As most of you know, the minimum required distribution (MRD) rules require affected taxpayers to withdraw at least a minimum annual amount from tax-advantaged retirement accounts. If the taxpayer fails to withdraw at least the MRD amount, the IRS can impose a 50% penalty on the shortfall. The taxpayer can always take out more than the MRD amount, but that would cause the IRA account to end prematurely. For those taxpayers who want to dribble the minimum amount from their IRA account each year and squeeze the most tax-savings, the objective is to take out the MRD annually, but no more.
In early 2001, the IRS issued updated MRD rules in the form of proposed regulations. In April 2002, the IRS released new final regulations. While this article is written in the context of traditional IRAs, the same MRD rules apply to SEP-IRAs, SIMPLE-IRAs, Roth IRAs, and defined contribution qualified retirement plan accounts, such as 401(k)s, Keoghs, and 403(b)s.
No Account Beneficiary
If an IRA owner dies without having a designated beneficiary, annual MRDs are still calculated and must be withdrawn to avoid the 50% penalty. In this case, the withdrawals are received by the deceased owner’s estate or whoever the ultimate beneficiary of the account is. When the owner of an IRA dies before April 1 of the year following the year the account owner turned 70 ½, the five-year rule applies. Under the five-year rule, the account must be completely liquidated (and federal and state taxes paid) by December 31 of the fifth year following the year of the account owner’s death.
Example: Fred dies in 2002. He died without designating a beneficiary for his IRA. Fred’s estate, or whoever inherits his IRA, has until December 31, 2007 to completely liquidate the account to avoid the 50% penalty for failure to comply with the MRD rules. Instead, assume the same facts, except Fred’s estate is designated as the account beneficiary. The results are the same because under the MRD rules, naming one’s estate as the account beneficiary is the same as naming no beneficiary.
When an IRA owner dies on or after April 1 (the magic date), the first priority is calculating the MRD amount. The MRD must be withdrawn by December 31 of that year, assuming the account owner did not withdraw that amount before death.
Example: Fannie died in 2002 without designating a beneficiary for her IRA. The MRD must be taken by December 31, 2002, assuming she did not withdraw anything in 2002 before she died. In calculating the amount, the appropriate life expectancy divisor must be determined. The divisor depends on Fannie’s age as of December 31, 2002, had she still been alive on that date. If she would have been 74, the joint life expectancy divisor for a 74-year-old in the tables is 23.8. The next step is to divide the December 31, 2001 account balance, say $200,000, by 23.8 to arrive at the 2002 MRD. Fannie’s estate or the ultimate beneficiary must withdraw at least that amount by December 31, 2002 to avoid the 50% penalty for failure to comply with the IRS rules on MRDs.
The 2003 MRD must be withdrawn by December 31, 2003. To determine the amount, use the single life expectancy divisor based on Fannie’s age as of December 31, 2002 reduced by 1.0. The reason the divisor is reduced by one is because the calculation is for 2003. Find the single life expectancy divisor for a 74-year-old in the tables; the factor is 14.1. The 2003 MRD will be calculated by taking the December 31, 2002 account balance divided by 13.1 (14.1 minus 1.0). The 2004 MRD is equal to the December 31, 2003 account balance divided by 12.1 (14.1 minus 2.0). I think you get the idea.
Craig C. Le Bouef, CPA/PFS, CFP, MBA, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
With the stock market plunge since March 2000, investors have been paying more attention to bonds. Most investors are advised to hold some bonds to diversify their portfolio. The amount of bonds to hold depends on the investor’s financial needs and goals, investment time horizon, and attitude toward risk. The problem with purchasing bonds after two decades of falling inflation and interest rates at their lowest level in 40 years is that if inflation picks up and interest rates increase, then bonds will lose value.
Some investors may want to consider the following federal bonds. Two of them officially offer investors protection from the effects of inflation. The other is not officially labeled “inflation-proof;” however, that is effectively the case.
TIPS
TIPS are commonly called Treasury Inflation-Protected Securities. If you buy $100,000 worth of TIPS with a posted interest rate of 3%, and inflation for the first year is 2%, then the value of your bonds rises to $102,000 ($100,000 times 102%). With a 3% interest rate, you would receive $3,060 ($102,000 times 3%). The inflation adjustments occur every six months. TIPS pay interest twice a year. Therefore, your total return would be 5%, 3% interest plus 2% principal gain to keep up with inflation.
In October 2002, 10-year TIPS were priced to yield 2.8%. In May, when TIPS interest rates were reset, inflation was 1.4%, so the total return on TIPS would be 4.2%. By comparison, a traditional 10-year Treasury note was yielding around 4.6%. Therefore, TIPS would have an advantage with any inflation rate over 1.8% (4.6% - 2.8%) for the next 10 years.
When you own a TIP, you pocket the interest payments. The accumulated principal isn’t collected by you until the bond is sold or it matures. Even though you don’t pocket the principal buildup, you pay tax annually on both the current interest and the principal buildup. For example, if your $100,000 in TIPS grows to $102,000 and you receive $3,060 in interest, as above. Your annual taxable income would be $5,060, which includes the principal buildup. At a 35% tax rate, you would owe $1,771 in tax.
You can avoid this tax pitfall by holding your TIPS in an IRA or other tax-deferred retirement account. Because the TIP is held in a tax-deferred account, no tax will be due until the money is withdrawn.
I Bonds
I bonds are savings bonds designed to offer inflation protection to investors. I bonds are bought at face value, from $50 to $10,000, if you buy a $1,000 I bond, you will get $1,000 back when you redeem it. There are limits on the amount of I bonds you can purchase. An individual can buy up to $30,000 worth each year, so married couples can invest up to $60,000 annually.
I bonds pay both a fixed interest rate and a variable interest rate. The fixed interest rate is set when you buy the bond. The variable rate changes twice a year, May 1 and November 1 based on inflation, as measured by the Consumer Price Index. As with any saving bond, you can choose not to report the I bond interest as income until it matures, which is 30 years from issue. By deferring the income this way, you will also defer the tax obligation.
Like US Treasury issues, the interest income on I bonds is exempt from state income taxes. Potentially, the federal tax may disappear also if the I bonds are used to pay education expenses and you are within the adjusted gross income (AGI) limits. A disadvantage of I bonds are their yields. From May through October 2002, I bonds were paying a 2% fixed rate plus a variable annual rate of 0.57%, for a total of 2.57%. Another downside is if you cash in an I bond before a five-year holding period, you will receive even less because three months’ of interest will be forfeited.
EE Bonds
The 2.57% yield on I bonds is disheartening, especially compared to the yields on TIPS. However, for the best of both worlds you could consider EE savings bonds. EEs offer the tax shelter advantages of I bonds, and discussed above, and they were paying 3.96% in October 2002. In addition, because the interest is adjusted they do offer inflation protection. As stated in the opening, EEs are not officially “inflation-proof” bonds. Because EE bonds have variable yields, set at 90% of the average yields on five-year Treasuries, if inflation increases and interest rates rise, new EE bonds will offer higher yields. From 1998 to 2000, the US inflation rate rose from 1.6% to 3.4%. Concurrently, the yield on EE savings bonds rose from 4.60% in November 1998 to 5.73% in May 2000. Investors looking for inflation protection, tax shelter, and yield, EEs should be considered.
In a worst case scenario where inflation would rise significantly, none of the above would provide perfect protection. If inflation rises to 7% and your inflation-protected bonds pay 10% interest, and assuming a 35% federal tax bracket, you would net 6.5%, which is less than the 7% inflation rate. However, the inflation-protected bonds discussed above would not lose principal value as compared to other traditional bonds.
Craig C. Le Bouef, CPA/PFS, CFP, MBA, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
As most of you know, the minimum required distribution (MRD) rules require affected taxpayers to withdraw at least a minimum annual amount from tax-advantaged retirement accounts. If the taxpayer fails to withdraw at least the MRD amount, the IRS can impose a 50% penalty on the shortfall. The taxpayer can always take out more than the MRD amount, but that would cause the IRA account to end prematurely. For those taxpayers who want to dribble the minimum amount from their IRA account each year and squeeze the most tax-savings, the objective is to take out the MRD annually, but no more.
In early 2001, the IRS issued updated MRD rules in the form of proposed regulations. In April 2002, the IRS released new final regulations. While this article is written in the context of traditional IRAs, the same MRD rules apply to SEP-IRAs, SIMPLE-IRAs, Roth IRAs, and defined contribution qualified retirement plan accounts, such as 401(k)s, Keoghs, and 403(b)s.
Disclaiming an Inherited Account
Under the new MRD rules, the identity of the account’s designated beneficiaries can be finalized as late as September 30 of the year following the year of the original account owner’s death. During that time, the beneficiary can be removed from the MRD formula if the beneficiary disclaims (gives up the legal right to) his or her share, or receives a distribution equal to his or her share.
Example: Joe dies in 2002, and his wife Joyce is named the sole beneficiary of his traditional IRA. John, their son, is named contingent beneficiary, which means he inherits the account if Joyce dies or she disclaims her interest. If Joyce makes a valid disclaimer before September 30, 2003, she will be ignored for subsequent MRD calculations, and John will be considered the sole account beneficiary. John must then follow the MRD rules for non-spousal account inheritors. Under the non-spousal account table, John must withdraw an initial MRD by December 31, 2003. John’s MRDs for 2003 and after are calculated using divisors based on his single life expectancy. Keep in mind that for Joyce’s disclaimer to work for MRD purposes, John must be a designated beneficiary at the time Joe dies.
Assume the same facts as above, except Joyce and John are designated as equal 50% co-beneficiaries of Joe’s IRA. If Joyce disclaims her share by September 30, 2003, John will be considered the sole beneficiary for subsequent MRD purposes, and the tax results will be the same.
Assume the same facts as in the preceding paragraph, except this time assume Joe is age 73 when he dies in 2002 and Joyce makes a valid disclaimer after his death in favor of John. Joe dies on or after his MRD beginning date of April 1 of the year after he reached age 70 ½; therefore, a year-of-death MRD must be withdrawn by John by no later than December 31, 2002, assuming Joe did not withdraw from the account during 2002 before he died. The 2002 MRD must be calculated using the joint life expectancy table and Joe’s age as of December 31, 2002 had he lived. John’s MRDs for 2003 and after are calculated using divisors based on his single life expectancy. Assume the same facts as the preceding paragraph, except Joyce does not make a valid disclaimer until sometime after December 31, 2002, but before September 30, 2003. The MRD amount will be spit between Joyce and John because Joyce is still a 50% co-beneficiary as of December 31, 2002. After 2002, John is the sole beneficiary for MRD calculations, and the divisors used will be based on his single life expectancy.
Key: Valid disclaimers must satisfy the provisions of the Internal Revenue Code.
Craig C. Le Bouef, CPA/PFS, CFP, MBA, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
As most of you know, the minimum required distribution (MRD) rules require affected taxpayers to withdraw at least a minimum annual amount from tax-advantaged retirement accounts. If the taxpayer fails to withdraw at least the MRD amount, the IRS can impose a 50% penalty on the shortfall. The taxpayer can always take out more than the MRD amount, but that would cause the IRA account to end prematurely. For those taxpayers who want to dribble the minimum amount from their IRA account each year and squeeze the most tax-savings, the objective is to take out the MRD annually, but no more.
In early 2001, the IRS issued updated MRD rules in the form of proposed regulations. In April 2002, the IRS released new final regulations. While this article is written in the context of traditional IRAs, the same MRD rules apply to SEP-IRAs, SIMPLE-IRAs, Roth IRAs, and defined contribution qualified retirement plan accounts, such as 401(k)s, Keoghs, and 403(b)s.
Multiple Account Beneficiaries
An IRA account that is inherited by several designated beneficiaries who are all individuals, generally MRDs are based on the single life expectancy of the oldest beneficiary. Multiple beneficiaries means that several individuals are designated as primary co-beneficiaries. An example is Anne gets 25%, Bob 25%, and Claude 50%.
Example: Mary has an aunt 66 years old, and the aunt dies in 2002. Mary is age 32, and her two older sisters are named equal 33 1/3 beneficiaries of the aunt’s IRA. Unless the five-year rule applies, the initial MRD from the aunt’s account must be withdrawn by December 31, 2003. The 2003 MRD amount is calculated by determining the appropriate life expectancy divisor. The divisor depends on the oldest beneficiary’s age as of December 31, 2003. If the oldest sister is age 45, we must find the single life expectancy divisor for a 45-year-old. The factor is 38.8 from the tables. The next step is to divide the December 31, 2002 balance, $500,000, by 38.8 to arrive at the 2003 MRD amount of $12,887. That amount must be withdrawn by December 31, 2003 in order to avoid the 50% penalty for failure to comply with IRS rules.
In the above example, Mary’s aunt could have done her heirs a favor by splitting the IRA, while she was living, into three separate IRAs (through the use of rollovers), one for each beneficiary. The aunt could have put one-third of her IRA balance into an IRA with Mary named as the sole beneficiary. That way, Mary could have calculated her MRDs based on her much-longer single life expectancy.
Under the new MRD rules, there is still a way to divide the IRA post mortem. After the aunt’s death, the IRA can still be divided up into three new IRAs, one for each beneficiary. The benefit to the beneficiaries is that each can base his or her MRD calculations on his or her own single life expectancy.
Example: Assume the same facts as in the preceding example, except this time assume the deceased aunt’s IRA is split up by September 30, 2003 into three new accounts, with each getting one-third. By December 31, 2003, Mary must take an initial MRD from the inherited account of which she is now the sole designated beneficiary (unless the five-year rule applies). To calculate the 2003 MRD, we must first determine the appropriate life expectancy divisor to use. The divisor is based on Mary’s age as of December 31, 2003, and assume her age will be 33. From the IRS tables, you would find the single life expectancy factor for a 33-year-old, and it is 50.4. The next step would be to divide Mary’s share of the December 31, 2002 account balance $166,667 ($500,000/3) by 50.4 to arrive at her 2003 MRD amount of $3,307. Mary must withdraw that amount (at least) by December 31, 2003 in order to avoid the 50% penalty for failure to comply with IRS rules on MRDs.
The naming of a beneficiary that is not an individual generally means the account is considered to have no beneficiary for MRD calculation purposes. The result could be an unfavorable tax result for the other co-beneficiaries who are individuals. However, the potential problem can be avoided by removing the non-individual beneficiary by September 30 of the year after the year the account owner dies.
Example: Jane’s 66-year-old aunt dies in 2002. Jane is age 32 and her older sister are equal 33 1/3% beneficiaries of the aunt’s IRA, with the third beneficiary being the aunt’s charity. As explained earlier, the entire account will have to be distributed by December 31, 2007, because a non-human has been designate as a beneficiary. The result is a shortened deferral period for the IRA’s assets to grow. Jane and her sister would have preferred MRDs to be made over as long a period as possible.
To correct the defect, 33 1/3% of the account balance can be distributed to the charity by September 30, 2003. Distributing the charity’s share to it would remove the charity as a beneficiary. Then, the remaining IRA balance can be divided (via rollovers) into two equal new accounts, one for Jane and one for her sister. The rollovers to Jane and her sister must also be completed by September 30, 2003 to have the desired impact on subsequent MRD calculations. Craig C. Le Bouef, CPA/PFS, CFP, MBA, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
The third quarter of 2002 marked the stock market’s worst quarter since 1987. However, an allocation based on one’s financial needs and goals, investment time horizon, and attitude toward risk may have reduced volatility for the average investor for the quarter. A review of various asset classes that should be considered in one’s portfolio is discussed below.
Money-Market Funds
Cash-equivalent assets continue to provide very low returns as of the writing of this article. As of December 2002, taxable money-market funds were yielding approximately .9% to 1.1% on average, barely keeping up with inflation. Money-market funds are issued and redeemed at net asset value (NAV) of $1.00 per share, and this stability is comforting to investors. Investors who have held cash in proportion with their optimal allocation would have preserved a substantial portion of their financial wealth since March 2000. Any number of unpredicted events can occur that require emergency expenses. Holding an amount of cash equivalents as part of a diversified portfolio may prevent you from selling common stocks during a market downturn.
Intermediate-Term Bonds
Outflows from equities to bonds continue to hold up bonds, even as interest rates have dropped to levels not seen in over 40 years. The purpose of holding fixed-income securities is to enhance the stability of your portfolio. However, bond prices can change in response to a variety of factors uncontrollable by investors. The expected returns from bonds with maturities of more than five to seven years may be more than offset by the volatility they would add to a portfolio. Therefore, investors should carefully consider fixed-income securities with maturities that exceed that time frame.
Income Equities
Certain Real Estate Investment Trusts (REITs) and certain Utilities Funds should be considered in moderate to conservative portfolios. These funds may be good choices for investors seeking to add investment income and relative stability to their holdings. Utility stocks have fallen sharply with the Dow Jones Utilities index down 20.5% during the third quarter 2002. However, some utility funds are currently yielding a very attractive 8-9%.
REITs declined during the third quarter also after a strong first half of the year. However, some funds are yielding 5.5-6.0%. That yield is very attractive relative to the 10-year Treasury note, which is currently yielding about 4.2%. REITs are obligated to pay out 95% of their earnings as dividends in order to avoid taxation at the corporate level. Another attraction of REITs is they are not highly correlated with other fixed-income securities as bonds; therefore, they deserve consideration to diversify risk and maintain or hopefully increase returns.
Common Stocks
Many factors weighed on the returns of stocks: terrorism, threat of war, weak earnings reports, and economic uncertainty. All the equity asset classes were down for the third quarter 2002. The small-cap value index fell 25.3%, the large-cap value index was off 20.5%, while the large-cap growth index sank 14.1% for the quarter. Foreign stocks fared no better, as the European Index decreased 22.9%. In addition, mutual fund investors were fleeing as the market was falling. According to the Investment Company Institute, approximately $678 million left domestic-equity mutual funds during July and August 2002.
Those investors who pulled dollars from equity funds and parked them in bonds or cash should have considered their asset allocation first. Because if those investors were chasing returns by investing in bonds, then they may be in for a surprise as discussed in the Intermediate-Term Bonds section. If the money went to cash, now they will have to consider when to get back into the market. And as research has shown, and I have written previously about, they now have to be right not once but twice. The reason I say that is research done by Missouri-Columbia Professor John D. Stowe, Journal of Investing, showed that from 1991 through 1998, an investor who missed the top 40 trading days would have had their annual return reduced from 19.87% to 1.90%, after trading expenses.
Gold-Related Investments
This asset class is somewhat controversial and hard for many investors to accept, as part of a long-term, diversified portfolio. The reason is precious metals (or commodities) are viewed as volatile, and gold has not been a very good investment for the past 20 years. However, gold ownership provides some insurance against the day when general price inflation increases once again. Readers should be aware that investing in coins can be expensive (dealers have high margins).
Alternatively, investors can receive benefits of indirect ownership of gold via shares of precious metals mining companies or mutual funds. If you decide to invest in shares of precious mining companies, you should consider only well established, producing, dividend-paying companies. The reason is any increase in the price of gold travels almost entirely to the bottom line. However, the price of gold can be extremely volatile. Precious metals tend to perform well during times of market instability. The asset class precious metals returned 18.33% during 2001 and through November 2002 it has returned 33.10%.
Craig C. Le Bouef, CPA/PFS, CFP, MBA, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
Investing in foreign companies is much easier today because of computers that can access research on public companies based overseas, the explosion of mutual funds, and the availability of depository receipts (ADRs). With this level of access, the ease of investing abroad challenges past investment thinking on markets and investment diversification. The thinking is starting to drift toward the reasoning that as markets and people become more interconnected, they become more impacted by each other; therefore, a financial crisis in one country seems to spread to other countries, causing markets to dive around the world.
Traditional thinking was that exposure to foreign equities can not only increase returns, but reduce portfolio risk also. The topic of the world’s markets becoming more correlated has taken on recent debate as new studies improve upon old research and the world continues to reel from the technology bubble collapse. We will review the current debate over global investing.
Portfolio Theory
About 50 years ago an economist named Harry Markowitz published a paper that ushered in the concept of asset allocation. The new era of “modern portfolio theory” defined an optimal portfolio as consisting of a group of assets that achieve the highest possible return for a given level of risk. To reach optimality, assets or asset classes are chosen, in part, by considering their relationship to one another. Therefore, when one is performing poorly, others are not systematically affected (moving independently of the one performing poorly).
Research done in the 1960s showed that diversification benefits could be obtained using foreign investments as part of the portfolio. Through the years, foreign investing has increased steadily. According to the U.S. Treasury Department, U.S. portfolio investment in foreign securities increased from $89 billion in 1984, when the data was first followed, to approximately $1.8 trillion by 1997.
Impact of Globalization
The 1987 market crash raised interest about the advantages of global investing because of the spread of the U.S. financial crisis to other markets. Initial research showed that correlations among ten major stock markets increased on average 39% in the 76-month period following the crash as compared to the same period before the crash.
According to the International Monetary Fund (IMF), the average correlation for 23 developed markets was stable from the mid-1980s through the mid-1990s at about 0.4. The number appeared to be low enough to justify foreign equities in a portfolio to diversify. However, the average correlation has increased from the late 1990s to 0.9 by February 2002, according to the IMF.
In 2001, a study done by Yale University researchers examined 150 years of world equity markets. According to the researchers, this study of financial history found resemblance to today’s information revolution and the “golden” era of the late 1800s and early 1900s, when trade was spurred by the spread of the telegraph, railroads, steamships, and transatlantic cable. The researchers concluded that global integration today is much deeper than in the previous era.
In October of 2002, analysts at the U.S. Federal Reserve Bank looked at the current global economic turndown in historical terms, and they did not find a significant increase in the correlation of economic cycles. The analysts concluded that the current economic downturn is typical of the past 30 years and the interdependence of business cycles among countries varies widely. Their research seemed to indicate that there are also more transient factors, such as oil prices, that contribute to business cycles.
What to Do?
The esteemed investment-advising firm, Frank Russell Company, raises the argument that this debate on global investing compares to an earlier one on the out-performance of U.S. large-cap and small-cap stocks in the late 1990s. A Russell consultant draws attention to the conclusion that was reached by many investors – that it was unnecessary to invest in small-cap stocks since large-caps were strongly out-performing them. But, those who stayed out of small-caps missed significant out-performance over large-caps in 2000 and 2001.
It is virtually impossible to know where next year’s winners lie. It may seem logical to invest your savings at home only (U.S.). It is reasonable to think that if you can own companies such as GE, IBM, Microsoft, and Intel, why look elsewhere. However, those investors who put a portion of their savings outside the U.S. may get exposure to good companies like Nestle of Switzerland, Nissan of Japan, British Petroleum of the U.K., L’Oreal of France, Audi of Germany, and Heineken of the Netherlands.
Craig C. Le Bouef, CPA/PFS, CFP, MBA, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
Recent questions received on investing centered on is now a good time to buy bonds because of the volatility in the market. As always, people should not try to time the market to buy bonds or stocks but should work toward an optimal asset allocation based on their financial needs and goals, length of investment horizon, and attitude toward risk. Bonds periodic payments are fixed and their prices are inversely related to interest rates. Therefore, as interest rates rise, bond prices fall, and vice versa. In addition, long-term bonds are more interest-rate sensitive than are shorter-term bonds, because the longer time to maturity renders them more susceptible to fluctuating rates.
Research has shown that fixed-income securities with longer maturities have usually provided on modestly higher returns over time, but the risk assumed in owning those assets, as measured by their volatility, or standard deviation, has been disproportionately higher. In light of that risk/return tradeoff investors should consider avoiding fixed-income assets with maturities in excess of five years for the near future, when investing for capital appreciation.
Consider that ten-year Treasury notes are yielding approximately 3.8% in late 2002. Since October 1993, these notes on average yielded roughly 5.9% annually, ranging from a high of 8.2% to their current low of 3.8%. If interest rates were to simply revert to their mean since 1993, bond prices would have to fall, and the owners of these bonds would be in for stormy weather.
Seven to ten year Treasury Bond iShares are yielding approximately 3.84% versus 1.83% for the 1-3 year Treasury Bond iShares. iShares are fixed income exchange traded funds (ETFs). ETFs are investment vehicles that allow investors to capture broad segments of the bond market with a single trade and watch prices right along with stocks on an intraday basis. Investors may be tempted to purchase the longer-term shares if they focused just on yield. However, the 7-10 year shares have a duration of 6.08 versus 1.54 for the 1-3 year shares. Duration is a factor that measures a bond’s or bond portfolio’s sensitivity to changes in interest rates. In other words, the longer-term securities yield just over twice that of the shorter-term securities, but are almost four times as risky if interest rate volatility (as measured by duration) is used to assess the risk.
What if the 10-year yields were to revert back to their mean, and increase by 2%, and other yields along the yield curve similarly increased. Using duration as a measuring tool, the 7-10 year iShares would fall in value by 12.2%, while the 1-3 year iShares would fall by only 3.1% in comparison.
The above discussion does not mean that investors should not invest in fixed-income securities over the next few months to few years. Again, investors should work toward an optimal asset allocation and not try to time the market. However, investors who want capital appreciation from their fixed-income investment purchases over the near future should consider the above.
Craig C. Le Bouef, CPA/PFS, CFP, MBA, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
An area of finance that has become popular with many in the investment world is behavioral finance. Behavioral finance is the study of why investors make decisions for emotional reasons, why they base their decisions on shaky premises, and why they are quick to see cause and effect where there may be none. So what does this mean for the markets? The stock market is based on cumulative decisions of individuals, does that suggest that the market is not as efficient in determining stock prices as the industry has believed over the past decades.
The remainder of this article will summarize a debate that took place between Burton Malkiel, a Princeton University finance professor and author of the famed A Random Walk Down Wall Street, and Richard Thaler, a finance professor at the University of Chicago and a principal at Fuller & Thaler Asset Management, a money management firm based in San Mateo, CA.
Malkiel represented the efficient-markets camp. This camp argues that the market is a mechanism that utilizes the collective information of stock market participants to produce efficient prices. In other words, there is no easy money for investors to make by predicting how stocks will behave. Thaler represented the view that psychology plays a large role in the movement of stock prices and that patterns, or predictabilities, exist in the market that can be profitably arbitraged.
Malkiel argued that the most convincing proof of the efficiency of the market is the fact that professional portfolio managers cannot consistently outperform the market. He said, “if you look at the median mutual fund, and the S&P Index over the last 10, 15, and 20 years, there’s been about a 200 basis points underperformance of the median mutual fund vs. the S&P Index.” Some fund managers do beat the index, but the problem is that investors do not know in advance which managers will outperform. The 20 best performing funds in the 1970s, which doubled the returns of the S&P 500 index, underperformed the index in the 1980s, noted Malkiel. The 10 best in the 1980s underperformed in the 1990s.
Thaler noted a book entitled Irrational Exuberance argued forcefully that prices were not rational during the Internet bubble, and called the confusion about the bubble “one of the most remarkable errors in the history of economic thought.” In addition to bubbles, there may be stock market “funks”. Times when stock prices are irrationally low. “If bubbles break, what makes us think they break to the right level? Do we know that Japan’s stock prices are rational now?” asked Thaler. Stock prices have steadily fallen for over a decade in Japan, and if there was a bubble then, maybe they’re in a fund now.
Thaler offered an example of a company whose stock prices were incorrect at some point. In 1907 Royal Dutch and Shell Group formed a single company and merged their interests 60/40, but continued to trade as separate stocks. However, the shares of both companies didn’t always trade at that ratio, and over the last two decades in particular there were large deviations from their theoretical relationship.
Both professors agreed that stock market bubbles eventually deflate but when is very difficult to predict. They both noted that it’s hard to take advantage of mispricings because it might take too long for prices to return to a more sensible level.
As discussed above, given the difficulty of predicting stock prices reliably, how does Thaler make investment decisions? He noted that one strategy his money management company follows is to try to predict analyst revisions. However, when asked about current stock prices being revised up next quarter he joked that he didn’t know if the prices were becoming more rational.
Craig C. Le Bouef, CPA/PFS, CFP, MBA, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
When a deceased spouse (the original account owner) dies on or after April 1 of the year following the year he or she turns age 70 ½, the surviving spouse has two options regarding how to handle the inherited IRA. Before discussing those options, the surviving spouse must be the only primary account beneficiary and have an unlimited right to take withdrawals from the account. When the beneficiary is a trust, this definition cannot be met.
The first option allows the IRA to be treated as a surviving spouse’s own account. Under this option, the surviving spouse treats the inherited IRA as though it is the surviving spouse’s own account. Generally, this is the best choice from a tax planning point of view. The choice must be made (commonly by retitling the account in the surviving spouse’s name) by no later than the end of the year following the year of the deceased spouse’s death. Nonetheless, the choice may also be made in the year of death. In either case, the deceased spouse’s (original account owner) minimum required distribution (MRD) for the year of death must be withdrawn by the end of that year.
Example: Jane’s husband dies in 2002. He was age 73. Jane is the sole beneficiary of his traditional IRA. She should treat the inherited account as her own to benefit from the more-favorable MRD rules that apply to the original account owners. Whether Jane does this or not, she must take a MRD by December 31, 2002 (assuming no monies were withdrawn from the account by the husband in 2002 prior to his death). The 2002 MRD amount is calculated as if the husband were still alive at December 31, 2002, using the new tables discussed in prior articles.
As soon as emotionally possible but before December 31, 2002, Jane should treat the account as her own by retitling the account in her name to show that she is the new owner. If Jane is under age 70 ½, she is not required to take any MRDs until after she reaches that age. If she is already over 70 ½, the next MRD must be taken by December 31, 2002. As stated above, the MRD and subsequent MRDs are calculated using the taxpayer-friendly rules for original account owners, as discussed in prior articles. In essence, the new rules allow Jane to calculate MRDs using favorable joint life expectancy divisors.
The second option would be to leave the account in the deceased spouse’s name. Under this option, the surviving spouse simply leaves the inherited account in the deceased spouse’s (original account owner’s) name.
Key: Option 2 is generally not as beneficial from a tax planning perspective as choosing the first option. However, option 2 is the easiest for the surviving spouse. When dealing with an inherited defined contribution retirement account (401k, 403b, 457, etc.), the surviving spouse can roll over a distribution from the account into an IRA treated as the surviving spouse’s own IRA. In this decision, the surviving spouse can effectively implement the first option.
Example: Jane’s husband passes away in 2002. If he had lived, he would have been 73 at December 31, 2002. Jane is the sole beneficiary of his traditional IRA, and she chooses to leave the inherited account in her husband’s name. As explained above, a MRD must be withdrawn by December 31, 2002. By December 31, 2003, another MRD must be withdrawn. To calculate the proper amount, the appropriate life expectancy divisor must be determined. If Jane will be 68 on December 31, 2003, the single life expectancy divisor for a 68-year-old is 18.6. Therefore, if the account value was $500,000 on December 31, 2002, that value is divided by 18.6 to derive the 2002 MRD amount of $26,882. Jane should withdraw that amount (at least) by December 31, 2003 to avoid the 50% penalty for failure to withdraw the correct MRD for that year.
What happens if the account is a Roth IRA and the surviving spouse inherits his or her deceased account? If the surviving spouse is the sole beneficiary of the deceased spouse’s Roth IRA, the surviving spouse must be the only primary beneficiary, and the surviving spouse must have an unlimited right to take withdrawals from the account. In this circumstance, it’s almost always beneficial to treat the inherited Roth IRA as the surviving spouse’s own account. Choosing this option means the surviving spouse need not take any MRDs from the Roth IRA as long as he or she lives. Also, the surviving spouse is not required to take a MRD on behalf of the deceased spouse (original account owner) in the year of that person’s death.
To recap the above Roth IRA scenario, treating the inherited Roth IRA as the surviving spouse’s own account allows the surviving spouse to continue to earn tax-free income on the entire account balance for as long as he or she wishes. A very good deal for building or maintaining wealth!
Craig C. Le Bouef, CPA/PFS, CFP, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
Bond Basics
Bonds are debt securities. That is, they are simply an IOU to the buyer of the bond. The initial purchaser of a bond has lent money to the issuer, which may be a government, and agency of a government, or a public or private corporation. A bond is an issuer’s promise to pay a specified rate of interest periodically, most commonly every six months. Usually, the rate of interest is called the coupon rate. In addition to paying interest, the issuer also promises to repay the principal, or face value, of a bond at a specific future date (called maturity).
There is a fundamental difference between bond investments and the more familiar dollar-denominated holdings in accounts with banks, money market funds, savings and loans associations, credit unions, and similar institutions. The issuer of the bond is under no obligation to the holder beyond paying interest and principal when due and fulfilling obligations under the bond indenture. This difference matters because it means the bondholder who wants his money prior to maturity will have to sell the bond for whatever it will fetch, which may be less or more than its face value. In addition, there is no insurance on bond investments with the exception of certain municipal bonds. Based on these considerations, there are various risk factors that must be considered when purchasing bonds.
The risk factors are credit risk, market risk, and currency risk. U.S. Treasury bills, notes, and bonds do not carry credit risk because the government can simply print more money to meet its obligations.
Credit Risk
Credit risk is simply the possibility the issuer of an IOU will be unable to pay the principal and interest due the bondholder. There are rating agencies that assign ratings to bonds when they are issued and monitor developments during the bond’s lifetime. Rating agencies include Moody’s Investors Service, Standard & Poors Corporation, and Fitch. Each agency assigns its ratings based on in-depth analysis of the issuers’ financial condition and management. The highest ratings are AAA (S&P and Fitch) and Aaa (Moody’s). Bonds rated BBB or higher are considered investment-grade, and securities with ratings in the BB category and below are considered “high yield” or “junk” bonds. In general, the higher interest rates are associated with lower ratings and a warning of higher risk.
Market Risk
From the time bond is issued on through the day it matures, its price will fluctuate in the marketplace according to changes in market conditions or credit quality. There is constant fluctuation in price of each bond and of the entire bond market with every change in the level of interest rates. When interest rates rise, prices of outstanding bonds fall, bringing the yield of older bonds into line with higher new issues. When interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues.
Currency Risk
Currency risk is the possibility that the purchasing power of the currency may decrease more rapidly than expected. Short-term interest rates reflect credit demand and supply, which is largely determined by the open-market operations of the Federal Reserve. The Fed has little direct influence on long-term interest rates, which are said to include an “inflation premium” that fluctuates with inflationary expectations. That premium is the amount that lenders require to compensate holders for the decrease in the purchasing power of the currency expected over the life of the loan.
Based on the above, give the fact that bond prices fluctuate involves the possibility of gains as well as losses. If interest rates decrease, bond prices increase. If credit standard ease, low-grade bond prices will increase. If price inflation is less than was expected when the bond was originally issued, the real returns to bondholders would increase.
The bond market overshadows the stock market in terms of dollar values traded daily. Large and very sophisticated investors dominate this trading. Investors should consider that there is no guarantee the “big boys” will always prove to be correct in forecasting economic trends. Many of these sophisticated investors, during the 1980s, assumed that high interest rates of price inflation were going to continue. Similarly, many investors received high returns on “junk bond” during the boom times of the 1980s and 1990s.
At present, the Federal Reserve is creating dollars and interest rates are at four- and five- decade lows. Many feel the next major move in interest rates will almost certainly be an increase. Such a development could come as a big surprise to recent entrants to the bond market.
Craig C. Le Bouef, CPA/PFS, CFP, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
As you may recall, the MRD rules apply to account owners age 70 ½ or older and those who will attain age 70 ½ during 2002. If you are the account owner of a traditional IRA, a simplified employee pension (SEP), or other type of tax-deferred retirement account, the MRD rules say he or she generally must take mandatory distributions each year. When you do take the distribution(s) that means paying income taxes. If the account owner fails to take the MRD amount, the IRS can assess a 50% penalty of the shortfall. Account owners can always draw out more than the MRD amount; however, doing that speeds up the end to the account, or it brings the account’s tax-deferral advantages to a premature end.
MRD Basics
IRA account owners are required to begin taking MRDs by April 1 of the year after the original IRA owner turns 70 ½. Alternatively, the initial MRD may be withdrawn during the year the account owner reaches age 70 ½. After the initial MRD is taken, the IRA owner must take a distribution by December 31 of that year. Therefore, if an account owner doesn’t take the initial MRD during the year her or she turns age 70 ½; he or she must take MRDs, resulting in a double tax hit.
Example: Ray turns 70 ½ in 2002. He chooses to delay his initial MRD until 2002. Therefore, he must take two MRDs next year because the deadline for his initial MRD is April 1, 2003, and the deadline for his second MRD is December 31, 2002. The potential problem is that taking two MRDs in 2003 could push Ray into a higher tax bracket, especially if he has lots of money in his IRAs. In addition, Ray could be adversely affected by one or more of the AGI phase-out rules. For example, he could find more of his Social Security benefits get taxed.
The amount of each year’s MRD is dependent on the account balance at the end of the previous year divided by a joint life expectancy divisor. The younger the account owner, the bigger the joint life expectancy divisor. As a consequence, the bigger the divisor, the lower the MRD amount. If you want to maximize your IRA’s deferrals, a low MRD amount is what you want.
Example: Mary turns 70 ½ this year. She will still be age 70 at December 31, 2002. Assume she wants to take her initial MRD in 2002 for the reasons explained in the preceding example. If her account balance was $250,000 on December 31, 2002, then she should divide that amount by 27.4 (the joint life expectancy for a 70-year-old person from the IRS tables). Her MRD for this year would be $9,124 ($250,000 / 27.4). The $9,124 should be taken by December 31, 2002. In 2003, Mary must take her second MRD by December 31, 2003. That amount will equal her December 31, 2002 account balance divided by the joint life expectancy factor based on her age at the end of 2003.
The new rules allow an exception to the “automatic 10 years younger beneficiary rule.” In a situation when the account owner’s spouse is designated as the sole IRA beneficiary and he or she is actually more than 10 years younger, MRDs can be calculated using the longer joint life expectancy divisors based on the actual ages of the account owner and spouse.
Example: Bob has designated his wife as his sole IRA beneficiary. He will be 73 as of December 31, 2002 and his wife will be age 68. Bob’s IRA balance as of December 31, 2002 was $350,000. His 2002 MRD is $14,170 ($350,000 / 24.7). Bob must withdraw at least that amount by December 31, 2002 to avoid the 50% penalty for failure to comply with the MRD rules. Next year, Bob must take another MRD by December 31, 2003. The MRD amount will be based on his December 31, 2002 IRA balance divided by the joint life expectancy figure based on his age at the end of next year.
The only scenario that the identity and age of the account beneficiary matter for the original account owner in calculating MRD is when the account owner’s spouse is the sole beneficiary and he or she is more than 10 years younger than the account owner.
Example: The same facts as in the preceding example, except that Bob’s wife will be 40 on December 31, 2002. Bob’s account balance as of December 31, 2002 was $350,000. Bob’s 2002 MRD equals $350,000 divided by the joint life expectancy divisor of 43.9, from the table found in the new regulations. The divisor is based on Bob’s age as of December 31, 2002 (73) and his spouse’s age as of December 31, 2002 (40). Therefore, the MRS for 2002 is $7,973 ($350,000 / 43.9). Bob must take that amount out by December 31, 2002.
There are also certain rules to follow when a person has multiple IRAs. If an individual has several IRAs, the for MRD calculation purposes, the account balances must be aggregated (combined). However, the account owner need not take MRDs from each account. Alternatively, he or she can choose to take the entire MRD amount from one account, or from selected accounts, while leaving other accounts untouched. If the account owner’s spouse also owns one or more IRAs, the spouse makes separate MRD calculations for his or her IRAs. Remember to include SEP and SIMPLE IRA balances when aggregating IRA balances for MRD calculation purposes.
Craig C. Le Bouef, CPA/PFS, CFP, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
Wall Street has taken a pounding over the last few weeks, then it had a 400+point gain in one day. The pounding has taken place because of financial scandals, boardroom fraud, missed earnings estimates, and investors’ fears. The President and Congress state they are appalled at what they say is the betrayal of the public by Corporate CEOs, accounting firms, banking firms, and brokerage firms.
However, is the federal government the most qualified of all entities to lecture others on the virtues of full disclosure. If there were to be genuine financial and accounting reform, one would think it should start in Congress, which for decades has dedicated itself to hiding actual liabilities from taxpayers and voters. A good place to start would be honest accounting with respect to Social Security (which is not reported in the Federal Budget).
Markets are not affected by influential attempts of investors on its soundness or future movements. Given the recent downward trend of the market, most investors are concerned about how long and how deep the current bear market might be.
Does Wall Street Know?
Wall Street technical analysts use any number of measures to forecast the bottom of bear markets: advance-decline lines, volume ratios, dips, double dips, etc. The problem is, these data reflect short-term trading behavior and do not demarcate turning points in important trends.
In past bear markets, the market bottom is usually when even the most ardent stock promoters finally begin to throw in the towel that the end of the bear market in near. Generally, when despair reigns dominant on Wall Street and in the financial pages of magazines and papers does the downturn begin to up-tick. However, the question remains as to how long the downturn may persist.
Pricing Matters
Aggressive traders in search of short-term opportunities trade on an hourly, daily, or weekly basis. Therefore, sharp rallies do occur during bear markets. However, it is hard for almost anyone to know until after the fact whether they have picked the beginning of a bull market or not.
Prices provide the only means for determining the relation of an asset class’s valuation to prior market tops and bottoms. Even though this is backward looking information, it may be most useful to investors. The market value of equities as multiples of dividends, earnings, and cash flow suggest in basic financial terms whether stocks may or not be high-priced or low-priced relative to the market. The problem is they provide no information about potential swings in equity prices.
Statistical measures used with prices may be more applicable. Most time series eventually regress to the mean in statistics. Therefore, what may matter is not how far stock prices have dropped from their top, but the extent to which they have deviated from the average during previous market cycles. That information provides how badly earlier investors missed their mark in judging the market in previous bear market situations. Unless one believes that somehow today’s beginner investors are better judges of the market’s performance potential than were earlier generations, then you might think such information remains useful. The information merely suggests what might happen – really no one knows.
Previous Trends
The American Institute for Economic Research plotted a chart of the S&P 500 stock prices in current and constant dollars on an arithmetic scale for the period since 1970. When equities were really out of favor in December 1974, the constant-dollar S&P 500 Index was 38% below the arithmetic trend line for the period 1945-present, and half of its trend line for the period 1945-1995. Also, consider the July 1982 market bottom when the S&P 500 Index level was less than half the trend line of 1945-1995 and only a little more than a third of the trend line 1945-present. If the market repeated that performance today, the S&P 500 Index would reach an implied bottom of between 350 and 400, the index stood at 917 in July 2002.
When will we Reach Bottom?
One characteristic, thus far, of this bear market has been investor faith in the long-term potential of equities. Part of this is due to investing in retirement plans via IRAs, 401(k) plans, 403(b) plans, Keogh plans, and the like. Many participants in these “passive” plans have their contributions automatically withheld and are somewhat reluctant to make frequent or significant changes. The result has been the money keeps on coming in.
In current dollar terms, the stock market is approaching the longest bear market in recent history, but stock prices still remain historically high. This market valuation could imply that the bear market has longer to go. If stock prices continue their downward trend at the rate of the past two years, presumably they could reach trend level in 12 to 24 months and hit bottom sometime after that.
Just because stock prices eventually will reach bottom does not imply where they are headed afterward. Remember, it took decades for the stock market to recover fully from the crash of 1929.
Craig C. Le Bouef, CPA/PFS, CFP, Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
Medicaid plays a substantial role in financing long-term care. The Medicaid program pays for an average of 45 percent of all care provided in custodial nursing care and home health services (U.S. Department of Health and Human Services, Social Security Administration). In 1997, Medicaid payments for nursing facility and home health care totaled roughly $43 billion for the 3.4 million recipients of these services (U.S. Department of Health and Human Services, Social Security Administration). Not surprisingly, long-term care spending now plays an ever-increasing larger role in total Medicaid spending.
Lobbyists, sales people, and some financial planners for the elderly have long emphasized that the potential costs of long-term nursing or custodial care constitute the single largest potential financial risk for most retirees of average means. Obviously, the potential cost should be considered by most because a year’s stay in a nursing home now averages $40,000 nationwide (the cost varies state by state). Records indicate that the savings of over two-thirds of current nursing home residents are totally depleted within 24 months of their admission. Elderly advocates have publicized such data and aggressively promoted Medicare coverage for long-term custodial care. Understandably many retirees are worried that nursing home costs could quickly wipe them out, and prevent them from passing on their estate to the children. In fact, as discussed in prior articles, studies done by the U.S. Department of Health and Human Services, Vital and Health Statistics, show that a relatively small proportion of the elderly face lengthy confinement in a nursing home.
The liberalization of Medicaid eligibility had been somewhat reversed in the last few years. The 1993 Amendments to the Medicaid Law require states to increase the “look-back” for transfer of assets to 3 years for transfers to individuals and to 5 years for transfers to certain types of trusts. One issue that people should consider is that a significant proportion of nursing home residents recover from the conditions that led to their confinement and go home again. If these people have intentionally impoverished themselves in order to be eligible for Medicaid, they may find that they are unable to support themselves or are at the mercy of the beneficiaries of their transferred wealth.
Comprehensive Medicaid Coverage
Medicaid coverage for medical services varies considerably from state to state within the range of Federal Medicaid standards. All states are required to provide “core” coverage for a variety of services, including: inpatient and outpatient hospital services, physicians’ and some dentists’ services, skilled nursing facility services, laboratory and x-ray services, home health care, physical and occupational therapy, and speech pathology and audiology services. From this point of view, the important part is that Medicaid pays for the costs of custodial nursing home care once certain income and asset criteria are met. In addition, all states must pay the transportation costs of Medicaid recipients for travel to and from their health care providers.
In summary, even the “core” coverage provided by Medicaid is substantially greater that that offered to Medicare subscribers, or to most holders of even the most costly Medicare supplemental insurance policies. In most states, Medicaid beneficiaries receive virtually all medical goods and services, even peripheral ones, free of charge.
From a clinical perspective, Medicaid’s chief drawback has been that not all physicians and health care institutions will take Medicaid cases. Especially in the case of nursing home care, the better-rated care facilities may not accept Medicaid patients. The result has been that many impoverished Medicaid recipients have been forced to accept treatment at second-rate “Medicaid clinics” and ended up at “Medicaid mill” nursing homes. In the case of middle-class retirees whose financial plans include the deliberate transfer of assets and “spend downs,” nursing home admission can be made on a private-payment basis and the “cold-shoulder” treatment reserved for destitute Medicaid patients avoided.
The next article will discuss Medicaid eligibility requirements, asset conversion, Medicaid trusts, and public/private Medicaid partnerships.
Craig C. Le Bouef, CPA, CFP, MBA, and Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, 2811 South Union, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
For example, Fortune’s May 15 cover story about Cisco included the following:
·“Of the 33 analysts covering the company, 12 have ‘buys’ and 21 have ‘strong buys’.” ·“A Cisco executive stated, ‘Backlog is as good as we’ve ever seen it.’” ·“The deepest management team in the valley.” ·“Making a science of acquisitions is just one of the best practices that makes Cisco a star.” ·“A legendary grasp of its numbers…it can guide analysts down to the last penny as to what it will report for the quarter.” ·“A venture capitalist’s assessment of Cisco CEO Chambers: ‘the most customer-focused human being you will ever meet. He is relentless.’” ·“General Electric CEO Jack Welch: ‘We’ve had teams from all different parts of GE go study Cisco, and our people are really impressed.’”
In early 2000, investors and managers should have looked at the various analyses furnished by research companies (Standard & Poors for example is one) and seen these figures: price of Cisco about 130 times current earnings, which is 10 times the multiple of some Dow Jones companies. At such a lofty multiple, Cisco’s ‘earnings yield’ is less than 0.8%. The company has never paid a dividend. A price to earnings ratio of 130 is usually only applicable to a ‘start up’ company that is beginning to become profitable or to a well-established company whose earnings are temporarily depressed.
If one assumed Cisco would grow over the next 25 years to equal a 9.3% (growth plus income) return as on a slower-moving Dow Jones stock and Cisco would maintain its profit margin, the projection for its sales and earnings to grow together over the next 15 years would have to be $618 billion revenues and $128 billion earnings and over the next 25 years would have to be $1,441 billion revenues and $304.0 billion earnings. An investor would likely come to the conclusion that this may happen, but would probably not be likely. Because, if the U.S. nominal gross domestic product (GDP) grows by 6%, then $1.4 trillion in sales would be nearly 4% of GDP in 2025, which is a lot of internet routers. Also, if the company reached that level of revenues, its profit margins would be likely to wear down in the face of increased competition as its markets matured. Therefore, even higher revenue growth would be needed to reach the projected level of earnings.
Most investors should not be averse to holding large-cap growth stocks, nor Cisco systems. In fact, there are many merits of holding large-cap growth stocks as a component of an appropriately allocated and well-diversified portfolio. Cisco is included in many good growth mutual funds, and in a Large Cap Growth Index fund, it comprises only 2.36% of the fund’s net asset value.
The point is that investors must be extremely disciplined in order to avoid getting caught up in the hype that is so successful as selling magazines and investment “advice.” Perhaps it is human nature to chase short-term phenomenon. I hope this article serves as a reminder to “stay the course.”
Craig C. Le Bouef, CPA, CFP, MBA, and Shareholder of Going, Sebastien, Fisher, & Le Bouef, APAC and Registered Investment Advisors, Opelousas, LA. Website: www.goingcpa.com E-mail: craig@goingcpa.com
President Obama recently said that he wants a tax reform/deficit reduction package by August and lawmakers have many proposals to consider. The President has introduced a $3.77 trillion budget for fiscal year (FY) 2014 with a host of tax reform proposals, the House and Senate Budget Committees have approved competing deficit reduction and tax reform blueprints, other committees are exploring ideas for tax reform, and private groups, most notably authors of the Simpson-Bowles Plan, are also making proposals. Whatever proposals are adopted, the outcome is sure to impact your tax strategy and planning.
President Obama recently said that he wants a tax reform/deficit reduction package by August and lawmakers have many proposals to consider. The President has introduced a $3.77 trillion budget for fiscal year (FY) 2014 with a host of tax reform proposals, the House and Senate Budget Committees have approved competing deficit reduction and tax reform blueprints, other committees are exploring ideas for tax reform, and private groups, most notably authors of the Simpson-Bowles Plan, are also making proposals. Whatever proposals are adopted, the outcome is sure to impact your tax strategy and planning.
All of the proposals have one common goal: reduce the federal government's approximate $16 trillion federal budget deficit. To reduce the budget deficit, many of the plans propose to cut spending and raise revenues. Lawmakers and the White House also want to replace sequestration (across-the-board spending cuts for many federal agencies) for FY 2014 and beyond. Replacing sequestration will require spending cuts, new revenue or a combination of both. Let's take a look at how some of the tax proposals would affect individuals, businesses and others.
Individuals
The American Taxpayer Relief Act of 2012 (ATRA), signed into law on January 2, 2013, set the individual tax rates at 10, 15, 25, 28, 33, 35 and 39.6 percent for 2013 and beyond. The House GOP budget blueprint would consolidate the current seven individual income tax rate brackets into two rates. The lower rate would be 10 percent with the goal of a top rate of 25 percent. The Simpson-Bowles plan also calls for lower rates but does not specify the amounts; however, lower rates would be contingent on eliminating certain tax credits and deductions, possibly some popular ones such as the home mortgage interest deduction. President Obama has not proposed any changes to the current individual income tax rates.
President Obama has, however, proposed a minimum 30 percent tax on individuals with incomes over $1 million (full phase in at $2 million). This was known as the "Buffett Rule" (now called the Fair Share Tax). President Obama would also limit the tax rate at which higher income individuals can reduce their tax liability to a maximum of 28 percent. This limit would apply to all itemized deductions; foreign excluded income; tax-exempt interest; employer sponsored health insurance; retirement contributions; and selected above-the-line deductions. Another proposal would limit contributions and accruals on tax-favored retirement accounts, including IRAs, qualified plans, tax-sheltered annuities, and deferred compensation plans.
The budget blueprint put forward by Senate Democrats makes similar proposals. The Senate plan would impose across-the-board limits on itemized deductions claimed by the top two percent of income earners, by capping the rate at which itemized deductions and other tax preferences reduce tax liability, a percentage of income cap, or a specific dollar cap. The Senate plan also proposes to change, without giving details, unspecified itemized deductions into tax credits.
Not surprisingly, the House plan, written by the GOP, does not include these proposals. Along with consolidating the individual tax rates, the House blueprint would repeal the 3.8 percent net investment income (NII) surtax and the 0.9 percent Additional Medicare Tax, both of which took effect in 2013. The House plan also calls for repealing the alternative minimum tax (AMT). The House plan also calls for tax simplification but does not give details.
Another proposal endorsed by the President but which will be a difficult sale in Congress is to increase the federal estate tax. ATRA "permanently" extended the estate tax at a maximum rate of 35 percent with a $5 million exclusion (indexed for inflation). President Obama wants to raise the maximum rate to 45 percent with a $3.5 million exclusion (not indexed for inflation) after 2017.
Businesses
Reducing the U.S. corporate tax rate is a common goal of many of the tax reform proposals but they take different approaches. President Obama has said he would support lowering the corporate tax rate in exchange for businesses giving up unspecified tax preferences. These could include tax incentives for fossil fuels, the Code Sec. 199 deduction and more. The House blueprint would reduce the top corporate tax rate to 25 percent, paid for by tax savings elsewhere. The Simpson-Bowles plan also calls for a reduction in the corporate tax rate, contingent on businesses relinquishing unspecific tax preferences.
President Obama and the House and Senate budgets also propose a number of incentives to encourage business spending and job creation. These include:
- Enhanced small business expensing (Obama and House but at different amounts);
- Permanent research tax credit (Obama, House and Senate);
- Temporary tax credit for increasing payrolls (Obama); and
- Special incentives for manufacturing in the U.S. (Obama).
Another key difference among the competing proposals: the House budget plan would repeal the Patient Protection and Affordable Care Act, including all of its business tax-related provisions, such as employer-shared responsibility provisions, the medical device excise tax, and more. The Senate approved a non-binding resolution to repeal the medical device tax but is not expected to go along with repeal of the entire Affordable Care Act.
Internet sales tax
In May, the Senate is expected to approve the Marketplace Fairness Act (H.R. 743). The bill gives states the authority to compel online merchants, no matter where they are located, to collect sales tax at the time of a transaction. However, states would be able to compel collection of sales tax only after they have simplified their sales tax laws, such as by adopting the Streamlined Sales and Use Tax Agreement. The bill has the support of President Obama. However, the bill may not pass in the House, where many lawmakers view it as a tax increase.
Discussion drafts
The two Congressional tax writing committees – House Ways and Means and Senate Finance – are engaged in discussions among their members over tax reform. Ways and Means has produced three detailed discussion drafts exploring possible approaches to reforming the taxation of financial products, the taxation of small businesses and moving the U.S. to a territorial system of taxation. Ways and Means Chair Dave Camp, R-Mich., has promised to introduce tax reform legislation this year. Senate Finance has also produced four discussion drafts, less detailed than the House drafts, on simplifying the Tax Code, business taxation and education, and infrastructure, energy and natural resources. Senate Finance Committee Chair Max Baucus, D-Mont., has pledged his commitment to seeing tax reform through before his retirement, which he announced would start at the end of 2014.
Looking ahead
Tax reform coupled with deficit reduction is starting to gain momentum. Whether this will lead to legislation this summer or before year-end is unclear. As long as the key players continue their discussions, there is the chance of tax reform.
Our office will keep you posted of developments. Please contact our office if you have any questions about the tax reform proposals we have reviewed.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.
Did you owe tax on your 2012 tax return? Did you receive a sizeable refund? Or, conversely, did you receive a smaller refund than you expected? If so, take another look at your tax return from this past year. It is quite possible that by making a few changes, you could put more money in your pocket in the short term. And by examining your investments as they are reported on your tax return, you may be able to strategize for the long-term future. Trying to implement this type of plan may seem difficult at first. However, just by looking at your tax return, you can start the critical planning that can lead you to broader goals of financial independence and a comfortable retirement.
Did you owe tax on your 2012 tax return? Did you receive a sizeable refund? Or, conversely, did you receive a smaller refund than you expected? If so, take another look at your tax return from this past year. It is quite possible that by making a few changes, you could put more money in your pocket in the short term. And by examining your investments as they are reported on your tax return, you may be able to strategize for the long-term future. Trying to implement this type of plan may seem difficult at first. However, just by looking at your tax return, you can start the critical planning that can lead you to broader goals of financial independence and a comfortable retirement.
Federal withholding
If you received a large tax refund, it might be time for you to adjust the amount of tax the federal government withholds from your paycheck. Although next year your refund check may not be as large, you will have the advantage of seeing a larger sum deposited directly into your pocket every month. To adjust your withholding, fill out and sign a Form W-4, and submit it to your employer. You would want to do this in cases where your adjustments to income, exemptions, and deductions remain relatively steady from year-to-year, and where the government consistently is required to give you a large refund.
If you do not change your withholding allowances, the government essentially is holding your money for a year without paying any interest on it. You may lose some potential investment opportunity or, at the very least, the ability to increase your monthly discretionary income. On the other hand, many taxpayers prefer to receive the large refund check after tax filing season because it is a no-hassle way to ensure large savings at the end of the year.
Conversely, many taxpayers may want to change their withholding allowances because they owe the government a significant amount of money at the end of the year. Taxpayers who expect to owe at least $1,000 in tax for the 2013 tax year, after subtracting withholding and any refundable credits, and who also expect their 2013 withholding and credits to be significantly less than the projected tax owed for 2013, may need to file estimated taxes. Failure to do so could result in penalties. Alternatively, taxpayers should consider making quarterly estimated tax payments, especially if they anticipate a significant amount of investment gains for the year or other income unrelated to wage compensation.
State withholding
Some people are entirely exempt from state tax, but it is withheld from their paychecks nevertheless. At the end of each year, they may include the amount of their state taxes in their itemized deductions, but then receive a refund which they have to declare as income in the next year. This problem particularly applies to active duty military families, many of whom are posted in states other than their state of residency. Military families can check with their state income tax authority to see if there is an appropriate form that can be completed and filed, which would exempt them from withholding. A higher adjusted gross income (AGI), even if it is subsequently reduced by itemized deductions, can erode other adjustments to income, such as a deduction for student loans, IRA contributions, higher education expenses, and more because of certain AGI caps on these benefits.
Tax rates and adjusted gross income
As you may have heard, Congress allowed the Bush-era tax cuts to expire for higher-income earners. That means joint filers with more than $450,000 of adjusted gross income ($400,000 for single individuals) are now in the 39.6-percent tax bracket. Taxpayers at this level of income or above are also subject to a higher long-term capital gains tax rate: 20 percent, up from 15 percent paid by other taxpayers.
In addition, for tax years beginning in 2013, the 33-percent tax bracket for individual taxpayers ends at $398,350 for married individuals filing joint returns, heads of households, and single individuals. If you were hovering near the bottom of the 35-percent bracket for the 2012 tax year, then you might want to see if you can readjust your income so that you fall within the 33-percent category.
Higher-income taxpayers also have two new taxes to worry about for 2013 and beyond. Joint-filing taxpayers with modified adjusted gross income of $250,000 ($200,000 for single filers) are also subject to the 3.8-percent surtax on net investment income and a .9-percent Additional Medicare Tax. Look at your adjusted gross income for last year. Does it approach these figures? Is it on the edge of the income brackets? Will stock market increases this year put you over the top of those income thresholds? If so, it may be time to find ways to reduce your income for 2013.
Investments
At some point in your efforts over the years to accumulate a savings nest egg, you will need to consider diversification, the process of putting your money in the right kind of investment vehicles to satisfy your personal risk strategy and achieve your goals. Looking at your tax return will help you decide whether the investments you now have are the right ones for you. For example, if you are in a high tax bracket and need to diversify away from common stocks, investing in tax-exempt bonds might help, especially if you have state income taxes to worry about, too.
Reviewing the Schedule D and Form 8949, which cover Capital Gains and Losses from last year's return and from the past three or four years, can be an eye-opener for many. Did you hold stocks long enough to be entitled to the long-term capital gains rate? Did you try to balance short-term gains with short-term losses? Are you bouncing from one investment trend to another without a long-term investment plan that achieves long-term needs? Are your mutual funds "tax smart"? Become familiar with different types of banking institutions and their products. Find out about CDs, money-market funds, government securities, mutual funds, index funds, and sector funds and how they interrelate with the determination of your tax liability each year. You may want to put that knowledge to work in your investment strategy.
Medical costs
Should you be taking advantage of the medical expense deduction? Many people assume that with the 10 percent adjusted gross income floor on medical expenses now imposed for tax years starting in 2013 (7.5 percent for seniors) that it doesn't pay for them to keep track of expenses to test whether they are entitled to itemize. But with the premiums for certain long-term care insurance contracts now counted as a medical expense, some individuals are discovering that along with other health insurance premiums, deductibles and timing of elective treatments, the medical tax deduction may be theirs for the taking.
Retirement planning
Don't forget to protect for eventualities. Are you maximizing the amount that Uncle Sam allows you to save tax-free for retirement? A look at your W-2 for the year, and at the retirement contribution deductions allowed in determining adjusted gross income should tell you a lot. Should your spouse set up his or her own retirement fund, too? Are you over-invested in tax-deferred retirement plans? If so, you may lose a significant amount of your nest egg to tax after retirement.
When you are reviewing last year's tax return, it may help to review some of what you've learned from it. This could foster an important conversation with your tax advisor about how to establish or modify your plan for your financial future. If you would like to review last year's completed tax return with future planning in mind, please feel free to give us a call and set up a time when we can meet and discuss this matter.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.
Questions over the operation of the new 3.8 percent Medicare tax on net investment income (the NII Tax) continue to be placed on the IRS's doorstep as it tries to better explain the operation of the new tax. Proposed "reliance regulations" issued at the end in 2012 (NPRM REG-130507-11) "are insufficient in many respects," tax experts complain, as the IRS struggles to turn its earlier guidance into final rules.
Questions over the operation of the new 3.8 percent Medicare tax on net investment income (the NII Tax) continue to be placed on the IRS's doorstep as it tries to better explain the operation of the new tax. Proposed "reliance regulations" issued at the end in 2012 (NPRM REG-130507-11) "are insufficient in many respects," tax experts complain, as the IRS struggles to turn its earlier guidance into final rules.
A public hearing on the existing regulations, held at IRS headquarters in Washington, D.C., in early April 2013, only confirmed how the application of the NII Tax to certain categories of income—particularly income arising from "passive activities"—is challenging even the experts. Nevertheless, taxpayers are not getting a reprieve from the immediate application of this new tax. The 3.8 percent Medicare surtax on net investment income (NII) became effective January 1, 2013. Current confusion over exactly how the 3.8 percent operates can impact on tax strategies that should be put into motion in 2013. Any misinterpretation can also bear on 2013 estimated tax that may be due to cover any 3.8 percent NII Tax liability.
NII Tax Thresholds
For tax years beginning after December 31, 2012, the NII surtax on individuals equals 3.8 percent of the lesser of: net investment income for the tax year, or the excess, if any, of:
- the individual's modified adjusted gross income (MAGI) for the tax year, over
- the threshold amount.
The threshold amount in turn is equal to:
- $250,000 in the case of a taxpayer making a joint return or a surviving spouse,
- $125,000 in the case of a married taxpayer filing a separate return, and
- $200,000 in any other case.
Trusts and estates are also subject to the NII surtax, to the extent of the lesser of: (i) undistributed net investment income, or (ii) the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins (which, for 2013, is $11,950).
Net Investment Income
The primary confusion over application of the 3.8 percent NII Tax revolves around finding a precise definition of "net investment income" as enacted by Congress. To appreciate the complexity of the task, just look at the applicable Internal Revenue Code provision. Code Sec. 1411(c)(1) defines net investment income as the sum of:
- Category (i) income: Gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in Code Sec. 1411(c)(2);
- Category (ii) income: Other gross income derived from a trade or business described in Code Sec. 1411(c)(2); and
- Category (iii) income: Net gain attributable to the disposition of property, other than property held in a trade or business not described in Code Sec. 1411(c)(2); over
Deductions properly allocable to such gross income or net gain.
A Code Sec. 1411(c)(2) trade or business includes a passive activity under Code Sec. 469 with respect to the taxpayer or trading in financial instruments or commodities.
Comment. Code Sec 1411 effectively creates a new tax and a new tax base, on top of the income tax, alternative minimum tax, self-employment tax and payroll taxes. Nevertheless the Preamble to the proposed regs states that, except as otherwise provided, the income tax rules should apply to Code Sec. 1411 unless good cause otherwise exists. Practitioners have asked the IRS that the final regulations give greater reassurance of this general rule.
Complexity
The IRS has stated that the principal purpose of Code Sec. 1411 is "to impose a tax on unearned income or investments of certain individuals, estates, and trusts." Unfortunately, Code Sec. 1411 is not so direct and simple, with its three categories of income (that is, (i), (ii) and (iii), above), complicating matters, albeit in an effort to close every door to those who try to "game the system."
Application of the 3.8 percent NII Tax to capital gains and dividends from a personal stock portfolio is clear under this rule of thumb. But clarity breaks down when a "trade or business" is thrown into the mix and the concept of "passive activity" is added to it.
If gain or other income is the result of an active business activity, it generally escapes NII Tax. However, when the "active" business is a passive activity (for example, a rental business), it may be deemed to generate income that is subject to the NII Tax. Furthermore, when a passive activity is not merely incidental to a business however otherwise active that business should be, the NII Tax also becomes an issue.
Passive Activity
Any revised or additional rules from the IRS on the application of the NII Tax on passive activities should be made more user friendly to the broad middle range of taxpayers and their advisors, one expert at the hearing recommended. The IRS should err on the side of explaining things clearly and simply, even at the expense of not covering every possible nuance of interpretation.
At the same time, however, other experts are asking for more detail, at least in the way of clarification. For example, the IRS has stated that passive activity for NII Tax purposes should be applied within a narrower scope than the passive activity loss rules under Code 469. Those Code Sec. 469 rules restrict "passive losses" from reducing income that is not "passive income." Experts want the IRS to explain exactly what they mean by a "narrower scope."
Self-Rental Activities/Grouping
The self-rental recharacterization rule under Code Sec. 469 affects taxpayers who rent property to a trade or business in which they materially participate. Concern has been expressed over the possibility of interpreting net investment income under Code Sec. 1411 to include rental income from a self-rental activity grouped with a trade or business activity in which the taxpayer materially participates.
The material participation and trade or business requirements should be tested on the grouped activity as a whole rather than on a component basis, one expert in particular stressed at the hearing. If that test is passed, he argued, the trade or business income and rental income from the grouped activity should be excluded from the reach of the NII Tax. For example, the owners of self-rental properties should not have that rent considered as separate from their overall business activity and subject to the net investment tax simply because properties are held in a separate LLC to avoid tort liability.
Regrouping deadline
The proposed regulations permit businesses subject to the NII Tax to elect to regroup their activities for passive-loss purposes in 2013 or 2014. This regrouping election allows taxpayers with a fresh start to accommodate the new NII surtax. Without permitting regroupings, taxpayers would be bound by their original grouping decisions, some of which may have been made as many as 20 years ago, only for purpose of Code Sec. 469 passive loss rules and not the NII Tax. Some small business representatives are also concerned that, because of the complexity of the rules, the final regulations should extend the deadline for a regrouping election through 2015.
Application of the net investment income tax is particularly difficult to get a handle on in a variety of situations. Unfortunately, however, at 3.8 percent, it is costly enough not to be ignored.
If you have any questions about how the NII Tax may apply to your business, rental operations, or overall investment strategy, please do not hesitate to call our office.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.
Under the Patient Protection and Affordable Care Act (PPACA), small employers can claim a credit for providing health insurance for employees and their families. Health insurance includes not only basic medical and hospital care, but dental or vision, long-term care, and coverage for specific diseases or illness. Self-funded plans do not qualify; the insurance must be provided through a third party.
Under the Patient Protection and Affordable Care Act (PPACA), small employers can claim a credit for providing health insurance for employees and their families. Health insurance includes not only basic medical and hospital care, but dental or vision, long-term care, and coverage for specific diseases or illness. Self-funded plans do not qualify; the insurance must be provided through a third party.
For 2010-2013, for-profit employers can claim a credit of 35 percent of the employer's nonelective contributions, increasing to 50 percent for 2014 and 2015. Nonprofit employers can claim a credit of 25 percent through 2013, and 35 percent for the two succeeding years. Beginning in 2012, the credit for nonprofit employers is limited to the payroll taxes paid by the employer.
Small employers
Employers can claim the full credit if their full-time equivalent (FTE) employees are 10 or less, and their average annual wages per employee are $25,000 or less. FTEs are determined by figuring total hours of service for all employees and dividing the total by 2,080.
The credit is phased out for employers with 11 to 25 employees or with average wages between $25,000 and $50,000. The credit percentage is reduced 6.67 percent per "excess" employee (over 10) and four percent for each $1,000 of average wages in excess of $25,000.
To determine the amount of the credit, employers must add up the total premiums they paid on behalf of their employees during the year, subject to the state average premium limit. This total is then multiplied by the applicable percentage (25 or 35 percent for 2013, minus any phase-out). The credit is then reduced for FTEs in excess of 10, and for average annual wages (in units of $1,000) over $25,000. The result is the total credit that the employer can claim.
Other requirements
Under current law, employers must pay at least 50 percent of the insurance costs and must pay a uniform percentage for all employees. The credit is reduced if the employer premiums exceed the state's average premium for small group markets.
In its proposed fiscal year 2014 budget, the Obama administration would modify or eliminate some of these requirements. The credit phase-out would apply to employers with 21-50 employees, rather than 11-25. The phase-out rate would also be more gradual. Furthermore, the administration would eliminate the requirement that employers make a uniform contribution for each employee, and would eliminate the limit for state average premiums.
Reports indicate that the small business health insurance credit is being underutilized, with many businesses leaving this tax money on the table without claiming it or arranging their affairs to do so.
If you have any questions about how you might be able to position your business to claim this credit or claim a larger credit, do not hesitate to call this office for an update.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.
A business that manufactures products to be sold, or purchases products for resale, must value its product inventory at the beginning and the end of each tax year to determine the cost of goods sold (COGS) during the year. The business determines its gross profits by deducting COGS from its gross receipts for the year. The business then deducts its other business expenses from gross profits, to determine its net (taxable) income for the year.
A business that manufactures products to be sold, or purchases products for resale, must value its product inventory at the beginning and the end of each tax year to determine the cost of goods sold (COGS) during the year. The business determines its gross profits by deducting COGS from its gross receipts for the year. The business then deducts its other business expenses from gross profits, to determine its net (taxable) income for the year.
Certain expenses are included in COGS. Expenses that are included in COGS cannot be deducted again as a business expense. COGS expenses include:
- The cost of products or raw materials, including freight or shipping charges;
- The cost of storing products the business sells;
- Direct labor costs for workers who produce the products; and
- Factory overhead expenses.
Purchased inventory
If the business purchases its inventory for resale, its inventory costs are the invoice price plus transportation and other necessary expenses, less discounts. Discounts that must be deducted from the costs of purchased inventory include trade discounts, manufacturer's rebates, and cash discounts.
Trade discounts are a reduction in the price of goods that a manufacturer or wholesaler provides to a retailer. It includes a discount that is always allowed, regardless of the time of payment. A manufacturer's rebate is based on the dealer's purchases during the year. A cash discount is a reduction in the invoice price that the seller provides if the dealer pays immediately or within a specified time. The cash discount may reduce COGS, or it may be treated separately as gross income. Certain excise tax reimbursements may reduce the value of ending inventory and therefore reduce COGS.
Methods of accounting
It is usually impractical to associate items of intermingled or fungible inventory with specific invoices and costs. Instead, taxpayers use certain assumptions or methods of accounting to identify the goods on hand and their costs. The traditional assumptions include FIFO (first-in, first-out) and LIFO (last-in, first-out). In some cases, specific identification is used. The courts have approved the average cost method, although the IRS disagrees with its use. The IRS will permit taxpayers to use other inventory cost assumptions, such as the rolling-average method, if they are reasonable for the taxpayer's trade or business and clearly reflect income.
Under the FIFO, the taxpayer is presumed to sell the oldest goods in inventory and to retain the most-recently produced or purchased items. If production (inventory) costs are rising, the use of FIFO reduces COGS and increases the taxpayer's income. Under LIFO, the taxpayer is presumed to sell the most recently obtained goods and to retain the oldest goods in inventory. Assuming that inventory costs are rising, the LIFO method will increase COGS and decrease the taxpayer's income. Under the average cost method, all units purchased during the year are averaged with the cost of beginning inventory, to determine an average cost.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.
As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of May 2013.
As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of May 2013.
May 1
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates April 24-26.
May 3
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates April 27-30.
May 8
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 1-3.
May 10
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 4-7.
Employees who work for tips. Employees who received $20 or more in tips during April must report them to their employer using Form 4070.
May 15
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 8-10.
May 17
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 11-14.
May 22
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 15-17.
May 24
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 18-21.
May 30
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 22-24.
May 31
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 25-28.
June 5
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 29-31.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.