Thinking Beyond Numbers

 photo credit: lrargerich

1. If you had all the money in the world, what would you do different than you are doing now?
2. If you were told by a doctor that you had 10 years to live, and that you would die quietly, what would you do different?
3. If you were told this morning by a doctor that you were going to die within 24hrs, what would you regret not having done?

As you can see, these questions help you clarify what is most important in your life. We all live as if we are going to live forever. But as we contemplate mortality, our true purpose in life become easier to see. And if you are at all interested in helping an advisor walk you through this form of planning, I suggest you search their worldwide directory.

Other advisors use different life planning techniques to define what’s most important. One test is to grab a pen and paper and in 30 seconds write down the 5 most important things in your life. The reason you do it fast is so that you don’t have time to think. The 5 things that come to mind first, are usually what is most important.

Other good questions to ask:

• What have you always wanted to do, but have been afraid to attempt?
• What gives you the greatest feeling of self worth?
• If you had 1 wish, what 1 GREAT thing would you DARE to dream?

The purpose is to ask yourself what is most important in life. Create a vision of where you want to be in 5, 10, or even 30 years. Once you have defined that, once you  have that vision clearly in  your mind, you can begin your journey. Professionals such as life planners, financial planners, estate planners, and  others, can help you accomplish those goals.

If you would like to know what other types of life planners are out there, do a simple google search, and you will be amazed at the number of styles.

Below is a neat Year-End Tax Tips video AND 6 Year-End Tax Tips compliments of the IRS.

Six Year-End Tips to Reduce 2011 Taxes

The IRS wants to remind all taxpayers that with the New Year fast approaching, there is still time for you to take steps that can lower your 2011 taxes. However, you usually need to take action no later than Dec. 31 in order to claim certain tax benefits.
Here are six tax-saving tips for you to consider before the calendar turns to 2012:

1. Make Charitable Contributions – If you itemize deductions, your donations must be made to qualified charities no later than Dec. 31 to be deductible for 2011. You must have a canceled check, a bank statement, credit card statement or a written statement from the charity, showing the name of the charity and the date and amount of the contribution for all cash donations. Donations charged to a credit card by Dec. 31 are deductible for 2011, even if the bill isn’t paid until 2012. If you donate clothing or household items, they must be in good used condition or better to be deductible.

2. Install Energy-Efficient Home Improvements – You still have time this year to make energy-saving and green-energy home improvements and qualify for either of two home energy credits. Installing energy efficient improvements such as insulation, new windows and water heaters to your main home can provide up to $500 in tax savings. Homeowners going green should also check out the Residential Energy Efficient Property Credit, designed to spur investment in alternative energy equipment. The credit equals 30 percent of the cost of qualifying solar, wind, geothermal, or heat pump property. For details see Special Edition Tax Tip 2011-08, Home Energy Credits Still Available for 2011 on the IRS.gov website.

3. Consider a Portfolio Adjustment – Check your investments for gains and losses and consider sales by Dec. 31. You may normally deduct capital losses up to the amount of capital gains, plus $3,000 from other income. If your net capital losses are more than $3,000, the excess can be carried forward and deducted in future years.

4. Contribute the Maximum to Retirement Accounts – Elective deferrals you make to employer-sponsored 401(k) plans or similar workplace retirement programs for 2011 must be made by Dec. 31. However, you have until April 17, 2012, to set up a new IRA or add money to an existing IRA and still have it count for 2011. You normally can contribute up to $5,000 to a traditional or Roth IRA, and up to $6,000 if age 50 or over. The Saver’s Credit, also known as the Retirement Savings Contribution Credit, is also available to low- and moderate-income workers who voluntarily contribute to an IRA or workplace retirement plan. The maximum Saver’s Credit is $1,000, and $2,000 for married couples, but the amount allowed could be reduced or eliminated for some taxpayers in part because of the impact of other deductions and credits.

5. Make a Qualified Charitable Distribution – If you are age 70½ or over, the qualified charitable distribution (QCD) allows you to make a distribution paid directly from your individual retirement account to a qualified charity, and exclude the amount from gross income. The maximum annual exclusion for QCDs is $100,000. The excluded amount can be used to satisfy any required minimum distributions that the individual must otherwise receive from their IRAs in 2011. This benefit is available even if you do not itemize deductions.

6. Don’t Overlook the Small Business Health Care Tax Credit – If you are a small employer who pays at least half of your employee health insurance premiums, you may qualify for a tax credit of up to 35 percent of the premiums paid. An employer with fewer than 25 full-time employees who pays an average wage of less than $50,000 a year may qualify. For more information see the Small Business Health Care Tax Credit page on IRS.gov.

And here is one final tip to remember: you should always save receipts and records related to your taxes. Good recordkeeping is a must because you need records to prepare your tax return, and it will help you to file quickly and accurately next year.

For more year-end tax information and to access all IRS forms and publications, visit the IRS website at http://www.irs.gov.

Links:

• Publication 526, Charitable Contributions
• Special Edition Tax Tip 2011-08, Home Energy Credits Still Available for 2011
• Publication 590, Individual Retirement Arrangements (IRAs)
• Publication 550, Investment Income and Expenses
• Retirement Topics, 401(k) and Profit-Sharing Plan Contribution Limits
• Small Business Health Care Tax Credit for Small Employers

photo credit: mbowlersr

My last post discussed next year’s changes in Michigan’s taxes. This time I’d like to discuss changes on how pensions will be taxed starting with your 2012 pension income.

Probably one of the first things you should know is that if your pension income is subject to Michigan tax, you NEED TO WITHHOLD 4.35% starting January 1st, 2012. This includes distributions from pension and retirement benefits such as defined benefit pensions, IRA withdrawals, annuities, profit sharing, stock bonus and other deferred compensation plans.

Your pension may or may not be taxed (and require withholdings) depending on when you were born. The new law separates taxpayers into three groups:

• Taxpayers born before 1946
• Taxpayers born from 1946 to 1952
• Taxpayers born after 1952

photo credit: Balthazira

Yesterday I went to a Pure Michigan tax seminar put on by the Michigan Chapter of the National Association of Tax Preparers. Aside from getting an update on the relatively unaltered 2011 Michigan tax return, I was also given the inside scoop on the changes headed our way in 2012. Because the Michigan Treasury is leaving the general education of the changes up to tax practioners and pension companies, who will also be largely impacted by the changes, I thought I’d post a blog or two on the subject.

What are some of the changes headed our way in 2012? As you probably already know, Gov. Snyder changed the tax landscape in Michigan drastically by eliminating the Michigan Business Tax or MBT. This tax was hindering an already cripple economy by hurting existing business and dissuading new businesses from coming here.

In place of the MBT, revenue will come from increased tax on income. This increase will not come by way of a tax rate increase, but rather by less deductions and credits.

Michigan Taxpayers will no longer be able to deduct:

• Political Contributions
• $600 exemption for children under age 19
• IRA distributions used to pay higher education
• Charitable contributions made from a qualified retirement plan
• Proceeds won from MI bingo, raffle, or charity games
• Net Income from gas and oil royalty interest

photo credit: VinothChandar

Since I reviewed most of my clients’ estate plans last year, I’ve had a few questions about when it makes sense to have a trust, especially since you need to have $5 million dollars in your estate ($10 million for couples) before you have to pay tax on your estate. The answer depends largely on your wishes and personal preferences. Here are a few reasons why people choose to create a trust:

Avoid Probate
Probate is the process of going to court to settle one’s estate according to either a will, or state laws. If there is property in multiple states in an estate, probate can become a headache and lawyer fees can add up. Avoiding probate is beneficial mainly for heirs, because spouses can own things jointly or use beneficiary designations on accounts like IRAs.

Keeping Your Estate Private
When you go to probate, your business becomes everyone’s business because your estate becomes a matter of public record. Unfortunately, I’ve heard horror stories about less scrupulous professionals that try to make a living off selling bad investments to beneficiaries of estates that they’ve read about in the county news. A trust allows you to execute your wishes away from the public eye.

Protecting Beneficiaries
Let’s face it, not everyone is good with money. I have heard of situations both professionally and personally where inheritances in lump sums were not a good idea. With a trust, you can also offer guidance on distribution of assets. My trust is set up so that my kids get a portion at certain ages like 25, 30, and the remainder is distributed at 35.

Protection from Creditors
Creditors can be an unexpected beneficiary in an estate if you are not careful. I heard about an example of this in one of my forums. A $25 million dollar estate was being distributed to the remaining son. Unfortunately, that son was involved in a partnership that had recently been sued for $22 million. As a result, when the son finally inherited the estate, the majority of it went to creditors. A trust can help protect against this sort of situation.

Having a trust is not absolutely necessary. The main benefit is for kids. If you are single, or don’t have kids, you may still protect your spouse from creditors, or maybe just make things a little more organized. Either way, the choice is yours.

FYI – The average cost of a complete estate plan including a trust can range from $1,000 to $1,800. About the same price I charge for a financial plan, or you would pay for cable TV for a year.

photo credit: epicharmus

Dividend investing is all the rage. See my response to a client’s question on whether to consider switching to a dividend income philosophy below.

Hi Rich – I have been listening to the talking heads on CNBC the last few weeks during the market volatility and most seem to think that the smart move is to buy stocks that have a history of paying good dividends….. The ETF SPDR S&P Dividend, (SPY) seems like a good move…. I would like to hear your opinion on this and any other moves we might consider taking…..the current yield on this ETF is 3.2%. I look forward to hearing your thoughts…

Disclaimer: I am not recommending readers invest in the funds mentioned in this article. They are used as an example of funds used in the two different investing philosophies. Any use of these, or any funds, should be a part of a well designed investment plan. It is the author’s opinion that asset allocations and investing philosophies should be designed as a compliment to a financial plan. What you are trying to achieve in life should dictate how you invest. Go to http://findanadvisor.napfa.org to find a fee-only financial advisor.

You’ve touched on the great debate of investing for Total Return or Dividend/Income.

Total return investing is investing for maximum return with income coming from the sale of fund shares. This results in minimal dividend tax and more capital gain tax on taxable accounts. Any income from IRA accounts is of course income tax, not including Roth withdrawals.

Dividend or Income investing is buying dividend paying stocks or funds that invest in dividend paying stocks. Income comes from dividends, and little or no shares are needed to sell for income. Dividend income is taxed at a more favorable rate if it is qualified. There is a holding period to qualify dividends.

Over the last 3 years, dividend investing has been favorable. Over the the last 5 years they’ve been almost even, with slight edge going to Total Return investing. (See 3 and 5 year Total Return figures of Vanguard Total Stock Market Fund, ticker VTI and SPDR S&P Dividend fund, ticker SDYon Morningstar by clicking on the links.) My philosophy has always leaned towards Total Return, but I have a client that prefers dividend investing. We’ve compromised and put a portion in a total return fund, VTI,  and a portion in a dividend oriented fund, VIG, which is Vanguard Dividend ETF. VIG is a blend between VTI and SDY. It doesn’t pay as much as the S&P Dividend Fund (SDY), but pays more than the Vanguard Total Stock Market fund (VTI). The strategy has worked out well, but has resulted in a lot of extra income on his tax return each year.

Morningstar’s Christine Benz just wrote an article on this topic recently because it seems to be the hot topic as of late. Income vs. Total Return. Her conclusion was to use a combination of both.

Why I lean towards Total Return - My preference has always been towards total return for tax reasons. By sheltering the bonds in your 401k and IRAs, and investing in indexes in your taxable accounts, you minimize taxes. If you’ve captured tax losses in your taxable account, which has been easy to do lately, you can further reduce your taxes, should you need to sell for income in the taxable account.

My Compromise – As one begins to take income, I am open to the idea of shifting a portion of large cap allocations to dividend paying funds. Just as Ms. Benz mentions, a little of both Total Return and Income investing is probably key. I’ve always been a big believer in moderation. However; if qualified dividend rates are taken away in 2013, dividend investing may lose its moxy.

photo credit: lumaxart

The following article is a summary of an interview on the Small Business Association of Michigan’s Business Next radio program. You can listen to the interview here. 

1. They don’t begin with the end in mind. Just like Stephen Covey says in his 7 Habits of Highly Effective People, business owners need to have a vision of where they are going with their company. Most of the time, a small business owner is someone that enjoys doing something and thinks they can do it better than their current employer, so they start their own business. But somewhere along the way they get bogged down in work and forget to think about where they are headed. They have no focus. Having a vision gives focus to your efforts and be it consciously or subconsciously, allows you to move toward your vision.  A great way to do this is with a business plan that actually puts pen to paper and spells out what you expect to make, spend, and invest towards your vision.
2. They don’t have enough cash reserves. Most veteran business owners I know like to have a lot of cash reserves available in case they run into a down economy, such as we are experiencing now, or if their company is cyclical. A cash reserve helps smooth out those times when things are slow so that you dont’ have to go into debt to keep things going, or worse, close shop when you’ll get the least for it because you are desperate. How much you save in cash reserves depends largely on your comfort level. If you are a dual income household, and your spouse has a steady job, you might only save 3 months worth of business expenses. If you are both self employed, or your spouse works in your business, you might need 6 months to a year’s worth of expenses. Those same veterans I just mentioned, usually prefer to have 1 to 2 year’s worth of expenses so that they can weather the longer recessions or down business cycles.
3. They don’t pay themselves first. Whether you’re a business owner or not, everyone should put a little money aside every month so that they can retire when the time comes. This is especially important for small business owners because they have a tendency to invest all their time, effort, and resources into their business and when they reach retirement age, they can’t retire. But most business owners that I speak with tell me they couldn’t possible set aside $500 a month for retirement. This was exactly what a client of mine who owns an auto repair shop said to me when I told him he wasn’t going to be able to retire any time soon. This was eye opening to him because he said that he was getting tired physically, and wasn’t going to be able to turn a wrench his whole life. After some discussion I learned that his truck payment was stopping this summer. I said, “how much is it?” He said, “$400″. I said, “why not set up an automatic payment of $400 in August when your truck payment stops, and consider this another payment?” The light bulb turned on and he got it. Finally, he knew that he could set aside something for retirement.
4. They don’t diversify their investments. After you’ve started paying yourself first, and accumulated your cash reserves for emergencies, you need to make sure that you’re not shooting yourself in the foot by not diversifying your investments. What do I mean? Most of the time, a small business owner will invest in things they know, because they are comfortable with it. They best example is the IT company that invests in the NASDAQ or worse, individual technology companies. They already work in technology, so the majority of their livelihood comes from that industry. They accentuate their financial risks by investing in that industry with their extra savings too. This reminds me of a client of mine that is a jeweler. Going into a re-balance meeting I wanted to combat the possibility of inflation and was looking for investments he could use. Knowing that he already had a couple hundred thousand in gold inventory, I opted to suggest a Treasury Inflation Protection fund instead. He already had way too much exposure to gold to add more in his portfolio.
5. They don’t have the right amount of insurance coverage for their risk exposures. Small business owners usually fall into one of two catagories: either they don’t have enough insurance because they are pinching pennies, or they have too much coverage and they are insurance rich and cash poor. The key is to find a balance. You want to have enough coverage, yet also have the ability to increase it as your company grows. Unfortunately small business owner risk is not limited to insurance for their particular product or service. You have also got to have adequate coverage for health, life, auto, homeowners, disability, and even long term care. This is where resource partners like the Small Business Association of Michigan can really help. If they can’t help you directly with a resource partner, they more than likely know a member who can.
6. They don’t have an exit plan. As I mentioned earlier, one problem that many small business owners have is that they don’t start with the end in mind. This includes selling your business too. If you have a clear vision as to where you want to go, you can make the necessary steps along the way that will put in place buyout opportunities when that time comes. The problem is that by the time business owners stop to think about this, it is usually 5 to 10 years out. Then they quickly hire someone that they plan on grooming to be their replacement, and after a little time, realize maybe this isn’t working. Then they hire someone else, but they have less time, and therefore less leverage in negotiating a sale. If you could turn back time, you would have structured your business in a way that you had multiple opportunities for replacements and they would have to bid on your business. This all starts with setting up your business in a manner that allows for growth, and starts with the end in mind.

Creative Commons License photo credit: Dplanet::

Recently, the financial services industry has come under scrutiny for hidden and unexplained costs. These fees are not only unfortunate, but are also besmirching the reputation and integrity of the industry. In order for financial planning to become a respected profession, we need complete transparency of fees. In other words, NO HIDDEN FEES, NO UNDISCLOSED COMMISSIONS, and NO UNEXPLAINED COSTS. Advisor fees should be clearly communicated to clients so that they can make informed decisions with their money. This post will explain how advisors are typically compensated.

Advisors typically hold themselves out as being either commission based, fee-based, or fee-only.

Commission based advisors earn income based on a percentage of the product they are selling. For example, if you buy an American Funds “A” share fund you will usually pay a 5.75% commission to the advisor. On a $100,000 investment, that means you pay the advisor $5,750 for one transaction. The benefit is that it is a one time fee, and you do not have to pay any more advisor fees. The downside is that you may  never hear from the advisor again unless they want to sell you another product for a commission. In this type of relationship, the advisor clearly works for the company of the product they are selling.

Fee-based advisors advise clients for a fee based on the amount of assets they manage AND can make a commission when they suggest a particular product such as life insurance or long term care insurance. This form of compensation really puts the client at the mercy of the advisor. A good advisor will charge a fee for most investment advice and ONLY charge a commission when the product is ABSOLUTELY necessary for planning purposes, like when life insurance is necessary. IF the advisor charges a fee for managing the investments AND receives a 5.75% commission from the sale of the funds, they would receive $5,750 up front, followed by an annually percentage, or about $1,0oo. (According to a recent Financial Planning Association Research Center study, 60+% of fee advisors charge 1% or greater.) This is a worse case scenario. What’s also concerning is that the advisor is working for both you, and the company whose product they are selling. This causes a conflict of interest as to their loyalty. Whose interest are they putting first? What is most important with a fee-based advisor relationship is that the advisor disclose ALL their compensation so that you know if they are double dipping by charging fees and commissions.

Fee-Only Advisors are the only advisors that are paid STRICTLY by the client, therefore eliminating many conflicts of interest, and introducing objectivity. Fee-only advisors can be compensated a few different ways:

1. Hourly – The advisor charges an hourly rate for time spent working on a project. Typical hourly rates range from $100 to $500 an hour, averaging $180/hr.
2. Fixed Fees – The advisor quotes a fee for a project based on the the number of hours he thinks it will take him to complete the plan. Costs range from $1,000 to $5,000 depending on the complexity of the situation.
3. Retainer – The advisor charges a flat annual retainer fee for services rendered throughout the year. Retainer fees range from $2,500 to $10,000 a year.
4. Percentage Based Fees – The advisor charges a percentage fee based on the Assets (investments) Under Management, often called AUM.

Hourly and fixed fee payment methods are most utilized by the Do-It-Yourself (DIY) and beginner investors seeking a second opinion on their personal finances without a long term commitment. This also keeps the costs down long term because you can get your advice, and save money implementing the advice yourself.

Retainer and AUM Fees are mostly utilized by investors that have enough money or income to justify paying their fees out of pocket. Typical retainer and percentage based clients are well into the accumulation phase of life, or retired investors that are in the preservation phase of life.

Retainer fees are good because you can easily judge whether you are getting your money’s worth. The downside is that it doesn’t give the advisor incentive to do any additional work.

Percentage based fees are good because they align the interest of the client and the advisor to either maintain or increase the value of your portfolio. The downside is that the advisor may suggest planning techniques, like not paying down debt, that maximize the amount of money they manage, or worse, they may take too much risk in order to increase their fees.

All forms of compensation have their conflicts. Finding the form that is right for your depends on how much advice you need. If you are new to investing, you might consider doing it yourself using online resources. If you are nervous about making these decisions, you could hire a fee-only advisor on an hourly basis, or seek a commission based advisor and pay a one time fee. If you are a seasoned investor, you might delegate your investment, financial planning, and tax needs to a retainer or percentage based advisor. Or, you could do it yourself and not hire an advisor at all. It all depends on how comfortable you are making decisions that can have an impact on your golden years.

As an advisor, I’m biased towards using an advisor. One reason I’m am biased is because a good advisor can navigate the HIDDEN FEES in Investing.

Creative Commons License photo credit: JD Hancock

Tax deferral means postponing the payment of tax on income, interest, dividends, and capital gains until the investor takes possession of them. The simplest form of tax deferral is by putting money in your 401k or IRA. You put a portion of your income away before taxes so that you can use that income later in retirement. That’s the basic form of tax deferral. But did you know that there are advanced forms of tax deferral?

Advance Tax Deferral involves placing highly taxable investments in your tax deferral accounts and placing your less taxable investments in your taxable accounts. Confused? This one is best explained with an example. For simplicity, we’ll use round figures.

Suppose your a millionaire. You have a one million dollar portfolio exactly and your asset allocation is 50% equity and 50% bonds. The bond fund pays 4%.

Your portfolio is divided into two accounts: an IRA, and a taxable joint account with your wife. Each account has $500,000 in it.

Most people would put 50% bonds and 50% equity in both IRA and joint account. This would mean that $250,000 is invested in bonds in a taxable account. At 4% interest, the bonds would generate $10,000 of interest that is added to your tax return at the end of the year. Someone in the 25% tax bracket would owe $2,500 extra in taxes that year.  More importantly, after taxes you’d only make $7,500 on your bond fund, which is equivalent to a real after tax return of 3%, NOT 4%.

Using an advanced tax deferral strategy you’d allocate all of your fixed portion of your investments in your IRA account. This would equal $500,000 which would pay dividends of $20,000 ($500,000 x 4%), none of which would  be added to your taxes this year. Your real after tax return is the FULL 4%.

You can further lower your tax bill by Tax Loss Harvesting, and  investing in low turnover index funds in your taxable account. Click here for The Simple Reason Why Index Funds Beat Actively Managed Mutual Funds, or Tax Loss Harvesting.

Creative Commons License photo credit: Mariano Kamp

There has been a lot of research that explains why index funds outperform actively managed mutual fund. I thought I’d share a distilled version:

An index fund has low turnover because it knows what stocks it will invest in; whatever stocks are in that index. Furthermore, because it knows the stocks it is going to invest in, it doesn’t have to pay a manager big bucks to beat the stock market. That means low fund expense ratios.

On the flip side, an actively managed fund has to try to beat the stock market by constantly buying and selling stocks. This causes turnover, which spin out capital gains and dividends that you pay tax on in your taxable accounts.

Also, if you are expected to beat the market, you should earn big money too, so actively managed funds have to pay their managers high salaries that cause them to have high internal expenses.

Between high turnover, and high expenses, it makes it very difficult for actively managed mutual funds to beat an index fund. Of course, there is not guarantee that index funds will beat actively managed funds. There are some active funds that outperform indexes. But they usually don’t outperform index funds for long periods of time. And the chances of you getting in these active funds during the periods they do outperform the indexes, and out of these funds when they under perform the index, are slim.