Holiday Planning Series with the Squash Brothers, part III, debt management

Watch our Holiday Planning Series, Part II, as Steven and the Squash Brothers discuss debt management so you do not overspend and end up with credit card debt you can’t pay off.

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Holiday Planning Series with the Squash Brothers, part II, cash management

Watch our Holiday Planning Series, Part II, as Steven and the Squash Brothers discuss cash flow planning so you have more to spend (or to save!).

Next time, debt management.

Budgets? “We Don’t Need No Stinkin’ Budget”

Budgets rarely work. It takes tremendous effort to accurately record all transactions so that you have a valid budget. Then, frequently, after all this effort, you rarely come back to the budget. That means that the work had no payoff. Furthermore, people often claim that they had nonrecurring expenses. Doing so, they artificially understate their expenses, not realizing each year has some nonrecurring event.

A much easier way to test savings is to take a twelve-month period, look at cash and credit card balances at the beginning and end, check for any inflows from gifts or other non-salary items, and then measure the change. Did the cash accounts go up or did the credit cards go up? That is your savings/dis-savings for that year.

Rather than doing a budget to adjust behavior, force a change. You can do that by removing money from your discretionary spending by contributing the maximum to a 401(k) plan, by an auto debit that put funds into an investment account, and other auto payments. If your credit card balances go up, then you have to make a decision to alter behavior, such as cutting entertainment, or decide to delay goals (retire later, no new car now, etc.)

How does cash flow relate to debts? Managing your debt means getting the lowest after-tax interest rate so that you pay as much principle with each payment to pay off the loan as quickly as possible. You can deduct the interest paid on a mortgage and an equity line of credit debt. You can deduct up to $2,500 of student loan debt. But you cannot deduct the interest on most other debt, unless used for your business (watch for a post on side hussles).

Financial impact of the budget plan and planning for tax reform

First, the on-going budget battle in Washington, or “the debt ceiling crisis,” should be kept in perspective. The battle is more a game of chicken, where one side will eventually blink and the ceiling increased. This political battle is not likely to have an impact on investments, as the markets have already accounted for the outcome, as usually happens well before the event. In fact, by way of example, this is much like 1989 when the municipal bonds of the Commonwealth of Massachusetts we downgraded to a rating just above that for Louisiana. Many investors panicked. However, the underlying economy had not changed. Therefore, the smart investment strategy at the time was to buy Massachusetts bonds. After Governor Weld came to office, the rating went back up and investors who held or bought the bonds had a nice profit. The equivalent today would be to buy treasuries.

Second, as it is shaping up, the deficit reduction package contains major tax reform provisions as well as huge spending cuts. This could ultimately be good for the economy and our markets, as it would bring corporate tax rates in line with other countries, falling in the 23 to 29% range. However, the base would be broadened, possibly including depreciation over longer periods, eliminating deductions for domestic production and trimming or dropping the R&D credit.
The tax overhaul raises substantial revenue, $1 trillion over 10 years. However, this less than half the amount that would have been raised by simply letting the Bush tax expire as scheduled.

New Tax Law: Many specifics will not be known until a new tax law is enacted, which is not likely to occur this year. What Kiplinger’s Tax Letter and others are predicting the following: Instead of six tax rates or brackets, with the highest at 35%, three are expected: one in the 8 to 12% range, the next in the 14 to 22% range, and the in the last in the 23 to 29% range. The Alternative Minimum Tax (“AMT”) would be repealed. The earned income credit and child credit would remain.

To do all this, there will be pain: itemized deductions would be significantly reformed, changing home interest and property tax deductions as well as charitable deductions. For example, deduction of interest might be limited to a mortgage of $500,000 used to purchase a home, but not any for a second home. In addition, the deduction of equity line of credit interest may be eliminated (no one knows what will be grandfathered, so better to have a line in place than to wait). Higher bracket taxpayers may see the deductions converted into a 12% credit.
Something of a surprise, given the push over the last ten years or more to increase personal savings, the deductions for retirement contributions may be cut back, lowering the ceiling and amount of the contributions that will be allowed for 401(k), IRA, Keogh, SEP-IRAs, profit-sharing plans and so on. Similarly, flex plan and health savings accounts may be curtailed or repealed.

We will continue to monitor the information on tax reform, and post updates when appropriate.

Any changes that are this sweeping will require serious tax planning, so that should be on your “to do” list for this fall!