Monday, January 14, 2013

Financial Blueprints


If you had a piece of land and wanted to build a house on it, you wouldn’t just dig a hole in the dirt, pour some concrete into it and start building room by room, hoping to one day end up with your dream home, would you? Most likely you would do some research, consult with friends and family and find a professional with whom you could sit down to define your vision and draw up a set of plans to guide you. With the plans in place, you would then seek out an experienced and well-regarded builder (perhaps the same person who drew up the plans, perhaps not) to execute them. Yet so often, when it comes to planning their financial future, including eventual retirement, people do exactly the former by diverting their hard-earned money to a series of so-called investments in a haphazard way with no professional help or pre-defined plan to guide them.
The house building analogy is one that we use quite often in our practice to help drive home the importance of planning, but there are many more that we have heard through the years that are equally effective in painting the picture for clients. A favorite of a former colleague was more of a travelling comparison that essentially boiled down to not starting a long journey without mapping out the route first. The list of potential metaphors is long and which one resonates with each person is not important. What is important is why advisors who are committed to financial planning feel so strongly about the effects of sound planning on the client’s ultimate outcome, that they deem it necessary to express this relationship in any way they can in order to highlight the point.
To those of us who believe that having a well-thought-out plan in place is not only helpful, but essential in determining financial outcomes for clients, the plan is not simply a collection of statistics, but a barometer that defines, in advance, what steps will be taken under different market conditions. A guide for decision making not based on how we ‘think’ or ‘feel’ during the stresses or euphoria of up and down markets, but on what  effects these steps historically have had or likely will have on the client’s individual circumstances.
We regularly cite the statistics of lagging average investor returns versus those of the overall market, and have addressed some of the potential causes in previous blog posts (see “It’s Different This Time”, July 27, 2012). And, as firm believers in many of the main principles of behavioral finance, we do not see these statistics as particularly surprising or remarkable. On the contrary, we find the forces of herd mentality, loss aversion and the like to be expected responses to volatile market conditions. Such forces need to be addressed, accounted for and counteracted by planning for them in advance so that important financial decision are not being made during times of high stress and market uncertainty. Volatility is a natural function of financial markets (the sensationalist nature of financial news reporting during highly volatile conditions notwithstanding), and an investor armed with the confidence of a pre-determined action plan is much more likely to avoid the costly mistakes that lead to severe underperformance over time than an investor without one.
There have been roughly 15 recessions in the past 100 years in the U.S., meaning one every 6-7 years or so. Clearly not an unusual event, and as anyone who studies economics or markets knows, a necessary yang to the yin of expansion. And because of the irrational exuberance (as Alan Greenspan so eloquently put it) that so often occurs, particularly in the late stages of economic expansions, the resulting recessions can often be equally powerful. The pendulum swings too far in either direction as it were. 
And, while these swings are perfectly natural, each has a distinctly different feel while it is happening- a feel that, to the untrained actor, seems entirely new and unnatural. What we see then is the investor who has built his foundation on little more than some internet research and the advice of well meaning friends and family, suddenly second guessing his methods and likely the overall health of the system as a whole. The steps that follow range from discontinuing contributions to outright paralysis to conservative repositioning and often culminate in the dreaded “I’ll just get all the way out until the market turns around” reaction.  This last response generally results in locking in losses at the worst possible time, likely missing the customary bounce off the bottom and effectively torpedoing the long-term return potential of his portfolio.
This is not to say that to the investor who has properly planned for and been coached to expect the volatility that comes with the inevitable recessionary downturn, it doesn’t also feel new and unnatural. However, the confidence that has been created through the execution of a carefully produced financial plan, acts as a bastion against the natural feelings of fear and loss aversion that set in during such times.  What’s more, when an investor is not clouded by feelings of fear and doubt, she can see the recessionary environment clearly for what it is, a small moment of opportunity.  By continuing to contribute to investments and rebalance current positions during market downturns and intervals of great volatility, the planning client typically takes advantage of a buying opportunity, purchasing high-quality assets at depressed prices. This effectively lowers her overall investing costs over time, resulting in potentially higher returns in the long run.
In our practice, we believe in the the virtues of comprehensive planning far beyond the effects on just the investment piece of the financial puzzle, and will continue to preach the gospel of planning to all of our clients going forward. For everyone else, you might want to make sure your foundation is solid before starting on that third-story addition.



The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

The American Taxpayer Relief Act of 2012



The new-year began with some political drama, as last-minute negotiations attempted to avert sending the nation over the "fiscal cliff." Technically, we actually did go over the cliff, however briefly, as a host of tax provisions and automatic spending cuts took effect at the stroke of midnight on December 31, 2012. However, January 1, 2013, saw legislation--retroactively effective--pass the U.S. Senate, and then later the House of Representatives. The American Taxpayer Relief Act of 2012 (ATRA) permanently extends a number of major tax provisions and temporarily extends many others. Here are the basics.

Tax rates

For most individuals, the legislation permanently extends the lower federal income tax rates that have existed for the last decade. That means most taxpayers will continue to pay tax according to the same six tax brackets (10%, 15%, 25%, 28%, 33%, and 35%) that applied for 2012. The top federal income tax rate, however, will increase to 39.6% beginning in 2013 for individuals with income that exceeds $400,000 ($450,000 for married couples filing joint returns).

Generally, lower tax rates that applied to long-term capital gain and qualifying dividends have been permanently extended for most individuals as well. If you're in the 10% or 15% marginal income tax bracket, a special 0% rate generally applies. If you are in the 25%, 28%, 33%, or 35% tax brackets, a 15% maximum rate will generally apply. Beginning in 2013, however, those who pay tax at the higher 39.6% federal income tax rate (i.e., individuals with income that exceeds $400,000, or married couples filing jointly with income that exceeds $450,000) will be subject to a maximum rate of 20% for long-term capital gain and qualifying dividends.

Alternative minimum tax (AMT)

The AMT is essentially a parallel federal income tax system with its own rates and rules. The last temporary AMT "patch" expired at the end of 2011, threatening to dramatically increase the number of individuals subject to the AMT for 2012. The American Taxpayer Relief Act permanently extends AMT relief, retroactively increasing the AMT exemption amounts for 2012, and providing that the exemption amounts will be indexed for inflation in future years. The Act also permanently extends provisions that allowed nonrefundable personal income tax credits to be used to offset AMT liability.
 

        2012 AMT Exemption Amounts
 

Before Act                             After Act

Married filing jointly                              $45,000                                   $78,750

Unmarried individuals                           $33,750                                   $50,600

Married filing separately                       $22,500                                   $39,375

 
Estate tax

The Act makes permanent the $5 million exemption amounts (indexed for inflation) for the estate tax, the gift tax, and the generation-skipping transfer tax--the same exemptions that were in effect for 2011 and 2012. The top tax rate, however, is increased to 40% (up from 35%) beginning in 2013.

The Act also permanently extends the "portability" provision in effect for 2011 and 2012 that allows the executor of a deceased individual's estate to transfer any unused exemption amount to the individual's surviving spouse.

 
Phaseout or limitation of itemized deductions and personal exemptions

In the past, itemized deductions and personal and dependency exemptions were phased out or limited for high-income individuals. Since 2010, neither itemized deductions nor personal and dependency exemptions have been subject to phaseout or limitation based on income, but those provisions expired at the end of 2012.

The new legislation provides that, beginning in 2013, personal and dependency exemptions will be phased out for those with incomes exceeding specified income thresholds. Similarly, itemized deductions will be limited. For both the personal and dependency exemptions phaseout and the itemized deduction limitation, the threshold is $250,000 for single individuals ($300,000 for married individuals filing joint federal income tax returns).

 
Other expiring or expired provisions made permanent

  • "Marriage penalty" relief in the form of an increased standard deduction amount for married couples and expanded 15% federal income tax bracket

  • Expanded tax credit provisions relating to the dependent care tax credit, the adoption tax credit, and the child tax credit

  • Higher limits and more generous rules of application relating to certain education provisions, including Coverdell education savings accounts, employer-provided education assistance, and the student loan interest deduction

Temporary extensions

  • Provisions relating to increased earned income tax credit amounts for families with three or more children are extended through 2017
 
  • American Opportunity credit provisions relating to maximum credit amount, refundability, and phaseout limits are extended through 2017

  • The $250 above-the-line tax deduction for educator classroom expenses, the limited ability to deduct mortgage insurance premiums as qualified residence interest, the ability to deduct state and local sales tax in lieu of the itemized deduction for state and local income tax, and the deduction for qualified higher education expenses are all extended through 2013

  • Charitable IRA distributions (IRA holders over age 70½ are able to exclude from income up to $100,000 in qualified distributions made to charitable organizations) are extended through 2013; special rules apply for the 2012 tax year

  • Exclusion of qualified mortgage debt forgiveness from income provisions extended through 2013

  • Exclusion of 100% of the capital gain from the sale of qualified small business stock extended to apply to stock acquired before January 1, 2014
 
  • 50% bonus depreciation and expanded Section 179 expense limits extended through 2013

 

Source: Broadridge Investor Communication Solutions, Inc, January 2, 2013

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Securities and Advisory services offered through LPL Financial, Member FINRA/SIPC.