- The Debt Dynamic
- The Year-End Sunsetting of Estate Provisions
- Planning for the 3.8% Medicare Tax
- Investment Spotlight
By: Paul Sutherland, CFP ®
In recent weeks we’ve had a noticeable increase in client questions related to the “macro” environment. Two particular macro issues, the global debt bubble and the policy-maker response to it, seem to be the most common points of concern. This is perfectly understandable given recent policy announcements from the Federal Reserve (more “quantitative easing”), the continued economic stresses in Europe, and the daily onslaught of election season rhetoric here in the U.S. So this month, I’d like to make a few comments on debt and how my world view on debt influences our investing.
The Debt is Still There
We are professional investors. I have been doing this for nearly four decades and have seen the fads about bonds, gold, CDs, annuities, stocks, and paradigms shifting from one extreme to another. For example, I know a financial planner who told me he felt it was “planning malpractice” if a financial planner did not tell his clients to “borrow as much as they can on their home to invest elsewhere.” I wonder how his clients have fared through this recent real estate collapse and if his clients have had to make ethical decisions about whether they should pay their debts and keep their promises to lenders.
When I listen to talk radio, I often hear ads or invited gurus touting the “debt free” financial solution. I can tell you three things about debt from my life experiences:
- Debt must be managed
- Debt can be a useful tool if you have the earnings, earning power or liquid assets to support it
- Debt can be addictive for most people, countries and companies. In many if not most cases the borrowing just funds current consumption (rather than funding investments that generate future returns greater than the cost of borrowing). In other words, we simply bring consumption forward and hope that we’ll have some combination of increased future earnings or increased future asset values, to pay off the debt in the future.
So we borrow, spend, borrow, spend and feel rich. When our fellow citizens join the debt party en masse, we get lulled by illusions of “economic growth” (all those jobs required to build McMansions, $50,000 ski boats, and movie-theatre-sized flat screen TVs) and ever-rising asset prices (think real estate). At some point, of course, the music stops, the assumed pay raises and asset price gains fail to materialize and guess what: the debt is still there!
Resisting a Reset
Of course, a debt-fueled economy benefits more than just the U.S. consumer who can live an “unearned” lifestyle for as long as the music keeps playing. Companies producing goods and services for these consumers rake in excess profits as do banks funding the transactions. And governments make out like bandits by taxing the debt-super-charged consumption (sales tax), earnings (income tax), and asset prices (property tax) as a result. This is why any free market solution to “normalize” the economy is resisted on so many fronts, both here and abroad. Those in a position of power to influence policy would all face immediate, significant negative financial consequences if such a transition was encouraged. Consumers would have to adjust to a world of spending within means, producers selling them goods on credit would see their revenues and earnings fall, bankers would see profits and bonuses vaporized, and governments would see tax revenues disappear. All of this would happen while the debt service bills keep on coming. Who wants that?
Our base case as investors should be that the can-kicking will continue, the policy-making experimentation will become even more unconventional, and those in power who have financially benefitted from such a regime will do all they can to keep it in place. We must try to prepare portfolios for and mitigate the consequences of this base case and put aside any notion that our economy and markets will suddenly be allowed to reset towards any resemblance of free-market capitalism.
Designated Driver Countries…
I consume on average about 4 oz of wine a year – my wife, Amy, consumes none. We don’t have hangovers, our dinner bills are cheap, and while we may not live longer we certainly will feel like we did.
Debt, like alcohol, is ok in moderation if handled responsibly. Many countries have been quite prudent about how they manage their affairs and have shied away from allowing the intoxicating influences of debts to ravage their societies. I would call these countries the “designated driver” countries. Switzerland, Singapore and even some African countries have resisted allowing debt to mess with their wellbeing. In many cases, these countries are the ones with limited natural resources to mine or farm, so the only way of surviving has been to perpetuate a culture of hard work and prudence. These designated driver countries are natural hunting grounds for FIM group investments.
Debt, like alcohol, is ok in moderation if handled responsibly. Many countries have been quite prudent about how they manage their affairs and have shied away from allowing the intoxicating influences of debts to ravage their societies. I would call these countries the “designated driver” countries. Switzerland, Singapore and even some African countries have resisted allowing debt to mess with their well being. In many cases, these countries are the ones with limited natural resources to mine or farm, so the only way of surviving has been to perpetuate a culture of hard work and prudence. These designated driver countries are natural hunting grounds for FIM group investments.
…and Companies Too
As dynamic global investors without “style” or relative benchmarks to constrain us, we have literally tens of thousands of companies in our investment universe to choose from. Some of these are leveraged to the hilt and five minutes from default, while others are so flush with cash that their balance sheet looks more like a cashstuffed mattress than that of an operating company. We have a strong bias against investing in companies that have what we consider to be excess leverage or debt. My life experience has taught me that it is hard to pick the companies that are going to get out of “debtors prison.” If I look at our investment losers over the years it has often been debt’s insidious march that killed the company rather than competition, bad luck with suppliers, market fickleness, or flawed product strategy. Simply put, too much debt can dramatically reduce management flexibility when external conditions change. If these changes are radical enough, the ticking time bomb of debt can be catastrophic.
By favoring companies that are prudently financed, we end up owning firms with greater resilience to changing conditions and therefore better chances to adapt and survive. An additional bonus is that those companies with big stuffed mattresses are well positioned to buy their overleveraged peers should conditions force them to trade at bargain prices. I have seen companies with real assets go for 10 cents on the dollar in debt liquidations. Obviously, buying investments at prices that low gives purchasers a large margin of safety.
As long-term, thoughtful investors, we must acknowledge the entrenched incentives of the powerful in our society. From Wall Street to Washington, there are many people (and institutions) with much to lose as our debt-saturated economy inevitably transitions to one based on more sustainable foundations. This will likely drive continued unconventional fiscal and monetary policies with consequences that are difficult if not impossible to predict. We continue to encourage our clients to be prudent with the use of debt in their own lives, and in our investing we remain highly attuned to debt levels at both the companies and countries in which we invest. The ultimate resolution of the global debt bubble could well take years or even decades. We expect this process will be messy at times, yet we feel strongly that our flexible investment style and ever-vigilant focus on client parameters, investment price and investment quality will guide us through whatever path this transition takes.
By: Kevin Russell, CPA, CFP®, AAMS®, CRPC®
As we approach another election, we are faced with lots of promises and uncertainties regarding Congress’s actions toward the post-2012 expiration of the Bush-era income tax cuts. Affected items include increases to the current tax rate schedules, elimination of low tax rates for long-term capital gains and qualified dividends, and the expiration of favorable estate and gift rules for estates of decedents dying, gifts made or generation-skipping transfers made after December 31, 2012. Absent any congressional action, the major changes to the estate and gift taxes are described below.
One change that could impact a broader range of estates is the rollback of the estate and gift tax exemptions from $5.12 million (the current level) to $1 million per person combined, with the top estate tax rate rising from 35% to 55%. If no changes are enacted, this could cause quite a few estates to become taxable (and at a higher rate) into the future. As a planning point, clients who currently have a potentially taxable estate or are overly concerned that they could be impacted by the changes should consider whether taking advantage of current exemptions (like the $5.2 million estate and gift tax) would complement their overall estate planning goals. The main disadvantage of using all or a portion of your lifetime gift tax exemption is that you give up the access to these assets and thus are not there to provide for yourself over your lifetime.
In addition to higher estate tax rates, trusts will also encounter much higher income tax rates for income that is retained inside the trusts. This includes five tax brackets ranging from 15% to 39.6% that will replace the current six marginal tax brackets ranging from 10% to 35%. Starting in 2013, the Health Care Act also imposes a new Medicare Surtax of 3.8% on investment income (e.g., interest, dividends, capital gains, rental profits) of higher-income individuals and trusts. For trusts, this surtax will potentially come into play when trusts have income retained in the trust starting at roughly $12,000. Therefore, with higher marginal tax brackets and the additional surtax, it is very important that investors determine if their trust income should be retained inside the trust or distributed outright to beneficiaries annually to potentially take advantage of a much lower tax rate.
One of most flexible estate planning tools recently enacted was the estate tax portability feature, whereby a spouse can leave his or her unused estate tax exemption amount to the other spouse upon their death. Though these rules took effect in 2011, they are scheduled to lapse at the end of 2012. Without an extension, each spouse will be limited to his or her own estate exemption and any unused portion will be forfeited.
There are many challenges ahead for more advanced estate planning strategies, such as limiting the minimum term on Grantor Retained Annuity Trusts (GRATs) to 10 years, eliminating the Zeroed out GRAT options, and setting maximum lengths of Generation-Skipping Transfer Trusts to 90 years, thereby reducing the value of these Dynasty Trusts. All of these changes effectively reduce the power of multi-generational wealth transfer techniques.
I recently attended an estate and tax-planning conference. The consensus from the experts was that both political camps are looking to lock in the estate tax exemption somewhere in the $3.5 million to $5 million per individual range, with the estate tax portability extended into the future and highest estate tax rate locking in at the 45%-55% rate. There is also a good probability that gift and estate exemptions might decouple with the estate exemption being locked in at a higher rate and the lifetime gift tax exclusion being set much lower. These changes might not be known for some time. In the meantime, if you would like to discuss estate planning or how these changes might potentially affect you, please contact one of FIM Group’s Certified Financial Planners in our Michigan, Wisconsin or Hawaii offices.
By: Jeff Lokken, CFP®, ChFC®
The health care reform package (the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010) imposes a new 3.8% Medicare contribution tax on the investment income of higher-income individuals. Although the tax does not take effect until 2013, it is not too soon to examine methods to lessen the impact of the tax.
Net investment income. Net investment income, for purposes of the new 3.8% Medicare tax, includes interest, dividends, annuities, royalties, rents and other gross income attributable to a passive activity. Gains from the sale of property that is not used in an active business and income from the investment of working capital are treated as investment income as well. However, the tax does not apply to nontaxable income, such as tax-exempt interest or veterans' benefits. Further, an individual's capital gains income will be subject to the tax. This includes gain from the sale of a principal residence, unless the gain is excluded from income under Code Sec. 121, and gain from the sale of a vacation home. However, contemplated sales made before 2013 would avoid the tax.
The tax applies to estates and trusts, on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute.
Deductions. Net investment income for purposes of the new 3.8% tax is gross income or net gain, reduced by deductions that are "properly allocable" to the income or gain. This is a key term that the Treasury Department expects to address in guidance, and which we will update you on developments. For passively managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.
For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property's basis. It also puts the focus on investment expenses that may reduce net gains: interest on loans to purchase investments, investment counsel and advice, and fees to collect income. Other costs, such as brokers' fees, may increase basis or reduce the amount realized from an investment. As such, you may want to consider avoiding installment sales with net capital gains (and interest) running past 2012.
Thresholds and impact. The tax applies to the lesser of net investment income or modified AGI above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married filing separately. MAGI is AGI increased by foreign-earned income otherwise excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not work overseas.
Example. Jim, a single individual, has modified AGI of $220,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($220,000) over the threshold amount for an individual ($200,000), or $20,000. The tax is 3.8% of $20,000, or $760. In this case, the tax is not applied to the entire $40,000 of investment income.
The tax can have a substantial impact if you have income above the specified thresholds. Also, don't forget that, in addition to the tax on investment income, you may also face other tax increases proposed by the Obama administration that could take effect in 2013. The top two marginal income tax rates on individuals would rise from 33% and 35% to 36% and 39.6%, respectively. The maximum tax rate on long-term capital gains would increase from 15% to 20%. Moreover, dividends, which are currently capped at the 15% long-term capital gain rate, would be taxed as ordinary income. Thus, the cumulative rate on capital gains would increase to 23.8% in 2013, and the rate on dividends would jump to as much as 43.4%. Moreover, the thresholds are not indexed for inflation, so a greater number of taxpayers may be affected as time elapses. Congress may step in and change these rate increases, but the possibility of rates going up for upper income taxpayers is sufficiently real that tax planning must take them into account.
Exceptions. Certain items and taxpayers are not subject to the 3.8% tax. A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs) and eligible 457 plans. At the present time, however, there is no exception for distributions from nonqualified deferred compensation plans subject to Code Sec. 409A, although some experts claim that not carving out such an exception was a Congressional oversight that should be rectified by an amendment to the law before 2013.
The exception for distributions from retirement plans suggests that potentially taxed investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities and IRAs, or to 409B Roth accounts. Increasing contributions will reduce income and may help you stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, if they have not yet established a plan, and should consider increasing their contributions to existing plans.
Another exception covers income ordinarily derived from a trade or business that is not a passive activity under Code Sec. 469, such as a sole proprietorship. Investment income from an active trade or business is also excluded. However, SECA (Self-Employment Contributions Act) tax will still apply to proprietors and partners. Income from trading in financial instruments and commodities is also subject to the tax. The tax does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity's property would be from an active trade or business. The tax also does not apply to business entities (such as corporations and limited liability companies), nonresident aliens (NRAs), charitable trusts that are tax-exempt, and charitable remainder trusts that are nontaxable under Code Sec. 664.
Please contact one our Certified Financial Planners at one of our offices if you would like to discuss the tax consequences to your investments of the new 3.8% Medicare tax on investment income.
There is no Spotlight for this issue.