Author: tomatpwa

The Value Of Volatility

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When the market falls, especially after a strong upward run (4+ years in this case), I think it’s worthwhile to remind everyone about the value of volatility. To keep it simple, let’s just think about a simple portfolio containing all US stocks and no bonds. This is what I would consider to be an extremely aggressive portfolio, one that would be hit very hard by a bear market like we had from late 2007 to 2009. Let’s look at 2 cases, with the stock index in both cases shown in the graph below:

Case 1: Reality (Volatile Market) – Using the actual performance of US Stocks from late 2007 to the end of 2012, suppose you had a $100k portfolio in September of 2007, just before stocks peaked and started heading lower. Your financial plan for retirement called for $1k per month contributions consistently (think of this as your 401k for example). The market tanks, losing almost 50 of its value by March 2009, and then slowly comes back to surpass where it started. By the end of 2012, you would have amassed a sum of $196,024.60. That’s your original $100k + $63k in contributions + over $33k in gains.

Case 2: “Ideal” (Market Never Falls) – In this case, we’ll pretend that the stock market moved in a slow straight line starting at the same value as in Case 1 and ending at the same value as in Case 1, but with no volatility. It never had a losing month and just kept slowly increasing. Let’s start with the same $100k and add the same $1k per month. This would feel much more comfortable. You could look at your statement and see constant progress… slow and steady. No sweating, no heartburn, no temptation to sell or alter your contributions. I call this the “ideal” case in quotes, but it’s actually far from ideal. In this scenario, you would have ended 2012 with $180,931.30. Again, your original $100k + $63k in contributions + ~$21k in gains. That’s only 2/3rds of the gain with the volatile portfolio, simply because you never get to add your $1k per month at lower prices.

The moral of the story here is that if you’re adding to your portfolio regularly, you really should be hoping for the market to fall from time to time, not rise, so that you can buy at lower prices. Sure, you want the market to rise right before you need to withdraw money, but until then, the lower it goes (a la March 2009), the worse it will feel, but the better it will be long-term. Volatility is the real “ideal” for the long-term investor.

All-Time Highs – A Historical Perspective

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If you watch business news TV, read the business section of the newspaper, or follow business/investing websites, you’ve undoubtedly heard a lot of “due for a pullback”, “too much too fast”, “need a correction” and “not safe to invest at all-time highs” lately. Mind you, many of these predictions started when the stock market was 10-20% lower than it is today. While I continue to believe predicting the short-term direction of the market is a fool’s game, and I’m definitely not saying it’s going to happen this way again, it’s worth looking at the last time in history that the stock market moved essentially sideways for 13-14 years and then broke out to new highs. The first chart below shows the S&P 500 from 1966 to mid-1980. Essentially no gains for over a decade, two massive drops (one near 50%). This was the period of the infamous Businesweek cover that claimed “The Death Of Equities”. The second chart shows the same S&P 500 index starting from the same point, but extending to 2000. If investors were too scared in 1980 to invest in the stock market, or were waiting for a correction to invest because it was breaking to new highs, they may have missed the run from 120 to 1500 on the S&P 500 (1150% return).

The moral of the story is not that you should invest now because the stock market is going to go up for the week, month, year, or decade. It’s that trying to use the recent past (or even 14 years of past) to determine the value of the stock market today is useless. It may even be worse than useless… it could lead you to feel that the market it overvalued, right before it increases 1150% over the longest bull market in history.

Charitable Contributions – Deductions and Recordkeeping

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I receive lots of questions around tax time about what charitable contributions are deductible and what records need to be kept to validate the deductions.  Here’s my brief attempt at the basics of donating cash, donating property, or performing charitable services through which you incur expenses:

Cash

1)      If you make a donation in cash that is under $250, an acknowledgement from the organization is not required as long as you have a bank record of the transaction (account statement, credit card bill).  The record must include the name of the charity and the amount of the contribution.  Alternatively, you can have a receipt from the organization, or a payroll record if you donated through a payroll deduction.

2)      If you make a donation in cash that is $250 or over, you must receive acknowledgement from the organization dated prior to the due date of your tax return, and it must state:

  1. The amount of cash and a description (but not the value) of any property other than cash contributed.
  2. Whether the organization receiving the donation provided any goods or services in consideration, in whole or in part, for any cash or property that was contributed.  This is important.  A simple letter saying you donated $1,000 to the organization will not qualify because it doesn’t say specifically that you didn’t receive anything in return for the donation.  In a recent court case, a couple contributed $25,171 to their church over multiple donations through the year, most of which were over $250.  At the end of the year, they received a letter stating the total (and thanking them for their generosity), but the letter didn’t include a statement that said they received nothing in return.  The IRS challenged the deduction, it went to court, and the Tax Court sided with the IRS since this clearly violated the rules for taking a deduction.
  3. A description and good faith estimate of the value of any goods or services received by the donor or if such goods and services consist solely of intangible religious benefit.

Property

If you donate property to a qualified charitable organization, you generally can deduct the fair market value of the property.  This is not the amount you paid for it.  It is the amount the property is worth at the time of the donation (generally not to exceed the value you paid for it).  The recordkeeping rules differ based mainly on the deductible value of the donation:

1)      If the deductible value is less than $250, you need a receipt from the organization showing the name of the organization, the date and location of the donation, and a reasonably detailed description of the property (“1 large bag of clothes” will not do).  Note, the IRS says that you do not need a receipt for donations < $250 if it is impractical to get one (like an unattended drop box).  You must also keep records of the donation which include:

  1. The name and address of the organization
  2. The date and location of the donation
  3. A reasonably detailed description of the property
  4. The fair market value of the property and how you determined it (i.e. thrift shop value, comparative sales, etc.)
  5. Your cost basis in the property
  6. The amount you claim as the deduction
  7. The terms of any conditions attached to the donation.

2)      If the deductible value is between $250 and $500 (inclusive), you need:

  1. the information from #1 above, AND,
  2. a written acknowledgement from the organization detailing the property donated, whether you received anything in return or not, and a description and good faith estimate of anything you did receive in return.  This must be received before the due date of your tax return.

3)      If the deductible value is over $500 but not over $5,000, you need:

  1. the information from #2 above, AND,
  2. your own records showing how you obtained the property, the approximate date you obtained the property, and your cost basis in the property.

4)      If the deductible value is over $5,000, you need:

  1. the information from #3 above, AND,
  2. a qualified appraisal

Special rules exist for cars, boats, and airplanes which include receiving a 1098-C from the charitable organization and your deduction being limited to the amount for which your donated item was sold by the organization (e.g. if you donate your car with a blue book value of $2k to your church and they sell it for $750, your deduction is limited to $750).

Expenses

You can deduct expenses you incur in connection with performing charitable work as long as the expenses are:

1)      not reimbursed,

2)      directly connected with the services you provided,

3)      expenses you only incurred because of the services you provided, AND

4)      not personal, living, or family expenses.

The cost of travel to perform charitable services is deductible including the cost of driving your own car at the annual charitable mileage deduction amount as posted by the IRS (14 cents per mile for 2012 and 2013).  Meals are generally only deductible if you’re required to be away from home overnight.

Note: you cannot deduct the value of your time in performing or traveling to/from charitable services.

See IRS Publication 526 for more information.

Where’s My Refund Tool

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The IRS is not providing estimates for direct deposit this year as part of your Form 9325 (E-File Confirmation). If you expect a refund from the IRS, you can check the “Where’s My Refund” tool available at irs.gov. See the information below from the IRS with more detail on the tool:

After the IRS starts processing returns, it expects to process refunds within the usual timeframes. Last year, the IRS issued more than nine out of 10 refunds to taxpayers in less than 21 days, and it expects the same results in 2013. Even though the IRS issues most refunds in less than 21 days, some tax returns will require additional review and take longer. To help protect against refund fraud, the IRS has put in place stronger security filters this filing season.

After taxpayers file a return, they can track the status of the refund with the “Where’s My Refund?” tool available on the IRS.gov website. New this year, instead of an estimated date, Where’s My Refund? will give people an actual personalized refund date after the IRS processes the tax return and approves the refund.

“Where’s My Refund?” will be available for use after the IRS starts processing tax returns on Jan. 30. Here are some tips for using “Where’s My Refund?” after it’s available on Jan. 30:

  • Initial information will generally be available within 24 hours after the IRS receives the taxpayer’s e-filed return or four weeks after mailing a paper return.
  • The system updates every 24 hours, usually overnight. There’s no need to check more than once a day.
  • “Where’s My Refund?” provides the most accurate and complete information that the IRS has about the refund, so there is no need to call the IRS unless the web tool says to do so.
  • To use the “Where’s My Refund?” tool, taxpayers need to have a copy of their tax return for reference. Taxpayers will need their social security number, filing status and the exact dollar amount of the refund they are expecting.

For the latest information about the Jan. 30 tax season opening, tax law changes and tax refunds, visit IRS.gov.

Additional IRS Resources:

IRS YouTube Video:

  • When Will I Get My Refund? –

American Taxpayer Relief Act (ATRA) a.k.a. Fiscal Cliff Deal

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I’ve parsed through the legislation (which can be found here if you want to check it out for yourself), as well as a ton of analysis, and to the best of my ability, here’s a quick summary of the relevant portions of the new law that averted the tax portion of the fiscal cliff. Note that while $400k/450k are getting all the press for paying higher taxes, there are a number of provisions which impact $200k(single)/$250k(married), and one really big one that impacts everyone (Payroll Tax Holiday Ended):

· Income Tax Rates: All existing rates remain the same with brackets increased for inflation (10%, 15%, 25%, 28%, 33%, 35%) and a new 39.6% bracket begins at taxable income over $400k for singles and $450k for joint filers.

· Long-Term Capital Gains: These were set to move from 0% for the bottom two tax brackets and 15% for everyone else to 20% for everyone. The legislation keeps the 0% and 15% rates for everyone except those in the new 39.6% tax bracket. They’ll pay 20% (not including the new Obamacare Medicare Surtax, see below).

· Dividend Rates: These were set to move from 0% for the bottom two tax brackets and 15% for everyone else to ordinary income rates for everyone. The legislation keeps this rate tied to the long-term capital gains rate with the same rules as above.

· Estate Tax Rates & Exemption: Retained the $5M per person exemption (was set to reset to $1M) and kept it portable (each spouse gets $5M instead of the couple getting $10M which forces complicated bypass trusts to be set up to try to use the $5M from the first to die spouse). Set the top tax rate at 40% (up from 2012’s 35%, but down from the 55% to which 2013 was due to revert).

· AMT Exemption: Patched the AMT exemption amount to the 2011 amount, increased for inflation. This was a big one since it was 2012 they were fixing, not 2013. Even better, they permanently fixed this so that each year’s exemption will be indexed to inflation going forward. This means no end of year scramble to get an AMT patched passed each year.

· Phaseout of Itemized Deductions: this was due to happen in 2013 without any new law, but ATRA tweaked the thresholds. If you are Single with AGI over $250k or married with AGI over $300k, your itemized deductions will be reduced by 3% of the amount that your AGI exceeds the threshold, up to a maximum reduction of 80% of your itemized deductions. To simplify, if you’re over the threshold by $10k, you lose $300 of itemized deductions. If you’re over by $100k, you lose $3k.

· Phaseout of Exemptions: this was also due to happen in 2013, but ATRA unified the phaseout level with the Itemized deduction phaseout. If you are Single with AGI over $250k or married with AGI over $300k, your exemptions ($3800 per family member) are reduced by 2% for every $2500 that you’re over the threshold. To simplify, if you’re over by $10k, you lose 8% of your exemptions. If you’re over by $100k, you lose 80% of your exemptions. This can be a pretty big bite.

· Payroll Tax Holiday Ended: this was due to happen in 2011, but was extended for two years and now is finally gone. It impacts everyone with income from work (employment or self-employment) by restoring the employee portion of Social Security (FICA) tax to 6.2% from 4.2%. This means everyone will pay 2% more tax in getting this level back to its pre-2011 setting (which still grossly underfunds Social Security over the long-term).

· Marriage Penalty: The standard deduction for married filers and the 15% tax brackets were due to revert to 1.67x the single amounts. ATRA kept them at 2x the single amount and made that change permanent. There is still a very large marriage penalty in the code anyway, as described here.

· Bonus Depreciation & Higher 1st Year Expensing: For business owners, 50% bonus depreciation on new purchases is extended into 2013 as is the higher limit for immediate expensing of certain purchases (Section 179).

· Misc. Permanent Extensions: Child Tax Credit ($1k per child subject to limits), Exclusion for Employer Provided Tuition Assistance ($5250 tax free reimbursement).

· Misc. Temporary Extensions: American Opportunity Tax Credit (college), teacher’s deduction ($250), exclusion from discharge of debt on primary residence (no income on short-sale or foreclosure), deduction for Mortgage Insurance Premiums, Deduction for State and Local Sales Tax paid (big in no income tax states), Tuition Deduction.

While not included in the ATRA legislation, it’s important to remember that two new fairly large changes also being in 2013 as Obamacare is rolled out. They are:

1) 0.9% Medicare Surtax on earned income (income from work) that exceeds $200k (single) or $250k (married). It’s important to note here that this will cause underwithholding from your employer if you have multiple jobs or are marred and both spouses have income since payroll systems will not realize that your earned income will exceed $200k/250k until you exceed that amount from a single employer.

2) 3.8% Medicare Surtax on investment income (interest, dividends, capital gains, rents collected, passive business income) if your Adjusted Gross Income exceeds $200k (single) or $250k (married). While there is no withholding on most investment income and you’re used to paying tax when filing or making estimated tax payments on that income through the year, the 3.8% additional tax effectively raises the tax rates on interest, dividends, gains, etc., even if you don’t meet the now well-publicized $400k (single) / $450k (married) income from the fiscal cliff deal.

I have no doubt that more tax changes will come in 2013 and/or 2014 since ATRA only reduces the > $1 trillion deficit by ~$60 billion per year, so it’s hard to count on anything above as permanent even where legislation made it permanent. The next major debate, likely to be more focused on spending than taxes will be in February as the Debt Ceiling will need to be raised again at that time. It’s quite possible that taxes, especially beyond 2013, become part of that negotiation as well.

Fiscal Cliff Deal Update 12/31

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At the 11th hour, as expected, here comes the mini-deal. All speculation so far, but here’s what it’s looking like:

· Threshold for income tax rate increase would be $400k for individuals or $450k for families. Top rate on these taxpayers would increase from 35% to 39.6% though the marginal rates below that level will remain the same as they are now.

· Long-Term Capital Gains rates AND dividend rates go to 20% from 15% (but not 39.6%) for those above the $400k/450k income level. 15% would be maintained for those below.

· Extension of unemployment benefits for ??? time

· AMT Patch for 2012

· Deferral of sequestration-related spending cuts for a limited amount of time

· 40% top tax rate on estates over $5M (per individual??), up slightly from current 35%

Details still to be worked out. Votes in both the Senate and House required to pass. Not a given by any means. This would also do nothing for the debt ceiling (which needs to be raised sometime around late Feb / early Mar) and does VERY little to close the $1 Trillion per year deficit at the heart of the matter.

Fiscal Cliff Update

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Reporters are already beating this story to death, but I wanted to provide a quick update from my perspective. Going over the Fiscal Cliff means higher taxes for all via the expiration of the 2001 and 2003 tax cuts, and forced spending cuts via the sequestration that was agreed upon during the debt ceiling debacle last year. We will technically go over the cliff on Jan 1 if Congress and the President don’t pass a law to extend the tax cuts and/or modify the sequestration. By now, everyone knows that. Ultimately, the “answer” is not to perpetually extend tax cuts and keep spending more than we can afford. But, the idea is to extend some of the tax cuts and some of the spending until the economy is back on its feet while setting the stage for major tax and entitlement reform in 2013/2014.

What isn’t as readily apparent is that virtually everything that changes if we go over the cliff can be modified retroactive to Jan 1. I hate to get into politics on this blog, but there seems to be a substantial incentive to go over the cliff, or come as close to it as possible, and then to place blame on the other party for doing so while each party is able to appeal to its base for sticking to its guns. Speaker Boehner’s re-election vote is on Jan 3 and the odds of re-election are thought to be higher if he stands his ground, consistent with the motivation for each party to obstruct progress and issue blame. Then, post Jan 1, after payroll systems are at the deadline for change to charge higher taxes, markets are on edge, constituents are threating to stop funding Congressional election campaigns, etc., a deal can be reached without losing face.

Whether a minor deal is passed on 12/31 or in early January is not relevant (2012 AMT exemption aside – this will almost certainly get passed). What is relevant is avoiding a traumatic shock to the economy and laying the groundwork for long-term reform, at least far enough to prevent another debt downgrade, and prevent the market from demanding higher interest rates in order to lend money to the US government. It’s hard to have faith in government at this point. But, as Winston Churchill supposedly once pointed out, you can always trust Americans to do the right thing once all other possibilities have been exhausted. I believe we’re getting close to that exhaustion.

One more thing… a CNBC commentator recently drew a parallel between Congress’s fiscal cliff actions and term paper deadlines saying, “Did you ever turned in a term paper ahead of its deadline?” Of course the answer for virtually everyone is a resounding “No”. Congress acts similarly. However, I think this is a little different. This is like a term paper where you’re penalized one point for every day late. If the deadline is 12/31, you would be tempted to miss the deadline by a few days, but would be unlikely to never turn in the paper. Even though the incentive to turn it in on any particular day is fairly low and you might be ok with losing a few points, there comes a time where you start to add up the damage, sit down at your computer, and just get it done. Damage will be done to the economy and to confidence each day that passes beyond 12/31, but it’s important to note that we’re not going to immediately get an “F” or fall off a cliff into the abyss, despite claims from ratings-hungry reporters. Markets will get antsy, reporting will get ugly, and the political blame game will be enhanced to its highest level yet. But, as long the short-term is handled in the next few weeks and the long-term is handled in the next few years, this crisis will pass like all others before it.

Have a Happy New Year. The Mayan’s couldn’t take it away and neither will the Politicians.

2013 Tax Changes & “The Fiscal Cliff”

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By now everyone has heard of the tax increases and spending cuts that will take effect in 2013 under current law, not-so-affectionately-called “The Fiscal Cliff”. This post takes a look at many of the tax changes which will have a broad impact on individuals and joint filers regardless of income. While the list is not all-inclusive, it covers most of the changes that would affect individuals and couples (leaving out some of the business tax impacts). Some of these may come as a surprise since they don’t get much attention in the press. The chart below shows the changes as they are currently on the books, the impact of each change if left as is, and the probable outcome of efforts to avoid the Fiscal Cliff.

The probable outcomes on the changes above are not likely to close the deficit enough to prevent another rating downgrade of U.S. debt, especially if the proposed spending cuts are also scaled back to avert the fiscal cliff. To close the deficit, a broader “grand bargain” will be necessary to cut spending on entitlements and discretionary items while raising tax revenue through a major tax revamp. There is no time for this to be negotiated in late 2012 / early 2013, but I think it’s on the table toward the end of 2013 / beginning of 2014, especially if motivated by the debt rating agencies and/or market-based increases in long-term interest rates as the U.S. loses credibility as a borrower. The solution needs to be a balance of higher taxes and reduced government spending, but most of it needs to be focused on long-term changes, rather than sudden short-term shocks to the economy. I suspect this will include pushing out the SS retirement age for those currently below age 50, greater Medicare limitations and/or higher Medicare premiums for those currently below age 50 when they reach Medicare age, an increase in the SS wage base, means testing of both Social Security and Medicare (i.e. if you have high income from other sources in retirement, you’ll receive less from these programs), a slight reduction in marginal tax brackets, a large reduction in items that are excluded from income or deductible (especially for mid-high incomers), and a modified AMT that will impose a minimum effective tax rate on all income for those earning $1M or more. It’s too early to know specifics, but I’ll continue to post about these items as ideas run through Congress and become more than just speculation.

College Costs

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I just read through an article in Investment News that shared some trends and averages for the cost of sending a child to college today and wanted to share.  Here are the highlights:

· According to the National Association of Independent Colleges and Universities, from 1998-2008, average private college year over year cost increases were 5.7% (many of you who have children may have heard me quote this “about 6% per year” number in the past).

· In 2009 and 2010, the average increase was 4.5%.

· In 2011, the average increase was 3.9% (thankfully the growth is slowing, but prices are still rising faster than the overall rate of inflation and the average middle-income earner’s cost-of-living adjustments at work).

· According to The College Board, the average tuition & fees for non-profit, private colleges and universities for the 2011-12 school year was $28,500. Add room and board and the total is $38,589 per year. The average amount a family pays after financial aid (grants and loans) is $12,970 per year, but given that most of that is Federally funded by Federally borrowed funds (e.g. the deficit/debt), counting on financial aid of this magnitude, especially in the form of grants, for the future is on par with counting on Social Security to be around in 20 years and continuing to operate the way it does today.

· For clients who have a goal of paying for all or part of college for their child(ren), we’re still using the ~6% annual increase in financial planning.  We think it’s easier to plan conservatively and be pleasantly surprised than to plan aggressively and come up short, though we’ll ratchet back the expectations somewhat if the annual cost increases continue to slow. For now, using 6%, a child born this year and starting school in 18 years would face a staggering four-year total tuition, fees, room, and board bill of $481,846.  Even using the 3.9% from last year, the total is $325,779 per child.

Save early and save often if you have a goal of paying for any substantial portion of that cost. In a future post, I’ll go through the best way to do that saving.

Housing Market Progress

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I wanted to quickly update two of the housing charts that I originally posted in the PWA Newsletter back in Q4 2009 (I’ve posted that article in the blog archives for reference). The first shoes the inflation-adjusted median price of a home in the U.S over time. The second shows a comparison of a national house price index (proxy for cost to buy) with a national rent index (proxy for cost to rent).

A few key takeaways (all from a national level of course):

1) House prices generally do not outpace inflation by very much on average. While there are repeated boom and bust cycles, and the 2000-today cycle is very fresh in memory, looking at the first chart above, you can see that on an inflation-adjusted basis (as measured by CPI), house prices have remained fairly steady over the past 40 years.

2) House prices, on average, are strongly correlated with rents.

3) The 2007-2012 bust in housing prices has not depressed the market as a whole to absurdly low levels. Real estate is not at a bargain price today as compared with rents or inflation-adjusted historical prices. Rather, the boom of 2001-2007 created prices that were absurdly high. These prices are now back to reasonable levels on a national level (local pockets of under/over valuation can obviously occur).

4) With mortgage rates at historical lows and prices at reasonable levels, affordability is near all-time highs. Buyers with a 20% downpayment and the median income level are able to afford a monthly payment that is very low as a proportion of their income, as measured by historical standards.

5) It’s tempting to say that prices are about as low as they can go, but it is a bit dangerous to make that assumption because:

a. If mortgage rates were at a more normal level by historical standards, buyers would be able to afford much less. What happens when rates eventually move back up?

b. The mortgage interest tax deduction is in question for the future. While we strongly doubt the deduction will be taken away in full, it is possible that it will be capped at a level much lower than the $1M of mortgage as it is today, and probable that the deduction for 2nd residences may be taken away completely. This would make the playing field between renting and buying much more equal, all other things being equal.

c. There is nothing to say that prices can’t overcompensate to the low side just like they did to the high side in 2001-2007.

6) Conclusion: no crystal ball, but the future of house prices looks considerably better than it did a few years ago.

On a more local level, I did some slicing and dicing of the Case-Shiller home price index data. As you might expect, the localities that had the largest price increases in 2002-2006 had some of the sharpest falls in 2007-2011. I also included a column for change over the past year so you can tell what’s currently going on in your area (or an area near you). Sad story for the Atlantans who are reading this, but Phoenix, wow. Many cities definitely starting to see a (at least temporary) turnaround. Amazingly, the annualized increase in prices from 2002-2011 for the Composite of all 20 localities in the index (weighted by number of units) was still positive 1.3% per year even after the traumatic drops over the last few years. The last 12 months have shown an increase at that same 1.3% pace nationwide.