How to Keep More of What You Make

by Alexander Green, Investment U’s Chief Investment Strategist
Monday, October 25, 2010: Issue #1373

Last week, I met with a tax advisor who said something a bit ominous – but also true, I think:

For the rest of our lifetimes, income and capital gains tax rates will never be lower than they are today.

This is a bit startling when you consider that tax rates aren’t particularly low right now. Income, in particular, is taxed at up to 35%, compared to 28% when Reagan was in office.

When you add in Social Security taxes, unlimited Medicare taxes and an average state income tax of 6%, federal and state governments may take up to half of what you earn.

Of course, the Obama Administration is itching to let the Bush tax cuts expire and allow the top marginal tax rate to rise another 13% (to 39.6%).

Thanks to the fiscal crisis that Congress has created over the past decade, tax rates are likely to keep rising in the months and years ahead.

Clearly, you need to take whatever actions are permissible to keep as much of what you’ve earned as possible. And for investors, that starts with tax-managing your portfolio…

Effective Tax Management in Five Easy Steps

Here are the five basic steps to tax-managing your portfolio properly:

• Use Your Retirement Account: Whenever possible, use your retirement account for short-term trading activity. That way, your short-term gains – rather than being taxed at the same level as your income – compound tax-deferred.

• Less is More: You should minimize trade turnover in your non-retirement accounts. As Warren Buffett once pointed out, “The capital gains tax is not a tax on capital gains, it’s a tax on transactions.”Hold your winners for at least a year, if possible. If you do, you’ll qualify for long-term capital gains treatment at the maximum rate of 15%. (This may change after January 1.)

• Offset Capital Gains: The IRS allows you to offset all of your realized capital gains with realized capital losses. And you can take up to $3,000 in additional losses against earned income.

• Use Tax-Deferred Accounts: Use your IRA, pension, 401(k) or other tax-deferred accounts to own corporate and Treasury bonds (since interest income is taxed at the same rate as earned income) and real estate investment trusts (since REIT dividends are taxed the same way).

• Use Index Funds: If you invest in mutual funds, use index funds rather than actively managed funds in your non-retirement accounts. Index funds tend to be highly tax-efficient since changes to benchmarks are rare. Managed funds often have high turnover and Federal law requires them to distribute at least 98% of realized capital gains each year. You can get hit with a big capital gains distribution even when you haven’t sold a share – and even if the fund is down for the year.

Take these steps and you’ll substantially lessen the government’s tax bite. The few remaining choices are simple ones – for example, owning tax-free rather than taxable bonds, especially if you reside in a high-tax state like New York or California.

An Artful Solution to Cutting Your Taxes

The 1995 Tax Act also allows you to donate – to any IRS-approved charity – works of art at their fair market value, not their cost basis.

Moreover, you can deduct the charitable gift’s fair market value on your tax return without being subject to the dreaded alternative minimum tax.

Pillar One Advisor Mike Kuschmann works closely with published artists and sometimes acquires limited edition prints or serigraphs at a substantial discount to their current market value.

As Kuschmann explains, “Clients of mine purchase them far below published cost – often for just a few thousand dollars – and later donate them to a local hospital or university at fair market value, allowing them to save thousands of dollars in federal taxes.”

For more information, contact Mike Kuschmann, president of Fine Arts Ltd, at: 800-229-4322 or 407-702-6638. He’ll send you a complimentary brochure pack explaining his services and detailing the tax savings available.

Over the next few weeks, I’ll highlight several other year-end tips for reducing your tax liabilities.

Because – remember – it’s not how much you make. It’s how much you keep.

Good investing,

Alexander Green

Business/Finance, Capital gains tax, Finance, Flat tax, Income tax, Income tax in the United States, Jobs and Growth Tax Relief Reconciliation Act, Political economy, Public economics, Tax, Taxation, Taxation in the United States

Buying Tax-Free Bonds: Why You Need These Fixed-Income Investments Now

by Alexander Green, Chief Investment Strategist
Monday, September 20, 2010: Issue #1348

In the three weeks since I pointed out the bubble in the U.S. Treasury market, those securities have gotten walloped as yields have risen over one half of one percent.

I’ve received letters from many readers asking what they should do now with the fixed-income portion of their portfolios. For income investors, I have three answers…

• High-yield corporate bonds.
• Inflation-adjusted Treasuries (TIPS).
• Tax-free municipal bonds.

Especially tax-free bonds. Here’s why…

• They yield more than Treasuries.
• They’re exempt from federal income taxes (and state income taxes if you buy state-specific bonds).
• Your taxes will soon be going up. Way up.

Why Income Doesn’t Properly Reflect Real Wealth

I know, I know. Washington politicians promise they aren’t going to raise your taxes. They’re only going to raise them on the 2% of American households that make $250,000 or more.

Horse manure.

Having deliberately set up a fiscal crisis over the past decade, our elected misrepresentatives will soon be searching for ways to raise revenue to meet these obligations. The politically convenient idea is to raise taxes only on “America’s wealthiest.”

Yet earned income is often a poor indicator of wealth. Apple CEO Steve Jobs, Citigroup CEO Vikram Pandit, Google CEO Eric Schmidt, Yahoo! CEO Jerry Yang, Oracle CEO Larry Ellison and Berkshire Hathaway CEO Warren Buffett all receive annual salaries of $1.

Real wealth is determined by looking at a balance sheet not an income statement. The tax code is set up to punish high-income earners, many of whom are not rich but rather striving to become rich.

The problem with raising taxes on high earners is that this country badly needs to create jobs in the private sector. These top 2% – who already pay almost half of all income taxes, according to the Internal Revenue Service – are overwhelmingly small business owners. If the economy is going to grow, we want to encourage them to open new businesses and expand existing ones.

I know some economists claim that raising taxes doesn’t discourage risk-taking. Let’s put that theory to a simple test…

The Small Business Tax Roadblock

Imagine if someone offered you $50 to deliver an important document to a business located in the next town. Would you do it?

How about if he offered $40? How about $30? Or $20?

If you feel less inclined to accept each declining offer, congratulations. You’ve recognized that the more you pay in taxes – which is the same thing as being offered less money to do the same job – the less interested you are in doing the work.

Of course, small business owners are primarily wage payers, not wage earners. Take a moment and put yourself in their shoes. Imagine risking your hard-earned capital on a new business, fully aware that customers may complain that you charge too much… employees may believe you pay them too little… suppliers may claim you drive too hard a bargain… government officials may insist you aren’t complying with their mountain of regulations… and competitors, plain and simple, would like to drive you out of business.

Factor in the well-known fact that four out of five new businesses fail in the first five years. If you manage to meet these challenges and become profitable, the government – between federal income taxes, state income taxes, social security taxes, Medicare taxes and others – will take up to half of what you make. And some argue that higher taxes aren’t a disincentive to start or expand a business?

The Problem with Taxing the Top 2%

Of course, you can’t run a government without collecting taxes. But here’s the key. You increase revenue by expanding the tax base not increasing tax rates. (That means expanding the private sector, not the public one.)

You want to reward education, hard work and risk-taking. In short, you don’t raise up the wage earner by pulling down the wage payer.

Of course, many of our elected “leaders” have never held a job in the private sector, so – to them – this is all just the sheerest conjecture.

I hate to burst anyone’s bubble. But we won’t solve this nation’s fiscal crisis on the backs of the top 2% of income earners. Nor should we try.

Sure, it’s a political winner in some circles. But history shows that “soaking the rich” doesn’t work.

Which state has the biggest fiscal crisis in the United States? California.

Which state has the highest state income taxes? California. Other high-tax states are in a similar pickle.

And look at Greece. The country has a top marginal tax rate of 40%, plus a 23% value added tax (VAT), recently raised from 21%. Yet the country is a financial basket case. Why?

Because governments around the world are overreaching and politicians – ever intent on securing their re-election – are addicted to spending.

How to Beat the Washington Pick-Pockets

As Margaret Thatcher pointed out a couple decades ago, the problem with the social-welfare system is that eventually you run out of other people’s money.

With the current state of the economy, most politicians are reluctant to raise taxes. But history shows that they simply will not cut spending. (That includes Republicans. Witness the rise of the Tea Party movement.) Heck, they won’t even cut the growth of spending.

Needless to say, it’s only a matter of time before Washington turns its attention to your wallet. And that, in a nutshell, is why you ought to own high-quality tax-free bonds, even though the outlook for investment grade bonds is less than salutary.

You can mitigate the effects of any future rise in interest rates by owning individual bonds and keeping maturities relatively short.

Because your taxes will be going up. Not immediately, but before long. And that will make tax-free yields look even more compelling.

Don’t say we didn’t warn you.

Good investing,

Alexander Green

Business/Finance, Finance, Flat tax, Income tax in the United States, Political economy, Public economics, Social Security, Tax, Tax rate, Tax reform, Taxation in the United States, Value added tax

The End-of-the-World Portfolio… Is it Too Early to Have One?

by Alexander Green, Chief Investment Strategist

Wednesday, June 9, 2010: Issue #1277

First one friend called. Then another. And then yet another.

Now their friends are calling me, too, asking about my “End-of-the-World Portfolio.”

So I’ve decided to just go ahead and tell everyone about it.

All the friends who called – and their friends, too – are well-educated businessmen. They’re convinced that not only the United States government, but also the governments of Europe, Britain and Japan have simply lost their tether.

We’ve all seen deficit spending before. It’s been a problem for decades. But nothing like this…

Putting the Eye-Popping Numbers into Perspective

The unfunded liabilities for Social Security, Medicare and Medicaid alone now top $108 trillion.

Of course, that number is too large to mean anything to most of us. It’s only when you bring it into context that it becomes alarming.

The $108 trillion is approximately $815,000 per U.S. taxpayer. (And this is just the projected shortfall in Social Security, Medicare and Medicaid. It has nothing to do with the rest of the federal debt, which tops $13 trillion.)

Entitlement spending in other parts of the world is an even bigger problem. And the federal deficits are even more gargantuan. In Japan, for example, debt as a percentage of GDP will hit 200% this year.

Many of my friends look at the fiscal problems in Greece – that necessitated a $1 trillion bailout from the European Union – as just a warning shot across the bow. They’re concerned that things are only just beginning to unravel and will get considerably worse.

Are they right? Only time will tell. But here’s what they keep telling me…

Are You At the Mercy of Wasteful Governments?

“Alex, I busted my hump to earn this money. I’ve paid taxes on it. I’ve saved it instead of spending it. I’m not going down with the ship if those boneheads in Washington spend us into oblivion. How do I protect myself?”

Let me begin by saying that I’ve listened to apocalyptic economic forecasts for decades now. Putting all your money in gold bullion, freeze-dried food and shotgun shells hasn’t been a particularly auspicious strategy.

The difference here is that these folks aren’t gloom-and-doomers who have droned the same message for over 30 years. They are ordinarily optimistic folks who think Western governments are driving the world economy down the road to ruin.

The knock against democracy in Greece and Rome a few thousand years ago was that once the electorate realized they could use their representatives to loot the Treasury, all would be lost. Lately, that remark is looking prescient.

As one friend summed it up: “Look, Alex, I don’t care if I’m wrong about Armageddon and my returns turn out to be lower than what they might have been. Just tell me what to do so I can hang on to what I’ve got and maybe match or beat inflation by a little bit.”

How to Allocate Your Assets in the “End-of-the-World Portfolio”

With that modest goal in mind, here is my suggestion if you want to hunker down for the end of the world – a posture that admittedly may be premature.

• Put 40% of your liquid portfolio in a laddered portfolio of AAA-insured, tax-free bonds. (Be sure to buy state-specific bonds if you’re in a high-tax state.)
• Put 40% in a laddered portfolio of inflation-adjusted Treasuries, also AAA-rated. (For tax reasons, these are best owned in your retirement account.) This is your protection against inflation, as Uncle Sam might opt to spend us out of a tight spot with interest rates already near zero.
• Put the remaining 20% in defensive, blue-chip, dividend-paying stocks. I’m referring to food companies, healthcare companies, utilities, defense contractors, gold mining companies and the like. This should provide some growth and income.

Why include stocks at all? Because 200 years of history shows that an 80/20 split between stocks and bonds is actually less risky than a 100% bond portfolio.

On a personal note, I would not invest my own money this way. (At least not yet.) I’m not calling for the end of the world.

But my friends seem grateful just to have a clear-cut plan. One of them even concedes that it’s not his “End-of-the-World Portfolio”: “I tell people it’s my “Cup-Your-Groin Portfolio.”

I suppose it is. I only hope our elected misrepresentatives get the message before we all need one.

Good investing,

Alexander Green

Laddering means varying your portfolio between short-, medium- and long-term bonds. This is your protection against deflation and the virtual certainty of higher taxes.

Business/Finance, Doomer, Economy of the United States, Government, Government debt, Medicare, Political economy, United States, United States public debt