Are the Markets Making You Nervous?

Stock markets have been more volatile lately, largely due to U.S. and European debt problems.  Although these are significant problems in need of long-term, structural changes, I view investing as a long-term, disciplined process.  That being said, how does one invest for the future but also take advantage of short-term opportunities to strengthen ones financial situation.

As explained by Andrea Coombes in a MarketWatch article posted on September 23rd, there are five things that should be the foundation of any long-term investment portfolio:

Minimize Taxes - Although investment income and capital gains are taxable, there are ways to structure a portfolio to minimize or defer these taxable events.  Gains can also be offset by losses in certain instances.

Control Costs  - Any investment has a cost associated with it, but these costs can be controlled by evaluating management fees and consolidating assets to reduce fees.  Costs can often be hidden or difficult to quantify, so an independent investment professional can assist in evaluating the true costs of various investments.

Diversify - This is as simple as "Don't put all your eggs in one basket."  Investments should be across various asset classes, company sizes and economies.  A large amount of an investor's portfolio in one specific investment, concentrates too much risk in one area, unless that investment is broadly diversified itself.

Rebalance - Different asset classes will perform differently in a portfolio.  Outperformance of one asset class should be realized and then reinvested in an underperforming asset class.  This rebalancing can contribute significantly to the aggregate performance of a portfolio over time.

Be Proactive, But Patient - A plan should first be developed before investing significant amounts of capital.  This plan should include goals and the amount of risk that you are comfortable with.  Portfolio performance should be monitored versus this plan over time and changes can made, if needed.  Accomplishing long-term financial goals is a patient process, though, and no rash changes should be made based on emotions.

Although the news headlines will always affect our emotional well-being, a long-term investment plan with a strong foundation provides a stable backdrop to the ups and downs of our daily lives.

Do you have control of your finances?

As I talk to family, friends and prospective clients, I often hear about financial challenges. Most people have financial challenges. If not, they would almost always like to be in a better place when it comes to their financial well-being. I try to remind people that the challenges aren't always the problem. The problem is often the fact that people don't have a clear picture of their financial situation. Many people aren't even aware of what parts of their financial lives they are in control of. I'd like to review a few areas and offer some suggestions.

A good starting point is a net worth statement and a income statement. In plain English, a net worth statement is a listing off all positive and negative account balances in order to come up with the net positive or negative "net worth." An income statement is a listing of all income and expenses over a chosen period of time. Once you have pulled together a basic summary of where you are, you can start to look at what you can control to improve your financial situation.

Bank Accounts - Are you paying unnecessary fees or missing out on earning interest? Do you have adequate savings?

Investments - Are you taking inappropriate risks considering your stage in life? Do you know what you are investing in and why you are doing it? Are your investments diversified? Have you had a professional assessment of your investments?

Real Estate - Do you have the lowest rate available on your mortgage? Is your mortgage balance appropriate? Are you maintaining your home and only spending money on it in "smart" ways?

Credit Cards - Do you pay more interest and fees than is necessary? Do you even need to use credit cards to begin with? Can you reduce the balances that are incurring interest?

Other Loans - Borrowing money for purchases should be well thought out and should not be a frequent behavior.

Salary - Are you living up to your potential at work? Have you evaluated your career path and what type of spending that supports over the long run?

Monthly Expenses - Which of these are necessities and which of these are luxuries? Can you really afford all the luxuries?

Taxes - Do you take advantage of all available deductions? Do you consider the tax impact of your large financial decisions?

The Bottom Line - Are you living within your means? Is more coming in than is going out?

Gaining control of your finances takes work, just like keeping your body healthy, keeping your marriage strong and teaching your children correct principles. Like all of these things, increased financial control will expand your options in life and lead to greater peace of mind. We are all faced with challenges we can't control, but we also have the ability to take charge and chart the path we want to follow in life.

The Complexity of the Tax Code

As the tax season is now upon us, I thought I would address the complexity of our current tax code and offer some of my ideas about simplification. I attended a tax presentation at my local chapter of the Financial Planning Association where the presenter, a CPA, questioned the entire value and purpose of our tax code in its current form. Once certain provisions of the Health Care Act are enacted in 2013 (if they are enacted), we will effectively have three concurrent systems of taxation, an ordinary income tax calculation, an alternative minimum tax calculation and a tax surcharge calculation. Although our government does need to collect revenue to serve certain functions, the method and complexity of the taxation of individuals, trusts, estates, partnerships and corporations has gotten somewhat out of control.

A lot of discussion has been going on recently in America (see this article) about our Federal debt, deficit and method of taxation. I am in favor of dramatically simplifying the current taxation system and using some type of a "flat" tax. Although certain favored deductions would be eliminated, this could be done gradually or with some type of a standardized exemption. The new estate tax provisions are a fairly good example of this, although they are only effective for the next two years at this point. A large $5,000,000 exemption is available to all individuals and a lower 35% tax rate is imposed beyond that exemption. Although simplifying the tax code like this would dramatically reduce the need for various tax and legal professionals, the resources that are currently focused on our tax system could be put to use in much more productive and valuable endeavors. America is known for adaptability and ingenuity when it comes to our economy. I think we should reduce the complexity of our tax system and let all Americans decide how to better use their time and money.

Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010

As usual, Congress has passed a new spending bill with a long, complex name. Despite the tax savings (tax rate preservation) that comes with this bill, it also includes additional deficit spending, which has become the normal way of doing things in Washington the past several years. Political opinions aside, I will summarize a few of the highlights of this bill:

1) Extension of all current tax rates through 2012

2) Temporary modification of Estate, Gift and Generation-Skipping Transfer Tax for 2010-2012

3) AMT Patch for 2010 and 2011

4) Extension of "tax extenders" for 2010 and 2011

5) Temporary Employee Payroll Tax Cut

The average American might wonder what all of this means. With the exception of the new estate tax rates, Congress and the President have left our tax system very similar to how it is now for an additional two years. Most tax filers will see a tax return similar to 2009 for 2010 and 2011. One temporary tax reduction is the payroll tax "holiday" that reduces payroll taxes by 2%, saving most working Americans between $800 and $2,000 during 2011.

Although keeping tax rates low and temporarily reducing the payroll tax will provide a short-term boost to the economy, I feel that a better, longer-term, strategic approach to providing government services and funding our government is needed. We should let Americans work hard and innovate as they have in the past and the jobs and prosperity will follow. In the meantime, each of us should take a hard look at our personal financial situations and make any necessary adjustments in order to put our individual financial houses in order.

Financial Lessons Learned

With another tax season behind us and some hopeful economic signs appearing on the horizon, I've taken an opportunity to reflect a bit on the past couple years. There are some lessons that have been learned or relearned by myself and many of you out there. If you haven't learned any lessons then this post might give you some more financial insight.

1. "Good Times" can't last forever. Although we are blessed as Americans to have a unique form of government that has fostered much success and prosperity throughout our history, we are still subject to the economic ups and downs of a free market economy. If anything, we are subject to these even more than some more socialist or heavily regulated economies.

2. Freedom isn't free. Somewhat related to my previous point, we have to pay a price for the "ups" in our economic cycles with the "downs" that inevitably follow. More government involvement in our economic lives my flatten these cycle out a bit, but the price of more government is less freedom.

3. There is a cost to everything. The recent downturn has brought out a sort of panic reaction which says we need to pull ourselves out of this downturn--quickly and at any cost. The cost of some of the recent government legislation is very significant. It might not be immediately apparent, but we are burdening our future generations with more taxes without giving them a say in the decision. There are also costs to the substandard moral behavior which brought on much of this crisis. The cost has been severe and not just to those who acted unethically.

4. Economic cycles are beneficial. Although this recent recession has caused much financial pain in many people's lives, changes are often made which will pay future dividends. Companies have improved processes and removed excess costs. Families have reevaluated purchasing decisions and paid down debt. Governments have been forced to provide services more efficiently or in a more need-based manner. Many of these changes will strengthen our country to allow for future growth cycles.

5. Despite the financial challenges, we should be grateful. We are blessed with families, friendships, freedoms and opportunities that many people in the world could never imagine. Let's not forget those things because of some short-term disappointments and surprises.

What's Ahead for Taxes?

As tax time comes around, many people are wondering what the future holds for taxes in the United States. If President Obama gets what he wants, tax rates will go higher for higher-income Americans. His recently proposed budget has the Bush tax cuts going away at the end of 2010 for individuals making $200,000 or more and couples making $250,000 or more (sounds like a marriage penalty to me).

The budget proposes that the top two tax rates would go from 33 to 36 percent and 35 to 39.6 percent. Capital gains taxes are also proposed to go from 15 to 20 percent for this same group of high-income Americans. It is also expected that the estate tax will be reinstated retroactive to January 1st at a 45 percent rate.

No one likes to see tax rates increase, and these changes aren't a sure thing, but we do need some fiscal changes at the Federal level in order to protect the future generations in America. As opposed to playing political games with tax policy, I would prefer that the President and Congress enact fair tax policy for all Americans so we all have "some skin in the game," as opposed to deciding who is rich and who is poor and who should be rewarded or punished for his or her political leanings. I would also appreciate greater consideration of the spending side of the equation. Consistent, increased spending seems to be a given, despite the economic ups and downs that American households face. We would all be on a path to bankruptcy if we increased household spending year after year without considering where the income was coming from.

All this being said, these tax changes can be managed and muted somewhat by staying informed of what's ahead and working with a licensed financial professional, when needed. We should do our best as citizens to influence the policies in Washington and then stay informed to deal with the good or bad consequences of those decisions.

Tax Rates - Where are They Headed?

A pretty strong consensus exists that tax rates are going up. The massive deficit spending and entitlement programs of our government make this a near necessity. Different political parties will express different solutions to our current fiscal crisis, but rising taxes is included in many of these. Although most people don't like paying taxes or the prospect of increasing tax rates, awareness can help us plan and be prepared for these impending changes.

Personal Income Taxes - It is unlikely that personal income tax rates will change in 2009 or 2010. The Bush tax cuts will expire at the end of 2010 and the top tax rate at that point will revert back to 39.6% from a 35% rate today. A surtax for high-income individuals has been proposed in various health care proposals, but this should not take effect until 2011. A higher capital gains tax rate and other tax increases would likely also take effect then.

Estate Taxes - The current estate tax is set to expire at the end of 2009, with no estate tax being due in 2010. It is extremely doubtful that Congress would let this revenue source go away. Various proposals are being debated in Congress right now. The current estate tax rate of 45% and the current estate tax exemption amount of $3,500,000 per individual could change, but this should become clearer in the next several weeks.

Business Income Taxes - Business income tax rates have not changed much recently, but Congress has implemented various bonus depreciation deductions and additional loss carryback provisions to try to give businesses tax breaks in recent years. A more comprehensive business tax overhaul is possible in the next couple years, but these changes are unclear at this point.

Taxes are a significant part of all individuals and families' financial situation. Although the tax impact of various financial decisions should not be the primary consideration, awareness of current and future tax rates and deductions is an important part of any financial plan.

Tax Consequences of Investing

The tax code is complex and constantly changing, but the tax consequences of building and maintaining a diversified investment portfolio are fairly straightforward. I will provide an overview of taxes and investments in this post and then delve into more details regarding specific investments at another time.

The federal tax system classifies taxable income in two ways. Income is considered ordinary income or capital gain income. The capital gain classification is then broken down into short-term or long-term capital gains. Ordinary income is taxed on a sliding scale in a progressive manner. This means that the higher your income, the higher percentage you typically pay in tax. Short-term capital gain income is taxed at your ordinary income tax rate. Long-term capital gain income is typically taxed at a flat 15% income tax rate.

Investment assets (stocks, bonds, mutual funds, CDs, etc.) are taxed in two ways. The first is the income that these assets produce on an ongoing basis. This income is taxed as ordinary income, except when it is qualified income and it is taxed at a 15% rate. The gain or loss realized from selling these investments, after holding them for a short-term (one year or less) period or long-term (greater than one year) period, is taxed at the capital gain tax rate described above.

As this basic introduction to investment taxability illustrates, the tax code is complex and convoluted. Despite being a Certified Public Accountant (CPA), I wish that Congress would enact a simple, straightforward tax system, as opposed to playing political games with our money. In the meantime, we are required to spend a lot of time learning how our tax system works or having professionals do this work for us.