Year-end planning, 2016 version

The election of Donald J. Trump could have a significant impact on your finances. Individual and corporate tax laws may change, the Affordable Care Act may be eliminated, trade war may ensue, infrastructure building may boost jobs and sectors of the economy, and national defense and diplomacy could lead almost anywhere – your guess is as good as anyone else’s.

So then, how do you incorporate this into year-end planning? Very carefully!

Corporate Taxes

Our analysis starts with a review of his proposal to limit corporate income taxes to 15% as a way to illustrate how tricky planning is:

Analysis of the way this limit applies to pass-through entities suggests that the 10-year cost could be anywhere from $4.4 trillion, assuming owners of pass-throughs pay 33% tax, to $5.9 trillion, assuming owners only pay a 15% tax.

Those are hefty cost numbers, which is why it is tricky to assume that any major tax changes will be enacted in 2017.

Income Taxes

There could be three rates on ordinary income: 12%, 25% and 33%, with the latter starting at $225,001 for married filers and $112,501 for single filers. The 0.9% and 3.8% Affordable Care Act surtaxes on upper-incomers would be eliminated. So would the AMT (“alternative minimum tax”). The 20% maximum capital gains tax would remain. Standard deductions would go up, personal exemptions would be eliminated and breaks for dependent care would be increased.

Check here for 2017 tax rates.

Estate taxes

The President Elect has revised his estate tax proposal, calling now for pre-death tax on appreciation in assets of large estates, subject to a $10-million-per-couple exemption. This may be accomplished by limiting the step-up in basis for heirs who inherit capital assets from large estates.

Another change would be elimination of the IRS’s proposal to restrict the use of valuation discounts for gift and estate tax purposes on intrafamily transfers of closely held firms.

Investing and retirement

Infrastructure building could boost certain investments, while conflicts on trade agreements could hurt many.

His proposed tax changes for retirement plans include extending the age for which contributions to IRAs are allowed and delaying required minimum distributions (RMDs).

Okay, enough, how does one act now?

Some moves still make sense

Tax plan – deferring income into 2017 and adding deductions to 2016 should work well, unless doing so puts you in the AMT, in which case the reverse will work best.

Most of our suggestions from our 2015 year-end planning post still work, including RMDs, 3.8% Medicare surtax, itemized deductions, stock options, investment income and sole proprietor and small business income. Also check out our estate planning post for more ideas.

If your deductions include donating to charities, gifting appreciated assets leverages your donation. That is, you can avoid the income tax on capital gains while still benefiting from the charitable deduction. Watch for the rules on exceeding 30% of your adjusted gross income and donating to private charities.

Research Your Charities

Check out websites like such as ImpactMatters and GiveWell to make sure what you donate has the best impact. Other tools include Agora for Good, a tool to track donation impact over many sectors.

Investing – your strategy should not be altered in any dramatic way now.

If you do sell mutual funds, be sure to wait to buy replacement funds until after the dividend distribution date, so you do not end up with a taxable distribution on gains in which you did not participate

Summary

Many of the income and estate tax rules may change during 2017. However, for now, your safest plan is to assume little changes and stick to the “traditional” techniques outlined above.

If you have any questions, please contact me!

What is the AMT?

 Not, it is not a dyslexic version of ATM!

 Back when people could shelter almost 100% of their high income, Congress decided to make that more difficult by creating the alternative minimum tax (“AMT”), a minimum tax that all must pay with a rate of 28%. This along with sweeping changes made in 1986 made it difficult for the top taxpayers, people with income over $1 million, to get much below an average tax of 20%.

On the other hand, an AMT rate as high as 28% is still great if your marginal rate is 39%.

Why do you care? Despite the title, you do not get to pick

You must pay the higher amount determined by the regular and AMT tax calculations. If you have to pay the AMT, you are paying almost a flat rate of 26% to 28%, not a graduate rate, and you are losing the value of many itemized deductions, including state income taxes paid, most mortgage interest and miscellaneous deductions. To make sure you pay taxes, certain “preference” amounts are added to your AMT income, including incentive stock options and alternate depreciation schedules.

Data on 2012 income tax indicates that nearly every married taxpayer with income between $100,000 and $500,000 owed some AMT. Thus, the AMT is no longer just for the ultra rich!

So what do you do? Plan carefully

Make sure that efforts to reduce regular taxes do not push you into paying the AMT. Here is one example: If you have a year with high ordinary income, be sure to pay all of the state income taxes due during that calendar year, since you are less likely to be in the AMT doing so but are like to be in the AMT next year if you wait until April to pay those state taxes. The lower ordinary income of next means that you will certainly be in the AMT.

Note: some states also impose an AMT, making planning quite … er, taxing!

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Oh, that looks complicated!

Good planning pays off, as in the example above, where preserving the deduction can be a very substantial savings on your federal income taxes.

Okay then, what is a financial plan?

You may hear some argue that robo-planners will not replace individual, human planners. I call them the “There’s no app for that” group.

We do believe that “There is an app for that.”
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Well, that is not what I had in mind.

But exactly what is “a financial plan”? Finding a good, workable definition is a challenge.

Wikipedia says:

Textbooks used in colleges offering financial planning-related courses also generally do not define the term “financial plan.” For example, Sid Mittra, Anandi P. Sahu, and Robert A Crane, authors of Practicing Financial Planning for Professionals[8] do not define what a financial plan is, but merely defer to the Certified Financial Planner Board of Standards’ definition of ‘financial planning’.

Can’t we define “financial plan”?

Yes. Investopedia offers this broad definition:

While there is no specific template for a financial plan, most licensed professionals will include knowledge and considerations of the client’s future life goals, future wealth transfer plans and future expense levels. Extrapolated asset values will determine whether the client has sufficient funds to meet future needs.

And Wikipedia gives more detail:

In general usage, a financial plan is a comprehensive evaluation of an individual’s current pay and future financial state by using current known variables to predict future income, asset values and withdrawal plans. This often includes a budget which organizes an individual’s finances and sometimes includes a series of steps or specific goals for spending and saving in the future.

So you need to project where your assets can take you to be sure you meet your future in good shape. Makes sense

And what is my definition?

A to do list or “action plan” that tells you what you need to change now so you optimize the use of all your resources to achieve your major, long term goals in the future.         

So what does a financial plan look like?

If you paid to have a financial plan prepared, and have a complicated situation, you may get a glossy, bound book filled with projections, charts and graphs, plus text. While much of it may be boilerplate, it will tell you where you are going from now until you die, how your money will follow if you invest according to the plan, and what you need to change on taxes, insurance, and your estate plan.

At the other extreme, you can glean the essential steps and write them all on a PostIt note, which you then place in a spot you see often enough to remind you what to do:

  • Maximize my 401(k) contributions,
  • Set up and contribute to a Roth IRA,
  • Review my investment allocation, use ETFs,
  • Steer clear of any major credit card debt,
  • Review my beneficiary designations,
  • Sign an medical directive, and
  • Save enough for a fun (not too expensive) vacation next summer!

In the end, it doesn’t matter how many pages or what the plan looks like; what matters is that you learn from reviewing your finances and change how you manage your resources so that improve your finances.

So, yes, a simple to do list could be enough, if you follow it!

China’s economy, the stock market and politics


(worried about investing?)

So far this year, checking your investment account balances could lead to an upset stomach, or worse. You are better off watching the historically unusual 2016 presidential campaigns. That way, you have enough to distract you from making a bad investment decision … even if Donald Trump or others upset your stomach.

What would a bad decision be? Here are several worries you may have, stated as “oh no,” along with a description of the potential bad investment decision:

“Oh no, stocks are too risky, I’m moving my money over bonds instead” – a.k.a., changing your portfolio allocation

If you (and your advisors) constructed a good long-term portfolio, then stick to the allocation in your portfolio. At present, the return on most bonds is less than the rate of inflation, after income taxes. The return on money markets is even less. So, unless you have amassed huge sums, you need the stock market returns to reach your financial goals.

That means you have to stay in stocks, and ride out the current downturn.

“But does that work?”

Let’s take the last big market dive of 2008 as an example. Measuring stock performance from 2008 through 2012, “the S&P 500 generated a cumulative return of 8.6 percent.”   See Went to Cash? Here’s the next Big Mistake You’ll Make.

Have you seen any bonds paying 8.6%?

“No.”

I didn’t think so.

True, there are alternate investments, such as hedge funds, precious metals, commodities and raw materials, which could perform better than bonds. However, each has different risks and expenses, and some of these have high barriers to entry. If any of these investments do belong in your portfolio, they are there to balance your other investments, which must still include stocks.

“Oh no, investing is too risky, I’m putting my savings in cash for now” – a.k.a., attempting to time the market

Pulling out of the market when it goes down and then putting all that cash back in just before it goes back up sounds great. However, the problem with market timing is no one can do it. Looking at 2008 through 2012, “If an investor missed the 36 percent drop in the S&P 500 in 2008 — or even worse, bailed on the markets mid-carnage — they probably also missed the 26 percent gain in the S&P 500 in 2009, and the next three positive years for the index that followed. See Went to Cash? Here’s the next Big Mistake You’ll Make.

So, you are thinking that 2008 to 2012 is an aberration.

“Yes, I still want to move to cash.”

 Then consider 1970 to 2016, where, if you missed just the best 25 days out of 11,620 trading days, “your returns would have gone from 1,910% to 371%, or [from] 6.7% a year to 3.4%. To give you an idea of how lousy that is, 1-month U.S. T-bills returned 4.9% over the same period.” See How missing out on 25 days in the stock market over 45 years costs you dearly.

The challenge of timing the market is capturing the best days. However, Nobel laureate William Sharpe “found that market timers must be right an incredible 82% of the time just to match the returns realized by buy-and-hold investors.” See Why you should stay in the stock market.

Are you that lucky?

“No.”

“Oh no, China is a total mess, this time is different, I’m am getting out of stocks forever” – a.k.a., attempting predict the future

True, the slowing of the Chinese economy is causing economic problems worldwide. But, in terms of the impact on stock markets worldwide, that is not dramatically different from the 1987 crash, only then it was Japan.

“Yes, but my friends are selling stocks …”

Did you know that the individual investor is a contrary indicator for the stock market?

“What does that mean?”

Historically, when individual investors are selling, that is a market low, a good time to invest. Similarly, when individual investors are putting everything into the stock market, that is a market peak and a time to sell the over-priced stocks.

By the time you realize that you are mistaken, you will have missed much needed performance. For emphasis, consider this:

From 1990 to 2005 a $10,000 investment would have grown to $51,354 had you just sat tight from beginning to end. However, if you had missed the best 10 days in that 15-year period, your returns would have dwindled to $31,994; if you had missed the best 30 days, you’d be looking at a mere $15,730. Why you should stay in the stock market.

Oh no, investing is too risky, I put my savings in cash” a.k.a., thinking short-term, another argument for going to cash

he stock market has to be risky, otherwise there would be no reward for investing.

“But I like cash!”

Cash is not volatile, but it is still “risky” – the return on cash – the interest earned – is less than the rate of inflation. Over time, investing only in cash puts you far behind, while long-term investing reduces the risks of stocks. The key is, you have to withstand the downturns to gain from the upturns:

A study by SEI Investments reviewed all the bear markets since World War II. According to the study, reported in The Wall Street Journal, stocks rose an average of 32.5% in the 12 months following the bear-market bottom. Yet, if you missed the bottom by just a week, that return fell to 24.3%. Waiting three months after the market turned cut your gain to less than 15%. Why you should stay in the stock market.

“Oh no, I need money to buy a house” – a.k.a., having the wrong investment strategy

What was your short-term investment doing in the market in the first place?

“I need my money to double so I can buy my dream house!”

Sorry, if you need that much then your dream is wrong.

For the stock market, anything less than 5 years is “short term.” If you have money set aside for a vacation, new car or other major purchase, like a house, those funds need to be invested more conservatively, taking less risk. Otherwise, while you could double your money in a couple of years, you could also end up with much less.

“Oh yes!” a.k.a., the conclusion, an important message – don’t forget it:

After watching investors for several decades, I know this to be true: you must create a good investment strategy and stick to it for it to work.

Even if do not have an optimum strategy, your investments will perform far better than someone who keeps altering their strategy.

“But the fund I have didn’t do as well as another fund last year, so I am selling ….”

Chasing after the last year’s star mutual fund usually works out poorly. You sell your current fund, paying fees and taxes, to buy the star fund, only to watch its performance return to the mean. Disappointed, you then sell the new star fund to chase another star performer, only repeat the same mistake with fees and taxes. After you repeat this a few times, you could end up with negative returns while someone who simply a bought and held a mediocre fund will have substantial gains.

If your investment strategy is better than mediocre, and it includes stocks, stick with it!

“Okay, I will.”

Good, the future you, sitting on a beach sipping drinks with paper umbrellas, will be so glad you did!

China’s currency devaluation, the stock market correction and Powerball

Recent news headlines could drive you crazy:

China’s currency devaluation and fears of slower worldwide growth lead to a stock market correction;

North Korea claims to have detonated an H-bomb, but the US says “we don’t believe you”; and

Powerball hits a record $1.5 billion prize.

However, just as the record size of the Powerball jackpot is no cause to buy lottery tickets, the January jolt to stocks is no cause to deviate from your long-term investment plan … although it is wise to brace yourself for what is likely to be a choppy market ride in the new year.

Abby Joseph Cohen, president of Goldman Sachs Group Inc.’s Global Markets Institute says, this is “the S&P 500’s worst-ever start to a year [sending] the index down 7.5 percent in 2016, near lows seen during a rout over the summer.” See “Goldman Sees 11% Upside in S&P 500 After ‘Emotional’ Selloff” in Bloomberg News, January 14, 2016.

Ms. Cohen goes on to say, “What is happening is really very much an emotional response … We need to put things into perspective. Stocks are probably the best place to be.”

I agree. Predictions of a US major recession, let alone a full market collapse, have not come to pass.

In fact, US GDP has grown for all but one quarter since the end of 2011 and unemployment is down to 5%; US Dept. of Labor consumer price index is near 0% – as a measure of inflation. CIT Voice of the Middle Market, where 59% of the middle market corporate managers think that the best way to judge economy is to observe economic stability of their community, says that its 71% of the group say their companies are strong and 57% say they doing better than last year.

Yes, China’s growth is cooling down to a still very robust 6.5%. But China probably had to devalue currency to continue that growth.

Its stock market should have seen the stimulus as favorable but so many market investors in China are individuals with a short-term horizon that they could have been more concerned with buying power of their wealth and sold off their holdings. The more important long-term issues are the impact of China’s increasing debt and the impact of China’s devaluation on emerging markets.

Meanwhile, the US dollar remains strong, keeping gold prices down, and US corporate balance sheets are healthy, many having cash to raise dividends.

We remain in the third longest bull market in US history. And everything I read, from very optimistic articles to predictions of a crash, ends with something like “stick with high quality holdings.”

Some authors say this because they seek dividends, for income. But, with the Powerball in mind, I translate this to:

Short-term plays in the stock market are purely speculative, so if you want to grow your portfolio, stay out of that betting game.

You can buy a lottery ticket if you want to be speculative.

I conclude with these reminders you can chant as you read headlines on the stock market or watch TV news:

News headlines are not about me,

I won’t panic because I have a good investment plan, and

I will maintain a long-term perspective and stick to my plan

That worked well in 2008. Sticking to a long-term plan meant you participated when the market shot back up almost 10% in January of 2009.

Let me know if you want to share your comments and concerns.