Advisers are split on whether it's wise to end burden early

InvestmentNews

By Janet Morrissey
August 11, 2008

It used to be the American dream to crack open a bottle of champagne and burn the mortgage the moment a homeowner paid off their house in full before settling into retirement.

...[Many] financial planners are now cautioning homeowners not to rush to pay down their mortgage, and to scrutinize carefully their personal finances and retirement investments first.

"I would encourage them not to [prepay their mortgage] especially in a liquidity crunch," said Gibran Nicholas, chairman and chief executive of the CMPS Institute in Ann Arbor, Mich., and a certified mortgage planning specialist. ...

Even if there isn't a credit crisis, experts said, it's still not always smart to pay off a mortgage early.

A key factor is total return, said Brett Hammond, chief investment strategist with TIAA-CREF in New York. In many cases, homeowners will get a smaller return by paying down a mortgage than they would by investing those dollars elsewhere, he said. ...

Still, there's no one-size-fits-all answer to the question. It all comes down to an individual's personal situation, advisers said. The person's mortgage rate, age, spending habits, liquidity, health and tax ramifications are among the issues that must be assessed. ...

Even personality and spending habits play a role.

"If that person is going to toss and turn every night because they're naturally predisposed to being nervous about having a large debt, then that has to be taken into consideration," said Brian Larrabee, a mortgage banker at Americorp Funding in Rye Brook, N.Y.

However, most financial advisers agree that the homeowner, first and foremost, must be fully funding a retirement plan before thinking about prepaying a mortgage. ...

Age is also a factor. If the homeowner is 30 years or younger, Mr. Larrabee encourages him or her not to prepay. ...

Then there are the tax ramifications. Under federal tax laws, homeowners can deduct the mortgage interest on their federal income tax returns if they use the itemized-deductions form.

"People tell me that they keep a mortgage because it's deductible — and so I tell them, 'Well, go have your bank double your [mortgage] rate, and you'll get twice as much deduction,'" quipped Larry Botzman, an independent certified financial planner in Somerset, Ky., with about $70 million in assets under management.

Even for those who do qualify, the deduction isn't hugely bigger than the standard deduction people receive without a mortgage, [Tony Proctor, a certified financial planner at Proctor Financial in Wellesley, Mass] said. ...

"I just think the whole tax deduction aspect is somewhat overblown," Mr. Proctor said.

Also, middle- to upper-income earners, whose salary falls roughly between $100,000 and $500,000, are subject to the alternative minimum tax, which effectively wipes out the mortgage deduction, he said. ...

Next is whether the house itself is a home. Experts said paying off a mortgage early can be a good strategy if the person plans to live in the house during retirement.

This way, the homeowner won't have to worry about making monthly mortgage payments if the broader market suddenly crashes and the person is left struggling with a decline in the cash flowing from his investment portfolio, Mr. Botzman said. ...

However, if a homeowner expects to downsize to a smaller home or relocate within the next five years, or if poor health could force a person into an assisted-living facility in the near term, Mr. Botzman recommends that the homeowner not try to pay off the mortgage early. ...

E-mail Janet Morrissey at jmorrissey@investmentnews.com.

Financial Planning

July 1, 2008

Making the right decisions regarding Social Security benefits is a crucial part of planning for retirement. ...

It's Better to Wait

Too often, people entering Social Security offices have been advised to start collecting benefits at 62, the earliest age possible. It's usually bad advice, and may put many retirees at risk of poverty in old age. Delaying claiming until age 70 can almost double a person's benefits.

[The] "break-even age" ... is the age at which total lifetime benefits beginning at a delayed claiming date would equal those received at an earlier claiming date. For instance, an individual eligible for a benefit of $758 at age 62 could receive a $1,000 monthly check by waiting until 65 and 10 months. Total benefits collected under the two scenarios would be equal at age 77 and 10 months-the break-even age. So an individual could choose when to claim benefits based on whether he or she was likely to survive to that age.

... But it has three main flaws:

First, clients may live longer than they think. A 2005 British study found that retirement-age individuals typically underestimated their true life expectancies by three to five years. ...

Second, the break-even age ignores benefits for a surviving spouse. Increased survivors' benefits are one of the best reasons to delay claiming, since widows have among the highest poverty rates of retirees. ...

Third, and most important, the break-even approach treats delaying benefits as a gamble, when it should be seen as insurance against outliving assets. ... While the typical 65-year-old will live to around age 83, one in four will survive to 90 and one in 10 to 95. There is a nearly 5% chance one member of a 65-year-old married couple will live to age 100.

By delaying claiming Social Security benefits, a worker effectively "purchases" more of the Social Security annuity. ...

On average, there is no "best" age that maximizes lifetime benefits. But by delaying claiming, individuals can increase their insurance against falling short in old age. FP

Andrew G. Biggs, a resident scholar at the American Enterprise Institute in Washington, D.C., is the former principal deputy commissioner at the Social Security Administration.

PLANSPONSOR Magazine April 2008

Plans are adding the Roth 401(k) as a feature very aggressively, says adviser Vince Morris, Vice President of Retirement Plan Services at Kansas City-based Bukaty Companies, but not many employees have gone for it. ...

Moreover, while a lot of recordkeepers initially could not handle these accounts, they are up to speed now, says Brian Ward, Brentwood, Tennessee-based Managing Director at Ward Financial Advisory of Wachovia Securities. ...

... Saving in a Roth 401(k) can affect issues such as estate planning, says adviser Douglas Prince, Indianapolis-based Managing Director of The Prince Group at Stifel, Nicolaus & Co., Inc. Its value also depends a lot on an employee's specific tax situation and on future tax rates in general....

If you run the numbers on it, Prince says, contributing to a Roth 401(k) benefits two distinct groups of employees the most: Higher-income workers, who perhaps would prefer to pay taxes at current known rates, can contribute to a Roth and “basically shelter the earnings on amounts that would otherwise be saved outside the plan,” he says.

It also can work for younger workers who are likely in the lowest tax bracket they will ever be in during their careers. “It is the two ends of the spectrum,” he says.

Among employers, it currently appeals the most to professional organizations that have more college-educated people who understand the tax consequences, Prince says. ...

However, many firms and doctors’ offices like it, Ward says. “There is clamoring from the higher-comps,” he says, “and the young and educated are interested in it.”

A Sticky Wicket

Providers’ Roth 401(k) ­offerings do not vary all that much currently, Morris says, but employers should make sure that their provider has good online tools such as a Roth calculator that helps participants figure out their contribution scenarios.

Sponsors generally utilize their existing provider to handle a Roth 401(k). “Most providers offer it as a plan-design feature,” he says. “Typically, what we have seen is that, since it is an amendment to the plan document, there is not an added administrative cost from the provider.” However, employers do need to make sure in advance that their payroll provider can handle it....

Judy Ward
editors@plansponsor.com

Financial Advisor Magazine March, 2008

—Dow Jones Newswires

   ...You may think that once you start Social Security benefits, you can't go back and change your mind, but a little-known rule allows you to cancel your decision and start over. The catch? You must have the assets available to pay back all the benefits you received. There's no interest or penalty tacked on.
    After paying back those benefits, you can re-apply for benefits at a higher monthly amount, thanks to the fact that you're older.
    Consider high-wage earners who are now 63 years old. If they started benefits at age 62, the payout would total just $18,794 a year.
By waiting until full retirement age of 66 to start benefits, the annual take goes to $25,732. At 70, the benefits jump to $35,250, almost double the dollars earned when tapping the system at the earliest age. (In general, your benefit increases by 8% per year until age 70, after which it does not increase).
...Meanwhile, people with health concerns who don't expect to live an average life span, or those who expect to need that lump sum for, say, nursing-home costs probably should avoid this pay-back strategy.
...If you plan to go ahead with the payback strategy, you'll need to file Form SSA-521, "request for withdrawal of application," with the Social Security Administration.
     The form asks for your reason for stopping benefits. It's OK to say "because it's financially better for you," said Mickie Douglas, a spokeswoman with the Social Security Administration. Note that a widow or widower cannot payback and reapply for benefits received on behalf of a deceased spouse.
    The agency will inform you how much you need to pay back, leaving any Medicare premiums paid out of the calculation, she said.
    After paying back your Social Security benefits, you'll need to reapply when you decide to restart benefits. ...

Did you start collecting Social Security checks before full retirement age? You can boost your income now by reapplying to the federal agency. Of course, there's a catch.

MSN Money (accessed 3/11/08)

By Scott Burns

If you're retired and are interested in having a higher income for as long as you live, you have two main options:

• You can buy a life annuity. But it will leave nothing for your heirs.

• You can buy a variable annuity with a variety of living-benefit provisions. These will guarantee a lifetime income. The income will be less than a lifetime annuity, but you'll have a modest chance of future increases, and you may leave something for your heirs.

Whatever you choose, the only thing certain is a lot of fine print.

Fortunately, there is a simple alternative. It will work nicely for retirees in their late 60s or early 70s who had opted, years ago, to take Social Security benefits at a relatively young age. ...

If you did this, you know that your benefits are a lot lower than they would be if you had waited and taken benefits later. Your benefits were reduced because taking benefits early meant Social Security would have to pay benefits for more years.

But you can reapply from scratch with these easy steps. Visit your local Social Security office. Make use of a little-known and seldom exercised provision: Request a "withdrawal of application." By filing SSA Form 521 (.pdf file), Social Security will treat you as if you had never applied for benefits. It will let you immediately reapply for benefits -- at your current age.

... You must repay every dime you've received in past benefits. But because Social Security charges no interest, reapplying turns out to be a really good deal. It represents a way to buy an inflation-adjusted annuity for a price that beats anything offered by the financial-services industry.

Here is how it works. ...

For example, if you were born between 1943 and 1954, your full retirement age is 66. If you retire at age 62, your benefit will be 75% of what you would have received if you had waited until age 66. In addition, those born in this period will receive an increase in benefits for each month of delay beyond their full retirement age. The increase is two-thirds of 1% a month, or 8% a year. At age 70 ...your benefit would be 132% of your full retirement benefit.

Now let's put that together. If your benefit at 62 is 75% of your full retirement benefit and your benefit at 70 is 132% of your full retirement benefit, your monthly check could increase by as much as 76%. (The benefit will also be adjusted for inflation over the period.)

How it works: An example

If your benefit was $1,000 a month at age 62, you'd have to return $96,000 at age 70 in order to receive a benefit increase of $760 a month. That's $9,120 more a year. (I'm ignoring inflation adjustments.) In effect, you are buying an inflation-adjusted life annuity with an annual payout starting at a stunning 9.5% of your initial "investment" -- the return of money you'd received earlier in benefits.

..You won't get a 9.5% initial payout with guaranteed inflation-rate increase from any of the living-benefits variable annuities. You won't get it from any of the new mutual funds geared to producing lifetime income. And you won't get it from a commercially available life annuity with inflation adjustment.

Vanguard, for instance, offers life annuities with inflation adjustments. A request for a quote on a $760-a-month inflation-adjusted lifetime benefit for a single lifetime brought back a cost of $129,085 for a 70-year-old man. That's a starting rate of 7.1%. ...Whether you measure in starting percentages (9.5% versus 7.1%...) or in initial investment, the same benefits can be had for a lot less at the local Social Security office.

Professor Laurence J. Kotlikoff of Boston University has examined this issue on his ESPlanner Web site. ... Using his consumption-smoothing software, he ...calculates that retirees can reap substantial increases in their lifetime consumption by following this strategy. Readers can learn more by reading the "Reapply for Social Security" case study on ESPlanner.

More advantages

But wait! It gets better.

By reducing investment income and increasing Social Security benefits, many retirees will be able to reduce their income taxes and, quite possibly, avoid the taxation of Social Security benefits....

On the Web

I know from reader mail that lots of people have a tough time getting their heads around this idea. So here is a list of Web-based resources and articles that should be helpful:

• Social Security retirement calculators.

• Social Security table of benefit reductions, by month, from 62 to 66.

• Social Security table of benefit increases, by month, from 66 to 70.

• Social Security request for withdrawal of application (.pdf file).

• Vanguard survival probability calculator.

• ESPlanner case studies.

Questions about personal finance and investments may be e-mailed to scott@scottburns.com. Questions of general interest may be answered in future columns. More columns by Scott Burns can be found here and here.

Published Feb. 20, 2008

Financial Planning Magazine

This year marks the beginning of the new, 0% rate on some dividends and long-term gains.

By Donald Jay Korn
January 1, 2008- ... As of 2008, there's a new way to get a break: Federal tax law has created a fairly wide 0% tax bracket for dividend income and long-term capital gains.

... In some cases, people with six-figure incomes can get some tax-free gains, according to Richard Vitale of Vitale, Caturano & Co., a CPA firm in Boston. Even among top-bracket clients, the 0% rate may cut the family tax bill.

LOOK MA, NO TAXES

From 2008 through 2010, taxpayers in the lowest two federal tax brackets may use a 0% rate on qualified dividends and long-term capital gains. That rate applies to up to $32,550 in taxable income this year for single taxpayers. For married couples filing jointly, the threshold is $65,100.

Remember, these numbers apply to taxable income, not gross income. ...

Suppose, for example, a married couple has taxable income of $100,000 this year, including a $70,000 long-term capital gain; taxable income without the gain would be $30,000.In this example, the 0% rate would apply to $35,100 worth of the capital gain: those gains from $30,000 to $65,100. (The remaining $34,900 of gain, from $65,100 to $100,000 in taxable income, would be taxed at the maximum 15% rate.)

...High-income clients may be helping to support elderly parents, who in turn could have low taxable income. These clients could transfer appreciated securities to Mom and Dad. The parents, who would retain the giver's cost basis and holding period, could sell the securities and pocket the proceeds, untaxed.

Likewise, clients may be able to give appreciated stock to adult children whose taxable income remains below the threshold. ... Again, giving away appreciated securities-which the child would sell-could generate tax-free gains.

SOCIAL INSECURITY

... Retirees, for example, may save on capital gains tax but pay more tax on their Social Security benefits.

The latter tax, among the quirkiest in the Internal Revenue Code, is imposed on Social Security benefits if recipients' income is over certain levels. Income, for this purpose, includes regular adjusted gross income (counting only half of Social Security benefits) plus tax-exempt income.

To see the possible interaction between 0% gains and Social Security taxation, take the hypothetical scenario of John and Jane Smith, both 66 years old. ...

The Smiths' taxable income is well below the $65,100 threshold, so they decide to cash in some stocks, realizing a $25,000 gain. Taxable income would still be under $65,100, but the sale would not be completely untaxed.

"Such a sale would effectively increase the couple's federal income tax by $700," says [Ken] Burstiner, [a tax manager with Weiser, a New York-based accounting firm]. "That's because the $25,000 long-term capital gain raises their income for Social Security purpose-and increases the amount of Social Security benefits that are taxable."

Cashing in $25,000 in gains and paying $700 in tax would generate an effective tax of 2.8% on the transaction. That's certainly not steep.

But suppose the Smiths decide to cash in $50,000 worth of long-term gains instead. In this case, they would owe $985 in taxes, bringing their rate even lower.

...Burstiner explains, "The $25,000 gain results in the maximum tax on these benefits. With a $50,000 gain, though, taxable income rises to $67,000, in this example, so some of the gain would be taxed at 15%."

Note that even though the $50,000 gain spills over into the 15% bracket for long-term gains, the effective tax on the transaction ($985) is less than 2%. ...Any plan to take capital gains needs to be evaluated from the perspective of an effective rate, as well as the individual tax thresholds, to make sure you're maximizing the tax-efficiency of the transaction. ...

KIDDIE CONUNDRUM

Just as taking 0% gains may be complex for seniors, the same can be said for juniors. Restrictive kiddie-tax rules, which go into effect in 2008, reduce the advantages of gifting appreciated securities to youngsters.

"For full-time students under age 24, any significant level of investment income and capital gains will be subject to tax at the parents' tax rates, with few exceptions," says Mark Gleason, a senior financial advisor with WESCAP Management Group in Burbank, Calif.

Nevertheless, giving appreciated stock to children may still be a viable option, says Rick Shapiro, who heads CPA Tax Defense in West Hartford, Conn. ... If a client's son or daughter is not a full-time student and has low taxable income, appreciated securities may be given to the youngster for sale at the 0% rate. Even college students under 24 may avoid the kiddie tax, points out Scott Snow, a planner in Westlake, Ohio, if the child earns income and contributes more than 50% of the cost of his or her support.

... A parent who is paying for a child's law school, for example, could gift appreciated securities to the offspring, who could then use the untaxed sales proceeds to pay for educational expenses....

WHEN TO TAKE GAINS

...There should be a good reason for taking gains, beyond the pleasure of avoiding a relatively modest amount of income tax.

...On the other hand, if there is a reason to take gains, why not do it in the most tax-efficient way possible? "If someone is going to sell anyway, it makes sense to try to use the 0% rate," says Jim Holtzman, with Legend Financial Advisors in Pittsburgh....

STRATEGIZING

Taking tax-free gains should be coordinated with other strategies. ...

Although the 0% tax rate is scheduled to last through 2010, conditions could change. "I would discuss taking gains with all clients who fit the criteria," says John Deyeso, head of Financial Filosophy in New York City. "The client should understand all the possibilities, including repeal of the 0% rate, before charging in. I would hate someone to go from a 0% rate to a 10% rate, unexpectedly."

Jason Cole, a managing director with Abacus Wealth Partners in Philadelphia, agrees that the 0% rate could vanish. "There's a risk that tax rates on capital gains might go much higher," he says. "Clients who can use the 0% rate might want to take gains now." ...

(c) 2008 Financial Planning and SourceMedia, Inc. All Rights Reserved.

http://www.Financial-Planning.com http://www.sourcemedia.com

The Journal for Financial Planning, December 2007

by Jim Grote, CFP®

Conventional wisdom has always encouraged prudent investors to sock away as much as possible in pre-tax accounts. But the prospect of higher taxes due to massive federal deficits and the looming specter of a Democratic Congress and presidency have re-ignited debate over the usefulness of a financial planning strategy known as tax diversification, with emphasis on the word debate.

“Tax diversification protects investors against tax rate fluctuation in similar fashion as asset allocation protects them against stock price fluctuation,” says Julie Welch, CFP®, CPA, tax director of Meara King and Company in Kansas City, Missouri....

“It’s best,” says Welch, “if retirees have different buckets of money to pull from after retirement. They can regulate their tax bill with these different buckets: there is no tax on income from a Roth IRA or Roth 401(k), there is ordinary tax on income from a traditional IRA [maximum of 35 percent], and there is capital gains tax on income from the sale of appreciated stock [maximum of 15 percent].”...

The Utkus Uncertainty Principle

Stephen Utkus, a principal at the Vanguard Center for Retirement Research in Valley Forge, Pennsylvania, co-authored the October 2005 Vanguard study, “Tax Diversification and the Roth 401(k).” While the study advocates tax diversification through the use of the Roth 401(k), particularly for investors expecting to be in a higher tax bracket in retirement, Utkus warns financial planners about the futility of forecasting future tax liabilities as if they were fixed in stone. ...

...According to Utkus, the distinction between marginal tax rates and actual tax rates makes diversification necessary since anticipating future taxes is so hopeless.

What might be coined the Utkus Uncertainty Principle states, “When you put $100 into your 401(k) plan, you have no idea at that moment what your ultimate tax savings from that contribution is going to be. That savings depends on future tax rates. Just recognizing tax uncertainty is the beginning of wisdom” (For a history of tax rate changes, see sidebar).

The Disadvantages of Qualified Plans

... An increasing number of planners agree that tax rates have nowhere to go but up. As Welch opines, “At today’s low tax rates, putting everything in tax-deferred accounts may not be a good idea if your time horizon is short, say ten years or less. Tax rates may be higher when retirees start having their IRA distributions taxed as ordinary income.”

Rebecca Pace, CFP®, CPA, PFS, of the Financial Clarity Group in Cincinnati, Ohio, ...thinks investors are putting too much money in their individual retirement accounts and other qualified plan accounts. ...Pace believes there are several reasons for clients to take their foot off the qualified plan peddle.

• First, qualified plans force retirees to take minimum distributions whether they need them or not, and to pay taxes on those distributions.
• Second, qualified plans are the worst place to put money intended for heirs. ...
• Third, there is no step-up in basis at death on unrealized gains embedded in qualified plans. ...
• Fourth, the income-in-respect-to-the-decedent tax deduction offsets only a portion of the income tax the heirs will pay.
• And finally, those investing in nondeductible IRAs who fail to keep track of their basis must pay tax on 100 percent of the distribution when they take the money out.

While Pace believes that qualified plans have a place in every retirement strategy, she recommends as an alternative to qualified plans the buying and holding of individual stocks as well as investing in tax-efficient index funds. ...

Furthermore, says Utkus, “the 401(k) tax deduction is a bird in the bush compared to, for example, the mortgage deduction, which is a bird in the hand. The interest from your mortgage payments times your marginal tax rate provides a guaranteed tax savings. However, when you put $100 in your pre-tax 401(k) account, you still owe the government tax on your deduction (say $35) at distribution time. There is zero direct tax savings from making pre-tax contributions unless your tax bracket decreases at your retirement.”...

The Advantages of Qualified Plans

Richard Dentinger, a financial advisor with Wachovia Securities LLC (member NYSE and SIPC) in Louisville, Kentucky, ... believes there is no universal rule of wisdom to follow in the tax diversification debate, but that deferral is almost always a plus. ...

In contrast to Utkus’s metaphor, Dentinger has a different interpretation of what a tax bird in the hand is versus one in the bush. “It appears that Congress has settled most of the tax diversification debate by putting ceilings on the amounts that can be invested tax-free or tax deferred. Naturally, those with money left to invest over and above these limits are going to put that money into taxable investment accounts because they have no other choice. Those able to meet the Congressional limits are furnished with both an incentive to save (tax deferral) and a spendthrift incentive (penalty for early or premature withdrawal). Whether their investment time horizon is long or relatively short, these people will usually be better off with a tax-free or tax-deferred account bird in the hand, rather than a taxable account.”

Kacy Gott, wealth manager and principal of Kochis Fitz in San Francisco, California, a fee-only independent wealth management firm with over $2 billion in assets under management, concurs with the advantages of tax deferral. According to Gott, despite the uncertainty of future tax rates, there are three fundamental advantages to putting money in qualified plans versus taxable accounts.

1. Clients can attain the same after-tax return as a taxable investment with much lower risk. ...
2. Clients who choose to invest in higher risk vehicles within those accounts sleep better at night due to the long-term time horizon of tax-deferred accounts. ...
3. Clients can rebalance with greater ease. ...

Despite all these advantages, Gott ... does not recommend that clients put everything into a 401(k) because “these vehicles often make no provision for investing in obscure asset classes like emerging markets or overseas small-cap indexes.”

Glenda Kemple, CFP®, CPA, president of Kemple Capital in Dallas, Texas, concurs with Gott on the advantages of tax-deferred investing for two reasons. First, because it is impossible to predict tax law changes, whether rates are going higher or lower, deferring taxes and saving money in the present only makes sense. Second, and more important, tax-deferred vehicles entail a form of forced savings and “forced savings is always a blessing for all families!” says Kemple....

Welch continues, “If you have the ability to fund a Roth, then you should do it. You get tax deferral forever and, before the age of 59½, you can still use the fund for education, a down payment on a home, or emergencies like health costs. ... Clients whose income is too high to take advantage of the Roth IRA should put everything they can into the new Roth 401(k)s.”

To Roth or Not to Roth

The issue of Roths adds another wrinkle to the tax diversification debate. ... Currently, the ability to invest in a Roth IRA starts to phase out for a married couple filing jointly at an adjusted gross income of $156,000 and ends at $166,000. For singles, the beginning and ending AGI phaseout is $99,000 and $114,000. But this restriction has been alleviated by the new Roth 401(k) plans that began in 2006.

...Says Welch, “Because tax rates are low historically, if a client is younger, we encourage them to invest after-tax dollars in a Roth 401(k). ...”

Also added to the Roth debate by the Pension Protection Act of 2006 is the arcane provision doing away with any income limitations to the rollover of qualified plans into Roths in the year 2010. ... Kemple sees it as the chance of a lifetime. “You can roll over all your qualified plans (assuming those plans allow rollovers) into a Roth even if you make $500,000 a year. You can spread your tax over the years 2011 and 2012, and then free up your retirement portfolio to grow tax-free forever. ..."

As always, there are caveats to this government largesse. Roth dollars cannot be used for five years following the start of the “Roth clock,” which can be defined either by an initial investment or an initial conversion. And, Kemple adds, “We cannot know what tax rates will be in 2011 and 2012 when the taxes on the conversion will be paid.”

...Still, others see an overwhelming case for putting as much as possible into Roths. President of Tobias Financial Advisors in Plantation, Florida, Benjamin Tobias, CFP®, CPA, CIMA, [says], “It’s better to pay taxes on traditional IRA distributions now (via conversion) and avoid higher estate taxes and income taxes for beneficiaries in the future.”

Other Tax Strategies

Roth issues aside, one strategy all planners interviewed by the Journal could agree on was putting the right investments in the right tax buckets. Tobias says it is obvious that, based on current tax rates, it makes sense to put income-producing assets like bonds in qualified plans and non-income producing assets, perhaps even low-taxed dividend assets, in nonqualified plans. “Anything taxed at full ordinary income tax rates should be put in qualified plans and anything taxed as low as 15 percent should be put in taxable accounts. ...”

For Kacy Gott, putting the right assets into the right tax buckets is just one method of tax diversification. Other simpler techniques include encouraging his corporate executive clients to invest heavily in their nonqualified deferred compensation plans and live off of their taxable portfolio by selling appreciated securities and paying tax at the lower capital gains rate. “This technique lowers their salary, which is always taxed as ordinary income,” he says. Furthermore, he urges clients to maximize their mortgage deduction (currently up to $1.1 million on purchase or construction) since the after-tax cost of a mortgage is good relative to other investment opportunities at this time.

Toward a Tax Consensus

In spite of the significant diversion of opinion on the value of tax diversification, all parties seemed to agree on one principle. “Never let the tax tail wag the investment dog,” asserts Gott. “If your 401(k) options are poor investments or have high costs, don’t overdo your 401(k).”

...Oddly, although the planners interviewed for this article do not all draw the same conclusions from the premise of higher future tax rates, everyone assumed that higher tax rates in the future were inevitable. According to Stephen Utkus, “In a world of historically low tax rates as we have at the current time, you cannot take for granted that you’ll be in a lower tax bracket at retirement. Because of this, investors might consider hedging their tax benefits.”

According to Gott, “It’s doubtful that tax rates will go down further or that they are even sustainable at current levels because of the federal deficit. ...”

Another strategy that most advisors agree on is that this is the time to diversify highly concentrated stock positions. Says Pace, “I think tax increases are inevitable, especially capital gains rates. Therefore, now is the time to look at Roth conversions and at diversifying concentrated equity positions.” ...

For Tobias, the history of capital gains rates is another indication that the time is ripe to sell highly concentrated positions. “For clients with low-basis concentrated stock positions, I urge them to start selling off while we have a 15 percent capital gains rate. For years before the Tax Act of 1986, the long-term capital gains rate was 50 percent of a person’s ordinary income tax rate. Following this rule, today’s 15 percent capital gains rate is too low for people in the 35 percent tax bracket. ...”

Tobias continues, “We’re preparing for the uncertainty of tax rates in 2009, especially if it looks like a Democrat will be elected as president in 2008. We plan to realize significant ordinary income and capital gains tax for clients on deferred compensation plans and on IRAs [for clients over 59½] in 2008. Ironically, 2008 could be a big year for tax revenue as people try to avoid higher taxes in the future.”

Conclusion

Is there a reasonable strategy for clients to follow in the interest of tax diversification? Richard Dentinger sticks to his tax-deferral guns for two reasons. “First, tax rates are likely to change over the period that the tax-deferred money is being withdrawn. Thus, since rates may be different when one is required to begin withdrawals, they are likely to bounce around over the next 15 or 25 years that withdrawal takes place. ...”

“Second, keep in mind that the deferral time horizon is always longer than the retirement time horizon. This is because, although on a diminishing scale, tax deferral is still going on over the 15- to 25-year period over which withdrawal is required. And there are lots of alternatives that can be chosen to keep the IRA from getting taxed all at once on the owner’s premature demise.”

Even uber-skeptic Stephen Utkus believes that deferral works well for frugal people. ...

While the experts concur that tax uncertainty is the beginning of wisdom, the various strategies discussed above for implementing that wisdom clearly remain a matter of debate.

Jim Grote, CFP®, is a financial writer whose articles have also appeared in Bloomberg Wealth Manager, Family Business Review, Financial Advisor, Morningstar Advisor.com, and Planned Giving Today. He can be reached at jimgrote@hotmail.com.

Journal of Financial Planning October, 2007

by Julie A. Welch, CPA, CFP®, and Randy Gardner, LL.M., CPA, CFP®

Julie A. Welch (Runtz), CPA, CFP®, is a shareholder and director of taxation with Meara, King & Co. in Kansas City, Missouri, and co-author of 101 Tax Saving Ideas.

Randy Gardner, LL.M., CPA, CFP®, is a professor of taxation and director of the Financial Planning Certificate Program at the University of Missouri-Kansas City. He is co-author of the book 101 Tax Saving Ideas.

With May 2007 came another tax law change. This time it was the Small Business and Work Opportunity Tax Act of 2007, which was signed into law on May 25, 2007. It is good news for many small businesses since it includes tax incentives. ...

Expansion of Section 179

Before this law, the maximum amount that could be expensed (depreciated under Section 179) for equipment, furniture, and off-the-shelf computer software purchases during 2007 was $112,000. Now the amount that can be expensed increases to $125,000 for tax years beginning after 2006. ...

Employer Credit

The Work Opportunity Tax Credit provides a credit to employers who hire “targeted” groups of workers. Examples of targeted groups include qualified veterans, qualified SSI recipients, and qualified food stamp recipients. ...The credit, which is generally up to $2,400 per eligible worker, is a percentage of the wages paid to the worker during the first year. This credit was set to expire at the end of 2007. This law extends the employer credit for roughly 3½ years through August 31, 2011, if the employer hires from the targeted groups. ...

Simplification for Couples in Business

There is also some simplification for married couples filing joint returns and operating unincorporated businesses, such as limited liability companies. They can elect not to be treated as a partnership, thereby eliminating the need to file a partnership tax return. ...

S Corporations

Several changes affect S corporations. One change deals with the tax on excess passive investment income. ... Specifically, if an S corporation that has accumulated earnings and profits (one that was not always an S corporation and has not distributed its previous accumulated earnings) has too much passive investment income, that income can be taxed at the highest corporate tax rate. ...

Tougher Kiddie Tax

... A child’s investment income over a certain dollar amount (currently $1,700) is taxed at the parents’ tax rate, thus reducing the income tax benefit of splitting income with a child. ... Last year, the law was changed retroactive for all of 2006 to increase that age to children under the age of 18. This law now raises the age to children under the age of 19 and also includes full-time students under the age of 24 if they don’t earn more than one-half of their own support. This new age change is applicable to years beginning after 2007. ...

IRS Has 36 Months

Another revenue raiser in the new law allows the IRS up to 36 months to initiate audits and still collect interest and penalties. ... The new provision applies to notices issued after November 25, 2007.

In an effort to thwart bogus claims for refunds and credits, the new law establishes a new taxpayer penalty. In general, the penalty applies to claims for refunds and credits filed after May 25, 2007, and equals 20 percent of the disallowed portion of the claim for which the taxpayer has no “reasonable basis.” ...

These are just a few of the provisions in the Small Business and Work Opportunity Tax Act enacted in May. There will most likely be more tax legislation this year to help the additional 25 million taxpayers who will become subject to the alternative minimum tax. Stay tuned.

Financial Planning Magazine September, 2007.

By Jim Grote
September 1, 2007- As millions more Americans part with the workplace for longer and longer periods, retirement—once considered the reward of a work life well-lived—is proving not to be all wine (at early-bird prices) and roses (from the new garden). Scott Neal, president of D. Scott Neal, Inc. in Lexington and Louisville, Ky., witnessed this in a terrible way. "One of my clients, a surgeon, retired with a six-figure income and a perfect plan for his multimillion-dollar estate," Neal recalls. "About one month afterward, he shot himself. A brief note said, 'Forty-five days ago I was Dr. Jones, today I am nobody.'"

This story tragically illustrates Mitch Anthony's famous line, "Retirement is an unnatural condition." According to Anthony, retirement takes you out of life's race; it eliminates the stimulation of challenges. Anthony and others are looking to replace the binary approach to careers—work versus retirement—with the notion of phased retirement, in which an individual gradually reduces work hours over years. ...

Bob Veres, publisher of Inside Information, sees retirement as a brief historical anomaly. "The whole idea of retirement as a total secession from work—as opposed to making work optional—may be an artifact of a single generation. Someday we'll look back and say that this was a waste of human capital, and a very poor way to keep people active and relevant during their later years."...

But this retirement ideal is becoming more elusive than ever. According to a new study by Alicia Munnell, Anthony Webb and Francesca Golub-Sass of the Center for Retirement Research, even when adults work until age 65 and annuitize all their financial assets, nearly 45% of American households are at risk of not maintaining their standard of living in retirement. ... The study, entitled "Is There Really a Retirement Savings Crisis? An NRRI Analysis," also notes that the National Retirement Risk Index (NRRI) is rising, reflecting "declining Social Security replacement rates, lower real interest rates and the continued shift from defined benefit to 401(k) plans."

So perhaps the new refutation of retirement leisure has an element of lemons-into-lemonade. What matters is that the very idea of retirement, like everything else that touches baby boomers, is now subject to reinvention and customization. Every client will have an individual take, based on his or her financial capital, human capital, needs and desires. And you will have to help clients find their balance.

VALUING THE CAREER ASSET

According to Neal, the fundamental retirement question is not, "When do you plan to retire?" but rather, "What does retirement mean to you?" Planners such as Michael Haubrich of the Financial Service Group in Racine, Wis., are merging financial asset management with career asset management for the simple reason that, as he says, "your most valuable financial asset is your career."

The boldest attempt to quantify human capital thus far comes from some of the biggest names in the business. In "Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance," a groundbreaking white paper just published by the Research Foundation of the CFA Institute, Roger Ibbotson, Moshe Milevsky, Peng Chen and Kevin Zhu are extending the boundaries of traditional asset allocation to include human capital in their asset mix.

According to study coauthor Moshe Milevsky, professor of finance at York University in Toronto, "Human capital plays a central role in personal financial decisions. People are worth more than their bank accounts and pension plans, and the investment in human capital generates great rewards."

PRESERVING RETIREMENT INCOME

Of course, retirement is not just about fulfillment. How to spend down retirement portfolios without running afoul of longevity risk has attracted increasingly sophisticated analyses from the planning community because, as Veres observes, "people are not particularly good at translating pots of money into an income stream."...

Some of the best minds in the business have come together to share ideas about financing boomers' retirements. Many of them contributed to Harold Evensky and Deena Katz's book, Retirement Income Redesigned, including Mitch Anthony, William Bengen, Laurence Booth, Rick Carey, Peng Chen, Roger Ibbotson, Moshe Milevsky, Louis Stanasolovich and Lewis Walker.

Milevsky believes that all three of the retirement risks he wrote about—investment/portfolio risk, longevity risk and consumption/inflation risk—are greater than they were in the past. ...

To the three risks of a normal retirement, Evensky adds some behavioral ones. The fact that people stay "young" in retirement—they're healthy, vital and active—means that they are tempted to overspend. So does the lingering attachment to a paycheck-like income stream, which often leads them to withdraw too much from overly conservative, income-oriented investments....

PRESERVING HUMAN CAPITAL

Ibbotson's new study extends the lessons of diversification from modern portfolio theory to include the shadow asset class of human capital. ...

Haubrich makes a similar observation. In order to properly diversify client portfolios (including financial and human capital), both the velocity (how often they change jobs) and the volatility (how much their income fluctuates) of their careers need to be examined. ...

This notion of a phased retirement solves the client's need to stay active and relevant as well as the financial need for a more secure retirement income. Unlike the old industrial economy where a worker's value decreased with age, Haubrich believes that in today's knowledge economy, a worker's value will increase with age. In fact, he says, older workers' knowledge, experience and contacts make them more efficient than younger workers. Haubrich predicts that among those approaching retirement, phasing will spark a movement toward project-based contract work....

Retirement planning has clearly morphed into a more complex, but also more integrated discipline: life planning integrated with financial planning, career counseling with retirement planning, human capital with asset allocation and annuities with the optimal retirement portfolio. In the process the traditional notion of retirement may be going the way of the dinosaur. ...

As Veres concludes, "Retirement is going to be entirely phased out of the planner-client discussion at some point in the fairly near future. What will replace it? The idea of a fulfilling career. So whether the client is 20, 50 or 70, the conversation revolves around: Are you happy doing what you're doing? If not, what can we do to make it better? That often means downsizing and moving away from high-paying, high-intensity positions. One of my favorite lines comes from planner Jim Johnson, in Sacramento, Calif., who told me: 'I help people transition from high-paying crappy jobs to crappy-paying great jobs.'"

In closing, we might question how social forces that are pushing retirees to work can be viewed in such a positive light. The idea of phased retirement is clearly legitimate for workers with high-paying, high-intensity jobs who have stashed away enough capital to be able to downsize their careers and stay relevant. But for the well-documented affluent boomers who have failed to build a nest egg, there is no new-style retirement. There is simply no retirement—and the desperate hope that the workplace will be accommodating.

And there may be no high-paying part-time jobs, either. ... As Mitch Anthony asserts in his book, "The law of supply and demand may be moving to the side of the worker for many years to come."

But in a globalized economy, why would corporate America look more benevolently at older workers than at inexpensive but well-educated foreign labor, or than they would at young, tech-savvy "echo boomers" (children of the boomers)? While human capital is clearly a piece of the retirement puzzle that needs to be taken more seriously, the current valuation of that human capital is still a matter for debate and analysis.

Jim Grote, CFP, contributes frequently to Financial Planning.

(c) 2007 Financial Planning and SourceMedia, Inc. All Rights Reserved.

http://www.Financial-Planning.com http://www.sourcemedia.com

Financial Advisor Magazine October, 2007

By Patrick R. Chitwood
A definition of risk must include an investor’s own perception of it.
    It is common today to find that investment risk is frequently expressed in terms of the annualized standard deviation (SD). Because the consequences of such usage are significant to portfolio construction and investment decision-making, we must carefully examine our premises and our definitions.

    In his landmark text A Random Walk Down Wall Street (1973), Burton Malkiel defines risk as follows: “Investment risk, then, is the chance that expected security returns will not materialize and, in particular, that the securities you hold will fall in price. … Thus, financial risk has generally been defined as the variance or standard deviation of returns.” 

    In two short sentences this groundbreaking publication has transferred the concept of risk to a number. It is interesting to note that even Markowitz (1953), dodged defining measures of volatility as risk.

    From Malkiel, Fama and French, Treynor, Black and Sholes, Sharpe, etc., the study of portfolio construction centered around enhancing return while decreasing “risk” as defined by SD. “Risk” by this definition is completely dependent on SD values. Uncertainty is only a byproduct of the dispersion around a mean. 

    Unfortunately, investment risk requires a decision maker—a human, in the case of investing. To the extent that events are important to the decision maker, one could posit that those events may impact the likelihood of making an undesirable decision. Because these events may be entirely unrelated to the underlying investment, risk is clearly much more than the volatility component of an investment.

    Addressing FAME in February 2002, Peter Bernstein stated: “What do we mean by risk? It’s a very messy four -letter word. Volatility is the most popular proxy for risk. It’s a good one. First of all, intuitively, it makes sense. When something is jumping around, it hits you in the gut, you’re not comfortable, none of us is comfortable with volatility. If we have a sense something is going on we don’t understand, we don’t know where the limits are. There are plenty of intuitive reasons for using volatility as a proxy for risk. Volatility is also nice because it’s a number, standard deviation or variance, it’s a number, and that means we can manipulate it mathematically. All those beautiful equations wouldn’t be there unless we had a mathematical concept for risk. But volatility cannot deal with fat tails, with non-normal distributions, with nonlinear relationships, with nonstationarity, with multiperiod analysis, and there’s more. It gets messed up, it doesn’t hold together. So we have to think about different kinds of risk models, and more elaborate kinds of risk models, and the more elaborate they get, maybe the further away we get from the basic ideas. And for long-term, buy-and-hold investors, volatility is essentially irrelevant. So our definition of risk, the thing that we use the most, is in a sense a floating crap game. Uncertainty means—this is what Keynes and Frank Knight were very clear to explain—uncertainty is something we cannot quantify, we do not know what is going to happen, we don’t know what the probabilities are.” And later in the same speech: “How well do we really understand investor responses and how they weigh the trade-offs between risk and return? How do we define risk aversion? How variable and how stable are utility functions? These are very important in making policy decisions for long-term asset allocation. We need some sense of this, and it’s very slippery because it is so intuitive and so internalized.”

    If the standard deviation does not represent risk but rather is simply a measure of volatility, what then is risk and how do we define it, or do we even need to do so? A critical part any risk definition necessitates that we understand that investment risk requires human behavior. That behavior is unique to the investor. 

    Put much more eloquently in the words of Glyn Holton (Financial Analyst Journal, Vol. 6, 2004): “The definition (of risk) depends on the notions of exposure and uncertainty, neither of which can be defined operationally. … All we can hope to define operationally is our perception of uncertainty. Consequently, it is impossible to operationally define risk. At best, we can operationally define our perception of risk. There is no true risk.”

    So then, we are left with the factors that influence an investor’s perception of his investment risk. This is the embryonic domain of behavioral finance. As professionals we must strengthen our ability to determine the risk for each individual, recognizing that the same investment has different risks in the hands of different investors. Because of the extensive dynamics of an individual life, risk determination is dynamic and potentially complex. Perhaps it is for this reason that there is such unfounded allegiance to quantifying risk with the proxy of a standard deviation. 

    As a point of discussion I would like to propose the following operational definition. Investment risk can be defined as the exposure of capital to a future decision based on the perceived value of an investment at the time of that decision.

   Notice that the exposure of capital is to a future decision, not to an investment. Also, that the decision is based on perceived value, and that perception is based on several factors such as observation frequency, deviation from expectation, volatility and current life factors, to name a few.

    It is not the purpose of this article to propose a strategy for assessing risk and recommending investments as a result of that assessment. Nor is its purpose to address the components associated with risk and how those components can be impacted by investment work.  What I do hope to accomplish is to further motivate a dialogue for investment professionals to open their thinking to other ideas of assessing risk and to question, (in the words of Ken Fisher), “What is it that I believe that is wrong?” 

    To quote Bertrand Russell, “In all affairs it’s a healthy thing now and then to hang a question mark on the things you have long taken for granted.”

Money magazine- Aug. 3, 2007

Internet-only banks have finally come of age. Are you ready for better service, higher rates and fewer fees?

By Carolyn Bigda, Money Magazine writer-reporter

August 3 2007: 8:59 AM EDT

(Money Magazine) -- Here's a familiar scene: Lunch hour at the bank, and you're waiting in line for a teller. You're there to deposit a few paper checks, as well as to ask about a service charge you noticed on your last statement (which annoyingly wipes out any interest you earned). The minutes tick by as your stomach growls, and you begin to think: There's got to be a better way.

Well, there is, but you won't find it at the bank around the corner. Instead you have to go to financial institutions that exist online and only online.

The first virtual banks were generally limited to high-yield savings accounts, but today's "pure play" Web banks such as E-Trade and EverBank offer free ATMs and check writing. (Click here to see Money's picks for top online banks.)

There are no branches, but you probably use those less frequently anyway: 41 million households now do some form of banking online, a number that's expected to nearly double by 2011, according to Forrester Research.

But without an expensive branch network, Web banks can offer higher yields and charge lower fees.  Here are four reasons why it's time to make the move.

The yields are way higher

Even though the Federal Reserve has kept short-term rates at 5.25 percent for more than a year, the yield on most money-market accounts remains stubbornly low, on average less than 1 percent. Not so with virtual banks.

"Pure-play banks are deposit specialists," says Jim Bruene, publisher of Online Banking Report.E-Trade (Charts) was recently paying 5.1 percent on its savings accounts; HSBC Direct wasn't far behind with a yield of 5.05 percent.

Online banks also tend to keep accounts refreshingly simple: no fees, few minimums, no strings whatsoever.

Do a few percentage points make a big difference? Over two years, a $10,000 balance at 5 percent could grow to more than $11,000 online. In that time at the typical branch you'd earn just $200.

A slew of Web banks have also rolled out checking accounts that pay from 1 percent to 4 percent, compared with a mere 0.28 percent on average at conventional banks.

These accounts aren't as carefree as savings (you may have to maintain a minimum balance or sign up for direct deposit in order to earn interest or avoid a monthly fee), but the same holds true for traditional checking accounts.

The convenience is finally there

The early versions of online banks were great at paying high yields, but getting your money in and out of an account (unless it was via electronic transfer) used to be tricky.

Today that obstacle has all but vanished. Online-only checking accounts now come with ATM cards that work in virtually every machine. Ah, you say, but what about ATM charges?

Again, the online-banking community is generally superior. Most virtual banks reimburse ATM surcharges (typically up to $6 a month, though E-Trade and Charles Schwab (Charts, Fortune 500) have no cap).

As for getting cash into your account, you can either make an electronic transfer, set up direct deposit or mail in checks (often by using prepaid envelopes, so making a deposit is as simple as finding a mailbox).

The service is comparable, if not better

A growing trend in traditional banking is to move in the direction of the airlines (those paradigms of customer service) by making more things self-service. With an online bank, all you're giving up is the opportunity to sit with someone in a poorly decorated cubicle. There are still ample customer reps available, not to mention far more efficient e-mail systems.

You're in control

Once you're a customer of an old-fashioned bank, there's a likelihood you'll stay with it for a while (direct deposit and automatic-payment plans only strengthen the bond). The sheer hassle of switching accounts to a new institution is enough of a barrier that most people stick with what they've got.

The beauty of banking online is that you can be a more informed shopper and easily take your savings elsewhere if there's a better deal.

"Information has become very transparent," says Larry Freed, president of ForeSee Results, which tracks online customer satisfaction. "The power has shifted from the banks to the customers."

There are also a number of online resources to help you find the best deals, in the form of discussion boards, safety ratings and yield trackers.

Click here to see Money Magazine's picks for top online banks.