an executive in a carpet factory. Susan's earnings history was cut short when she decided to stay home to raise their children leaving a limited personal Social Security benefit.

A loving husband, James would like to maximize the survivor benefit that he leaves Susan. He can accomplish this by delaying his Social Security filing. But neither are sure they will make ends meet during the ensuing years on Susan's limited monthly payment.

Thanks to loophole number 2, there is a way to increase their current income without compromising longevity insurance. When James, the higher earner, reaches full retirement age (FRA) at 66, he files for Social Security but suspends receiving any benefits. Filing only to immediately suspend may sound like silly gymnastics. But this strategy allows Susan to begin collecting a spousal benefit based on James's higher earnings record. And because James delays to accrue a higher personal payout, Susan is guaranteed to inherit the highest possible payments as a survivor.

With this "File and Suspend" method, stay-at-home moms who would typically have to wait for their spouses to file before realizing any benefits can now access their spousal benefits before their husbands retire. It is particularly beneficial when the primary bread winner is expected to have a limited life expectancy. The surviving spouse will inherit the larger benefit that much sooner.

If, instead, we assume that both James and Susan have strong Social Security earnings records and are in good health, they should consider the final loophole.

This third and potentially most profitable loophole is called "Deemed Filing." In this scenario, James and Susan are both 66. James is due a benefit of $2200 per month. Susan is due a benefit of $2100 per month. Typically, Social Security only gives you the higher of your personal benefit or spousal benefit. But those who file after FRA can deem to only collect spousal benefits. If Susan has already filed for her benefit and James is FRA, he can file for spousal benefits. That would entitle him to half of Susan's $2100 benefit. Then at age 70, when his personal benefit has fully appreciated, he can file for his own larger benefit. When appropriate, this "Deemed Filing" approach can add up to $50,000 to joint lifetime income.

These three loopholes all require careful analysis, but their payoff can be well worth the effort and planning for the right individuals. The further big government stretches into all areas of civic and economic life, the more savvy U.S. citizens will become in order to "game the system." Complexity creates a breeding ground for inefficiencies and loopholes. Big government will require even bigger calculators.

To help you understand your options before locking in the wrong choice, attend the nonprofit NAPFA Consumer Education Foundation seminar, "How to Determine the Best Age to Claim Social Security," on April 17, 2010. This free presentation will take place at the Northside Library meeting room in the Albemarle Square Shopping Center from 10 to 11:30 am. Financial advisor Matthew Illian is leading the seminar. For more information, e-mail .

from http://www.emarotta.com/article.php?ID=385

Appreciating Assets Part 1: Stocks and Bonds (2010-04-05)

2010-04-06T05:17:00.001-07:00

Appreciating Assets Part 1: Stocks and Bonds

(2010-04-05) by David John Marotta

All assets are not equal. Some investments appreciate better on average than others. If you have $100,000 saved toward your retirement, how you invest it can make a difference in the likelihood and standard of living of your retirement.

Let's look at various investments over a 25-year time horizon. That span of time could be before retirement, say from age 40 to 65. Or it could be your retirement years from age 65 to 90.

We begin with equities, shares of stock in companies that earn a profit and grow their business. Equities could be individual stocks, stock mutual funds or exchange-traded funds (ETFs). On average, equity investments appreciate at a rate of 6.5% over inflation.

In the United States, inflation has been higher since 1970. It has also been officially underreported since 1996 when the government changed the way it calculates the Consumer Price Index (CPI). This lowered the official inflation figures by about 2% a year. But for the purposes of this article, I assume inflation is a constant 4.5%.

The stock market averages between 10% and 12% a year. But the annual return almost never falls in that range. Just look at the returns of the prior five years: 4.9%, 15.8%, 5.5%, -37.0%, and 26.5%. None of these fell even close to the 10% to 12% average.

This return comes partly from a 4.5% annual inflation and partly from a 6.5% real return over inflation. Add those two components together, and you get an average 11% return. When inflation runs higher than 4.5%, you may get a higher return, but you won't get increased purchasing power. In fact, all you will get is taxed on the larger capital gains caused by inflation.

The appreciation of equities produces an engine of growth. Over our 25-year period at 11% growth, our $100,000 initial investment grows to over $1.3 million. At this rate of return, our investment doubles every six years.

Two important reminders: First, equity markets don't provide a smooth return. Pick any 10 years over a century, and 6% of the time you will find returns that are zero or have losses in the S&P 500. Diversification helps, but the equity markets are inherently volatile, especially in the short term.

Second, the $1.3 million you end up with only has the buying power of about $483,000. Inflation eats the other $875,000. You also have to pay capital gains on the entire $1.2 million growth. With Congress raising the capital gains tax from 15% to 20% or even 25% because health care reform has passed, it hardly seems worth all the risk. But as we will see, the alternatives are worse. Economically, the capital gains tax should be zero. It would certainly produce more jobs than taxing business to pay for extending subsidies of people not working and calling it a jobs bill.

When planning with clients, I've found it much better to factor out inflation and not use inflated numbers. It is difficult to hear $1.3 million and mentally translate into the equivalent in today's dollars. So let's use a 6.5% real return and compare against our $100,000 growing into $483,000 over 25 years.

Some equities, although more volatile, can boost returns even higher. Mid-cap and small-cap stocks average higher returns. So do value stocks and emerging market stocks. If small-cap value stocks averaged 8.5% over inflation, your initial $100,000 would grow to a buying power of $769,000. And history suggests the small-cap value growth rate is even higher.

Equities are the engine of your retirement savings. Most of your savings should be invested to take advantage of this appreciation. Even in retirement, you need enough appreciation to keep up with inflation, pay the taxes and still have some real return left over.

The second largest portion of a good investment plan should be in stable assets such as fixed income. Fixed-income investments are most commonly bonds: individual bonds, bond mutual funds or bond ETFs. A stock means you own a piece of the company. A bond means you have loaned the company money, and it has promised to pay you back with interest. If the company goes bankrupt, you may not get your money back. And if the company does incredibly well, you will not have a share in that good fortune. The most you will get is what you put in plus the agreed-on interest.

Fixed-income investments are much more stable than equity investments. On average, however, they only earn about 3% over inflation. With inflation at 4.5%, fixed-income investments should be paying about 7.5% on average. With the Federal Reserve holding interest rates low, fixed-income investments currently are earning below their historical averages.

Your $100,000 investment earning a 3% real return would grow to a buying power of just $209,000 over 25 years. Again, although you might have $609,000, you would only have the buying power of $209,000. And you would have had to pay ordinary income taxes on the $400,000 of interest that just kept up with inflation.

But you should not tie a large portion of your assets up in fixed-income investments over 25 years. We recommend only having the next five to seven years of safe spending rates in fixed income were you to retire today.

At age 65, this strategy would allocate about 25% to stable fixed income and the remaining 75% of investable assets to appreciating equity investments. This is a higher equity allocation than many agents would suggest. They will earn their fee just as well off a bond fund as an equity fund. And they have found that investors don't notice the high fees as much if they have a lot in stability.

They might allocate 40% or 50% to fixed income instead of just 25%. But this reduces your return. Stocks average 6.5% over inflation. Bonds average 3% over inflation. Any mix between the two provides a blended return. So a 50-50 allocation has a 4.75% average return. And a 75-25 portfolio averages a 5.625% return.

Your average real return is this percentage minus the expense ratio charged by your investments. With low expense ratio investments from Vanguard or iShares, your expense ratio should be around 0.4%. Typical mutual fund selections have average expense ratios of 1% or more. The average 401(k) plan has even higher expense ratios.

So a 50-50 allocation from an agent selling funds with an average expense ratio of 1.2% produces an expected real return of only 3.55%. But a 75-25 allocation with an average expense ratio of 0.4% produces an expected real return of 5.62%. In our 25-year case study, your $100,000 portfolio only grows to have the buying power of $239,000 in the conservative portfolio with higher fees. And in the other case, it grows to $392,000. Those who combine playing it safe but suffering higher expense ratios retire on average with a lifestyle of only 61% as much.

The top-level asset allocation decision determines both the ultimate return you will receive and the volatility you will experience. Your investments should be working for you. They should appreciate more than inflation in order to be an engine of growth that pays you money and provides some measure of financial freedom. A combination of stocks and bonds with low expense ratios and a tilt toward stocks provides the best tuned engine of growth.

from http://www.emarotta.com/article.php?ID=383

ObamaCare Is the Worst Legislation in 75 Years (2010-03-29)

2010-03-30T09:23:00.001-07:00

ObamaCare Is the Worst Legislation in 75 Years

(2010-03-29) by David John Marotta

Every week I write this column based on the principle that each citizen's first responsibility is to take care of themselves and their families so they won't burden society. And I believe the first responsibility of government is not to burden its citizens so they are able to take care of themselves.

When I suggest you save 15% toward your retirement or not spend more than 30% on housing, these are opinions just as much as when I write about health-care legislation. My goal is to provide personal wealth management to help people achieve financial freedom as well as to understand the public policy implications and consequences of government intervention. Both are an economic way of perceiving the world, seeking wisdom in the long run instead of momentary good intentions.

The recently passed health-care legislation marks a crucial turning point in the economics of our country. It is impossible to predict all the unintended consequences that will result from such a sweeping increase of federal powers. But we can be certain those powers will be used almost exclusively to limit our freedoms.

Almost anything you will be able to do in the future, you could have done without the current legislation. Every law, regulation or directive put into place will limit either what you are allowed to do or what your insurance company can do even with your consent. And from here on, every citizen, politician and lobbyist will have a stake in manipulating the new laws to further their own cause.

Many of my readers have suggested that people won't try to game the system. They claim that people are basically altruistic and will gladly pay their fair share and willingly limit their use of health-care services. I don't agree. Part of the selling point for this legislation is that people want lower health-care costs. Health care is about 18% of gross domestic product (GDP), but some grumble at paying this high a percentage even when they can afford it.

Additionally, only by using coercive methods, such as a fine or imprisonment, will the current free market choices be overcome. People rarely take kindly to such intervention in their lives. It's both natural and understandable that they will try to work the system for their own benefit.

Financial incentives matter, and the ones in this kind of socialized medicine are all in the wrong direction. Not only is the bill expensive, it is filled with bad ideas poorly implemented.

The bill requires all Americans to have health insurance and imposes a $900 fine for not having it. And all health insurance companies must insure people for the same price regardless of any preexisting conditions.

In the past people would pay thousands of dollars for health insurance so it would be there if they needed it. Now they will be able to pay a $900 fine and still be guaranteed insurance even after they develop a serious illness. As a result, healthy people with insurance will do better to drop their coverage and pay the fine until they get sick and need health care.

Rather than increasing the roles of the insured, this legislation could actually encourage healthy people to opt out of insurance. If insurance can't discriminate based on my health before insurance, why pay a dime until my out-of-pocket expenses are expected to exceed the cost of insurance?

No insurance system can survive such folly. Savvy consumers will only buy insurance if they anticipate that their expenses will exceed what they pay in premiums. Insurance companies will have no way to screen for a truly average risk pool. As a result, costs will go up until even the sick won't want to buy insurance.

The bill also provides measures for cost containment, which generally means it will be harder for doctors to get paid for their work. As much as half of the expense of running a medical office is trying to get reimbursed, and this legislation will only exacerbate the situation.

Although the details are not specified, much of the legislation will enable a broad range of powers to be granted to the federal government to use however it sees fit. Committees will decide which procedures are allowable and with what frequency. Technical groups will design the required reporting format for your private medical data. Stakeholder groups will fix prices after consultation with special interest groups. And new agencies will set minimum standards for health-care insurance.

Patients pay for about 12 cents of every health-care dollar today. This is not enough to deter health-care consumption. Costs cannot be controlled when the person who pays for a service, the person who benefits from a service and the person who grants the service are all different. Only when most of the money spent comes out of pocket will people have a vested interest in cost containment. Empowering patients to make their own health-care decisions is the only viable solution. Although the best economic alternative is having more out-of-pocket dollars, the current legislation requires insurance to pay at least 85% of health-care costs.

That last part may kill Health Savings Accounts (HSAs), which could save much of what ails our health-care system. HSAs are coupled with a high-deductible health insurance policy. Such policies are extremely inexpensive.

HSAs are based on the principle that because you pay the high deductible, you are motivated to keep costs low. And because you are unlikely to reach your deductible, your insurance costs are low. Insurance is affordable only when the likelihood of using it is low. An added benefit is that employees own their own health insurance. Hence it is completely portable. If they are laid off or decide to work elsewhere, they can take their insurance with them. In every way, privatized HSAs are working to contain costs. Given the new requirement that 85% of costs must be paid by insurance, HSAs will probably not survive the federal bureaucracy.

You can compare the current legislation to having grocery store insurance that pays for the first dollar you spend. Everyone in our risk pool will order filet mignon. First the costs will skyrocket. And then the meat will be rotten.

It isn't just that some portions of the bill are poorly implemented but the broad scope of the legislation could be fixed. It is fundamentally wrong. And it will have implications that will impoverish rather than empower individuals. The result is not good intentions with unintended consequences, but in fact ill intentions with disastrous consequences.

Only a utopian centralized planner could believe we will be able to anticipate or correct the consequences going forward. The unknown unknowns are liable to produce even more dire meltdowns. Government intervention, monopoly and regulation cause the rigidity that in turn provokes economic forces immune to market adjustments. Bubbles, shortages, deficits, defaults and moral hazard will result.

Once the government competes with the private sector, there is no competition. It is like the referee starting to play on the field. The government has banned private companies from competing with them on mortgages, Social Security and the U.S. Postal Service, and we all know how well those organizations are run.

Quality health care will suffer a similar fate. There is no systemic regulator for expenses, and consequently costs will go up and benefits will dwindle. As a result, the subsidy of the truly needy will be completely swamped by a tsunami of middle-class entitlements.

The current legislation has left undone the incentives to provide quality lowest cost health care. And it is put in place incentives that work toward impoverishing the quality and economics of our current health-care system. For these reasons and many more, the current legislation is the worst legislation passed by Congress in the last 75 years.

from http://www.emarotta.com/article.php?ID=382

2010-03-22T09:21:00.000-07:00

Avoid Budget Busters Part 4: Budgeting Pitfalls

(2010-03-22) by David John Marotta

Thrift is having a sure hand that controls your spending so your spending doesn't control you. The goal isn't to be rich but rather thoughtful, industrious, content and thrifty.

We all know that impulse spending and unexpected emergencies can wreak havoc on your budget. But sometimes we make the mistake of deliberately budgeting the impossible. Unrealistic plans are like piano music requiring you to stretch your hand farther than humanly possible. If you purposefully set the required spending in one category too high, you won't be able to trim other categories to bring your overall spending into harmony. Here's where to look in your budget where you may be inadvertently planning for failure.

Too much house

You can't afford more house than your budget will allow. If you spend 50% of your lifestyle expenses on housing, you will not be able to live proportionally on the rest of your budget. Too much house is one of the most common mistakes a young family can make.

Try to keep your rent under 20% of your take-home pay after you graduate from college. Aim for all associated expenses (mortgage, insurance, taxes, etc.) to be less than 30% if you own property and some of the payments go toward the principal. And by no means let your housing costs exceed 38%, or your budget will be doomed before it even begins.

Despite smaller families, the size of American homes has been increasing exponentially. In 1940, the average home was only 750 square feet. The square footage rose to 983 by 1950, 1,100 in 1960, 1,500 in 1970, and 2,080 in 1990. Today the average house measures about 2,400 square feet.

In previous generations, several children typically shared a room. In today's family, kids get not only their own room but their own bathroom and home entertainment system as well. In addition to direct costs, owners of larger houses have greater associated costs such as landscaping, energy use, maintenance and repairs.

Most of us never saw our parents and grandparents in their younger days when they were struggling financially and lived in tight accommodations. It is as though we can't feel successful without immediately enjoying the lifestyle of our parents at the height of their careers. To decide how much house is enough, calculate how much house you can buy for 30% of your standard of living.

Transportation

Transportation costs should be under 15% of your lifestyle spending and include insurance and maintenance as well as saving for your next purchase. Only buy a car you can pay for with cash. Your first car may be a clunker. Immediately start saving for your next car and the inevitable costly repairs. This strategy will limit the number and quality of cars you can afford. Remember, there are families earning more than you who take public transportation or share rides to work.

Most people view gasoline costs as inevitable, but they are not. Living close to where you shop and work, even if you have to own a smaller house, has economic advantages. Alternatively, consolidate trips to reduce expenses.

Eating out and prepared foods

Starbucks has become the poster child for budget busters. Buying a $4.50 cappuccino when you are young costs you $450 in your retirement account. And spending $4.50 a day costs you $450,000 in your retirement!

It doesn't have to be a latte. You can generate amazing savings from any expense. But a pricey latte illustrates the huge markup on a dollar coffee.

Aim for food to be under 15% of your lifestyle spending. You would like your food to be inexpensive, healthy and convenient, but it can't be all three. You can only pick two.

Healthy food tends to be more expensive per calorie. So do convenience foods. One person eating out can often fund the entire family eating at home. And even when you purchase food in the grocery store, prepared foods can cost more than twice what you would pay for the individual ingredients.

By learning to cook with common staples such as rice, beans, flour, oats, potatoes, and chicken, you can drastically reduce the percentage of your budget spent on food. Save even more by making your own gourmet coffee.

If you aren't rich enough to afford eating every meal out, this is the best way to scale back your lifestyle. Your food can be both reasonable and nutritious, but some assembly is required.

Clothing

Clothing expenses can break the budget. Designer clothes can be 10 times as expensive as more modest attire. And keeping up with the latest fashions requires renewing your wardrobe regularly.

For many people, shopping for clothing is a social outing and hobby unto itself. The goal is to buy something truly wonderful that will make a specific event memorable. Such designer moments may be the norm on the red carpet of the Academy Awards, but they will destroy an ordinary family's budget.

Most people aim for clothes that are respectable but not ostentatious. If that isn't enough, reexamine your values. If you must keep up with what everyone else is wearing, you need to earn more than everyone else. If you express yourself wholly through your clothes, your financial security is going to suffer.

Average-size people can find some great buys at secondhand stores. Or you can learn to sew. Children's clothes do not require much fabric, and the savings can be tremendous.

Other regular expenses

Review monthly, quarterly or annual recurring charges. Research the cheapest basic service for your phone, cable, Internet, and insurance. Compare that to what you are paying now, and ask yourself if those seductive extra features are really worth the cost. A gym membership used regularly might be a wise choice, but if you haven't shown up there for weeks, it isn't. For each expense ask yourself, "Is this really a necessity?" Any way you can reduce your regular bills saves money every year.

Increased insurance expenses

Most families who get insurance are self-selecting. If you wait until you are a high risk, your premiums will be higher. People who have insurance and then become a high risk often cannot switch providers. As a result, the pool of people covered by insurance tends to get riskier over time. As it does, those who can't switch end up with significant policy increases.

But if you have not had much in the way of claims, shopping for new coverage can help you avoid costly insurance increases. Reviewing your policies and getting a couple of quotes can be a quick way to rein in expenses.

To make this work in practice, you need to collect the quotes quickly and painlessly. Rather than the anonymity of the Internet, I recommend a few phone calls. First decide if you want to change the terms of your policy. Then get a quote for the exact same coverage from each company.

After you have eliminated a company, tell them directly. Giving someone your phone number won't waste their time, but e-mail spam can seem eternal and Internet sites are often not reputable. Review your policies once a year. After you are satisfied with your current provider, once every two or three years is sufficient.

In summary, every category of your total budget must stay within a limited percentage. Careful planning and a courageous look at your lifestyle can help you identify those budget busters. Adjusting a few spending excesses could solve all of your spending problems.

from http://www.emarotta.com/article.php?ID=381

Avoid Budget Busters Part 3: Plan on Budgeting Surprises (2010-03-15)

2010-03-15T11:03:00.001-07:00

Avoid Budget Busters Part 3: Plan on Budgeting Surprises

(2010-03-15) by David John Marotta

Thrift is having a sure hand that controls your spending so your spending doesn't control you. The goal isn't to be rich but instead to be thoughtful, industrious, content and thrifty.

To avoid unplanned budget busters, set three rules for your spending: Set a dollar limit, wait at least a week each time you're unsure of a purchase and be aware of the categories where you are most likely to make impulse purchases.

But raising your awareness on impulse purchases is only part of the battle.

Many budgets are doomed to failure because of the challenge of planning for unplanned spending. Here are some of the items you either did not put in your budget or they shouldn't be in your spending.

Interest on debt

The average American family carries close to $10,000 in commercial credit. At 18% interest, that's $1,800 a year or an unnecessary $150 every month per household. If you put that payment into the markets every month over your working years earning an average 10% return, you would retire with an additional $1.5 million.

There's no reason to buy anything on credit. If you find yourself considering an expensive purchase and then trying to find the payments in your budget, you are planning for failure. The only two loans you should even consider are a home mortgage loan and a student loan for an education or training that increases your earning potential. Money makes money. Credit does the opposite. Debt breeds poverty.

Paying bills late

Debt is terrible. Paying bills late is just bad. By establishing a system for paying your bills on time, you will save every $15 payment from getting a $35 late fee tacked onto it. These foolish expenses add up over time and will quickly undo your efforts at frugality.

Many people believe that paying bills as late as possible gains them a few days of extra interest. In reality, a year's worth of interest isn't worth even one late payment. Late payments also hurt your credit score, which ultimately will mean getting charged a higher interest rate. Pay your bill early, and put your efforts to better use.

Organized people are simply disorganized people who have found a system to help them get things done. Don't think being disorganized is an innate unchangeable quality. It is common to everyone before they take the time and effort to get organized.

Pay monthly bills at least twice a month in order to be on time. These cannot be postponed. Many people find the assistance of online bill pay systems invaluable. It may also help to have a calendar reminder system or a bill organizer. Others have their credit or debit card charged automatically so they are never late.

Unknown unknowns

None of us can anticipate all our expenses. Every stage of life brings a whole new set. Perhaps extensive study and research could help you prepare. But it is easier simply to budget 10% for unknown unknowns.

The first question I usually get asked regarding this category is "Like what?" The truth is that even after identifying every expense you can think of, there will still be significant new expenses that may push you toward deficit spending. But every surprise expense is an opportunity to anticipate and plan for that expense in the future.

Insurance deductibles

Review the insurance coverage for your car and home. A deductible and perhaps a 20% copay often apply. Out-of-pocket expenses could run several thousand dollars. It is more important to limit the maximum expense than to make sure the deductible is low. Budget for the deductible and copay expenses.

Medical costs

Medical expenses are rarely planned. To prepare your budget, have some insurance in place that will limit your catastrophic loss. Second, set up an emergency fund that will cover your expenses if they reach that limit.

For families who are relatively healthy, we recommend Health Savings Accounts (HSAs). As long you spend the funds you save on qualified medical expenses, all contributions, capital gains and withdrawals remain untaxed. And like any other bank account, HSAs come complete with debit cards and checks.

To protect you against catastrophic medical expenses, Health Savings Accounts are coupled with a High-Deductible Health Plan (HDHP). The deductible can be as high as $6,000. Because you might be required to spend up to your deductible, you need a savings plan that funds your HSA up to your deductible within two years. For example, if your deductible is $6,000, put $250 a month into your HSA. Once you have amassed at least that amount, you can take comfort knowing you can at least cover your deductible from your medical savings.

We have coverage for a family of four with a maximum out-of-pocket expense of $3,500. We pay $322 a month to protect our budget and cap our potential losses. We are also allowed to contribute $6,150 a year pretax into our HSA. So we know the most our health-care costs could be is $614 a month and we budget for them accordingly.

Unfortunately, "Obama care" threatens to eliminate consumer-driven care like HSAs by requiring minimum packages and removing the freedom to choose using insurance for disaster coverage. Forcing families to have low deductibles and be pooled with everyone else is like requiring grocery store insurance for the first dollar spent. Frugality disappears, and everyone tries to buy filet mignon.

Insurance should be only used for disasters, not everyday expenses, which provides just the right amount of negative feedback. The first $3,500 as an out-of-pocket expense works as a natural incentive to keep medical costs low.

Car repairs and replacement

Your car won't last forever. It will need major repair at some point and ultimately replacement. Decide how much you are willing to spend for the lifestyle you want, and then budget for it. Don't buy a new $30,000 car and think you won't have any car expenses for the next five years. Even if you plan on driving your new car for the next decade, you have to start budgeting for repairs and your next new car now.

Whatever you pay for your car, new or used, start budgeting to purchase another car in five years. Prices will be higher in the future, but maybe you can stretch the time to seven years so it will all work out.

If you buy a new car for $30,000, you must be able to set $6,000 aside every year ($500 a month) for the next new car. Don't borrow to buy a car and then start making payments. That's nearly always a bad idea and simply ensures you won't save, invest or grow rich. If you can't afford to save the payments in advance, you are stretching too much. Buy used or wait.

House repairs

Owning a home and surprise expenses are practically synonymous. The roof might leak. The plumbing could need replacing. A tree may need to be taken down before it falls. The heating or cooling system could need repairs. The carpet will need to be replaced.

Set aside at least 1% of the value of your house for repairs, not enhancements, each year. If you have an older home, increase the minimum to at least 2% of its value.

Emergency travel

Another unexpected category is emergency travel. Family illnesses, weddings or funerals impose themselves on a family's budget with some regularity. Sometimes even family vacations, graduations or other gatherings can strain finances. If you are both of humble means and have a large extended family, your budget could break under the strain. These are not easy decisions.

Here are some alternatives to help you cope. Perhaps you could send a letter to be read or a videotape. Maybe not everyone in the family has to attend. Consider sending a representative. Ask for help with travel or accommodations. I know that family expectations can seem unreasonable, but speaking the truth in love is always a good response.

Avoid sacrificing or jeopardizing the finances of your family simply to attend the birth of another family or a distant wedding. If you are rich in both time and resources, that circle can include a plethora of friends and family. But the rest of us need to be on a more modest plan.

No budget can anticipate every major expense. Life serves up surprises with some regularity. Putting a healthy margin in our daily living expenses gives us the stored resources to weather these major bills and then better plan for them going forward.

from http://www.emarotta.com/article.php?ID=380

Avoid Budget Busters Part 2 - Curb Your Worst Impulses

2010-03-10T07:54:00.001-08:00

Avoid Budget Busters Part 2 - Curb Your Worst Impulses

(2010-03-08) by David John Marotta

Frugality is the new status symbol, or at least it ought to be. It is green. It is compassionate. And it brings with it a financial margin for when life colors outside the lines. It helps bring us the priceless gift of serenity and contentment.

Bruce Waltke translates Proverbs 10:4 as "A poor person is made with a slack palm." To be wise financially, our hands must remain steady. Extend your hand toward an impulse purchase and with one weak flick of your credit card, all thoughtful budget planning can be hopelessly broken. And for many families, it's once on the charge, forever on the card. Excess spending slows our accumulation of capital to invest. When we are drowning in excess purchases, getting ahead is like trying to sprint through deep water.

Get control of the spending that breaks the bank. Certain purchases that are typically both unnecessary and unplanned are budget busters. Avoiding these financial slips requires hedging some of our worst impulses and constraining our desire for instant gratification. Only by saving enough in discretionary spending can we afford to put 10% of our budget toward those true and unavoidable emergencies.

Here are three rules that will help you and your spouse limit impulse buying and better align your spending with your thoughtful values.

First, limit the dollar amount you can spend unless you and your spouse both agree. You owe it to your partner not to undo months of frugality and sacrifice by acting on a whim. Honoring each other in this way helps avoid resentment and alienation that can bust your marriage as well as your budget.

Negotiate the dollar amount. I suggest setting a limit of 1% of your monthly budget. If your annual spending is $60,000 and your monthly budget is $5,000, you would need to confer on any purchase over $50.

The idea of setting a limit will seem more acceptable if you consider the millionaire mindset. Millionaires recognize that saving and investing just $100 a month over the course of your working career produces a million dollars at retirement. They watch their spending carefully. They recognize that frugality is just another way to describe deferred consumption, which is the definition of capital. And capital, once invested, is what produces an ongoing income stream.

Put another way, if the average budget should include 5% taxable savings each month, every time you mindlessly spend over 1% of your budget, you lose more than a fifth of what you should be saving and investing outside of retirement accounts. I've seen many financial affairs ruined by the repeated spending of amounts much less than $50 at a time.

If you are struggling financially and having trouble agreeing on your goals, you may want to set the limit lower. As you both begin to feel your spending is under control and your savings exceeds your targets, you can readjust the limit higher. Exceptions can be made for regular bills and necessary purchases such as utilities and groceries.

Talking with someone else about a possible purchase can clarify your thinking not just about the item but also about your other competing financial priorities. It changes the question from "Do I want to buy that?" to "What do I want to give up to buy that?"

The second rule limits the frequency of mistakes. Practically speaking, you can learn to postpone spending one purchase at a time. When our children were very young, they had to wait a week before spending money on a toy. After the seven days, they often wanted a different toy instead. Then they had to postpone the purchase again.

Children should be required to wait as many days as they are years old before being allowed to make a large purchase (that is, more than a week's allowance). You can use the same technique to strengthen your own slack palm.

When you're tempted to buy something, wait a week before acting. If you still aren't sure, wait another week. There is always tomorrow, and most of the time you won't remember what attracted you to it in the first place. Simply learning to delay and avoid impulse buying can cut your spending in half.

My wife and I sometimes wait years to be sure a purchase will further rather than impede our goals. The rule is simple. If you are not sure of a purchase, wait another week. This ensures that your hand will be confident, not slack, when it decides to act.

The goal isn't to be rich but instead to be thoughtful, industrious, content and thrifty. If you struggle with Madison Avenue's mantra of personal fulfillment through excessive spending, turn the image around. Nearly all of our spending is discretionary, and every spending delay can be a way to bring peace into your life.

The third rule is to recognize the categories where you make mistakes. Dieting works because you are forced to observe what you are eating and learn which foods tempt you to break your calorie budget. Creating a financial diet works similarly. It creates a system that makes spending money more painful. Simply keeping track of all your purchases in a small spiral notebook makes you more mindful.

Refrain from discretionary spending in any budget category that is under pressure. It might be eating out. It might be clothes. It might be household items. If you keep your budget in mind, it will help you not to spend more money than you intended.

Whatever your lifestyle, you probably think everything would be just fine if you had $10,000 more a year. That is the deceptive seduction of wealth. We don't realize there are people living off $10,000 less than we have who are saying the exact same thing.

Ask yourself, "What will I do when I run out of money?" Whatever you would do then, you should do now to keep your spending under control and live within your means. The best way to learn to be content is by taking money out of our spending categories and saving it. The less we spend, the better we will learn to be satisfied. Just as the harder we train, the better our endurance.

If you must satisfy frivolous spending, limit the amount and budget for it. Set aside a half of a percent each for husband and wife. For a family with a budget of $60,000 a year, this would be $25 a month each. If you wanted to buy a $300 item, you might have to save up for it for an entire year. But only put this in the budget if you are saving adequately for all your other big goals.

An even better way is to lovingly meet each other's desires through the portion of the budget allocated to giving gifts. Too often family members don't know what to purchase. Consequently, unwanted or inappropriate gifts represent a great deadweight loss of value. But when we leave our desires in the hands of others by offering, say, a gift certificate we can afford, we build family bonds rather than resentments.

In summary, to avoid impulse buying, set limits, wait a week, and watch out for those categories that entice you to break your budget. And when you must spend frivolously, limit those purchases to a small fraction of your budget.

from http://www.emarotta.com/article.php?ID=379

2010-03-03T08:06:00.000-08:00

Avoid Budget Busters Part 1 - Thrift, an Old-Time Virtue Making a Comeback

by David John Marotta

"Thrifty" isn't a virtue we hear about very often these days. In fact, the only association I used to make with the word is at the end of the Scout Law I had to memorize when I was a boy: "thrifty, brave, clean and reverent."

The Boy Scouts of America Handbook states, "A Scout is thrifty. A Scout works to pay his way and to help others. He saves for the future. He protects and conserves natural resources. He carefully uses time and property." Sounds like good advice for us all.

No matter how rich or poor you are, thrift is an integral part of your budget. If you are struggling, you need to stretch every dollar as far as you can. And if you are well off and in a higher tax bracket, every dollar you spend could cost you as much as two dollars in earnings. Recessions naturally bring out the quality of thrift in families but, more often than not, it's due to necessity, not virtue. But being thrifty is a godly and biblical virtue.

Bruce Waltke, an authority on the Bible, wrote the two-volume "The Book of Proverbs (New International Commentary on the Old Testament)." His commentary offers wisdom about life's important decisions on such issues as wealth, women and wine.

Biblical values provide an older and more holistic approach to life that runs counter to our materialism-trumps-all approach to happiness. If the book of Proverbs is part of your religious canon, the message will be particularly important. And even if you think the biblical message is too bound in its own time and culture, you can still consider it an alternative to being unwittingly manipulated by today's relentless advertising messages.

It seems strange that thrift needs both defining and defending these days. Back when "The Boxcar Children" was a popular series of stories about the virtues of depression thrift, the mantra was "Use it up, wear it out, make it do or do without." Today some of us may find that adage stingy and heartless. But our grandparents were wise in ways that are especially valuable in these times.

Waltke explains that in the first few verses of Chapter 10 of Proverbs, Solomon first lays out the ethical and theological and then the commonsense foundations of wealth. The practical sayings "teach that industry, contentment, thrift and forethought will produce wealth and protect against poverty."

He translates the first half of Proverbs 10:4, "A poor person is made with a slack palm." "Slack" connotes careless and negligence. He explains, "Chaos ever threatens to undo the created order, and, if unchecked by diligence, destroys hard-earned wealth." Many families trying to live within their means fall to impulsive coveting only to suffer from buyer's regret after the fact.

Marital fidelity is only as good as your worst affair. A chain is only as strong as its weakest link. And thrift is only as valuable as your worst budget blunder. To be financially successful, families must learn how to avoid these budgetary pitfalls. You cannot go into debt with time. Every day you are given another 24 hours. But it is possible to go deeply into financial debt. The consequences can be dire, and digging your way out is extremely difficult.

Waltke describes the admonition of Proverbs this way: "The diligent are thoughtful, not hasty, accumulate wealth, and attain power and dominion." This isn't a health and wealth gospel. God doesn't want you to be rich. God wants you to be thoughtful, industrious, content and thrifty. He is more interested in your character than your accumulated capital. To whatever extent God has given you control, it's your obligation to steward those resources well.

If thrift still makes you feel too much like a penny-pinching miser, consider that frugality is making a comeback as the eco-friendly green way to live. Today's planned obsolescence is taking a toll on the environment. And trading fads and fashions as they become "so yesterday" is as costly to the earth as it is to our pocketbooks.

And if you believe thrift means you aren't doing your part for the world economy, think again. Saving and giving or investing is the way to feed the hungry and raise the masses of the world out of poverty. Instead of indulging ourselves, we should live well below our means. Then we can afford to give generously and to invest in the development of countries where charity or capital investments can do the most good. We live simply in order that others might simply live.

Be proud of your thrift. Save, invest and be generous out of your largess. Only those who live well below their means have the means to fund the ventures that can change the world for the better.

from http://www.emarotta.com/article.php?ID=378

Your Parents' Estate Plan Part 2: What You Need to Know (2010-02-22)

2010-02-22T09:29:00.000-08:00

Your Parents' Estate Plan Part 2: What You Need to Know

(2010-02-22) by David John Marotta

A thoughtful estate plan can make your heirs' lives easier. But it is your parents' estate planning that will make your life easier.

Not every family has fostered the ability to speak openly in love. But if you have begun that process, here is an outline of what grown children need to know about their parents' affairs. In fact, adults of any age should update their estate plan every year.

Children may wish to ask their parents about their financial status but worry about being overly intrusive. Or they fear their elders may perceive their questions as motivated by self-interest. They may conclude mistakenly that their parents would prefer to keep their finances private.

However, whether it's our parents or ourselves, we are all certainly mortal, so planning for the future is always wise. Estate planning is just as critical when we are young as when we get older. And if you think estate planning information is hard for you to pull together, imagine how challenging it would be for someone else who may have to step in for you during a family crisis.

As a parent, if you are willing to share some of this information with your children--especially if one of them is also the executor of the estate--they'll appreciate having the facts and be more prepared emotionally when the time comes. They will know your wishes ultimately anyway, and good communication will lessen any surprises ahead of time. They will benefit from knowing the answers to the following questions.

Do you have enough saved for a comfortable retirement? We use a safe withdrawal rate by age to make sure clients will still have enough money toward the end of their retirement. Few parents manage to time spending their last dime the day they die, so adult children are justifiably concerned about their parents.

If your spending is under this withdrawal rate, you have more than enough and probably can leave a legacy to your heirs. But if you are over this rate, you may run out of money and have to compromise your standard of living abruptly. It may be uncomfortable, even embarrassing, for parents to share their finances with their children, but grown children often want to know how their parents are doing.

Where are the important documents? The five documents your executor or your children should be able to retrieve quickly are a will, a living will, a power of attorney, a directory of basic information and the latest end-of-year financial statements.

The directory of information should list the assets of your estate along with account or policy numbers and contact phone numbers. It also helps to indicate your intentions for the distribution of each asset, which will help confirm you have the correct titling and beneficiary designations on every portion of your estate.

You may have structured your will to divide your estate equally among your children. But if you have tried to make it easy for one child to access your bank accounts by adding his or her name, you have overridden your estate plan and left that child joint tenancy with complete rights of survivorship.

Titling and beneficiary designations are legal estate planning actions. It's best to review them with your legal advisor. Various types of assets are best designated differently in the estate plan. This is not the occasion for do-it-yourself thrift. It is a rare family that has compiled and reviewed a complete list of estate assets: bank accounts, investment accounts, retirement account, real estate holding, life insurance, health savings accounts and so on.

Are there any special bequeaths? Any promises you want kept should be documented. Your good intentions won't matter if you aren't around to implement them. If you have promised money to a charity and want that obligation kept, document it. If you have promised to loan a child money, document it. If you have promised to help fund your grandchildren's college education, document that. Without documentation, none of these promises can be kept if you aren't around to make the decisions.

Are there plans to remarry? If parents have remarried, intergenerational estate planning is even more critical. Prenuptial agreements and careful estate planning are required in the case of second marriages to avoid disinheriting children or grandchildren from the first marriage. The default is rarely a good option.

Do you have any prepaid funeral arrangements? Do you want to be buried or cremated? Do you have any preferences for a memorial service? Although it may seem macabre to plan your own funeral, a memorial service takes time and thought. It will be that much more special and comforting to your family when it is filled with your favorite music and readings.

Encourage your children's interest in your estate planning. Most of time, their intentions are honorable. They may simply want to understand your values and therefore your wishes.

from http://www.emarotta.com/article.php?ID=377