Child Tax Credits, IRAs and 1099s

by Bruce Fenton

Originally published in The Fenton Report on March 29, 2004

In 2003, the federal government treated nearly 24 million families to a tax credit check. The U.S. Treasury mailed checks to many people who claimed the Child Tax Credit last year as an advance payment for the credit’s increase (tax law changes in 2003 increased the credit from $600 to $1,000 for qualifying families). The IRS used 2002 returns to determine qualified households. Qualifying children must have been born after 1986 in order to be eligible for the advanced payment.

However, to ensure that you do not believe in free lunches, the IRS is reminding taxpayers who plan to claim the credit on their 2003 federal income tax returns that they cannot claim the full $1,000 per child if they received an advance payment last year. Rather, the $400 advance must be subtracted from the credit amount computed for this year.

In the category of other news you can use from our tax authorities, the IRS recently issued new, relaxed guidelines for requesting a waiver of the 60-day deadline for IRA rollovers.

IRA owners may take a distribution from their IRA one time each calendar year without penalty or tax—as long as they get it back into the account within 60 days. Unlike Cinderella, whose coach turns into a pumpkin at midnight, your coach will be hit with tax and possibly a penalty if you are under age 59 ½ when you make this withdrawal and you don’t hit the deadline.

As we all know, sometimes even the best of intentions don’t allow us to make deadlines. For example, if you sent a check to a financial institution and they failed to get the money into your account in a timely manner, it’s too bad for you!

The new kinder, gentler IRS guidelines allow the IRS to consider “all relevant facts and circumstances,” such as whether financial institutions were late getting your check applied to the account, whether health reasons precluded you from acting in a timely manner, or whether “the dog ate the mail” and your payment disappeared. In any case, where there was once an “iron-clad” rule about being late, the IRS is now willing to consider good excuses.

While we are on the subject of IRAs, let’s review the rules for Roth IRA contributions. A Roth IRA accepts deposits of after-tax money that then may grow without taxation of dividends, interest or capital gains inside the account. When the money is paid out, it comes out tax-free, unlike normal IRA distributions, which are taxable.

An individual can contribute $3,000 to a Roth in 2004. This limit goes up to $4,000 for 2005-07 and $5,000 in ’08. The maximum contribution limits are phased out for individuals with adjusted gross incomes between $95,000 and $110,000 and for married couples filing a joint return with AGI between $150,000 and $160,000.

Finally, I have noticed a number of revised brokerage 1099 statements being sent out. A primary reason for revised statements is the reclassification of certain mutual fund dividends from non-qualified to qualified. Qualified dividends are taxed at the lower 15% rate, while ordinary dividends are taxed as ordinary income. The bad news is that you may have to file an amended tax return to properly account for the changes. The good news is that in most cases, this should result in lower taxes.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Moving Out

Property rich and portfolio poor is not a totally inaccurate way to describe the retirement plans of today’s baby boomers. The stock market bubble that burst several years ago, taking with it hopes of millionaire lifestyles in soon to be achieved retirement, has altered many retirement plans. But, thanks to changes in tax laws and our inherent wander lust, that is not all bad.

Billy Joel wrote a smash hit “Moving Out” in 1977 that is now a popular musical touring the country. The title could also be used to reflect the changes that have occurred in retirement planning as a result of stocks down, real estate up.

According to an article in Kiplinger’s, 60% of boomers ages 44 through 56 plan to move to a new home in retirement. That’s up from just 31% of pre-retirees they interviewed just 5 years ago.

Unlike their parents and grandparents, today’s boomers are not about to kick back in a rocking chair on the porch of the old family homestead where they were born, grew up, raised their family and now expect to pass on the family plot nearby. Boring!

Instead, they are carrying their active lifestyles and innate desires for the new and different into retirement, seeking out communities that offer opportunities to pursue other interests. And, it is beginning to sink in that they will be living almost as long in retirement as they spent working, so it is making sense to look for more suitable digs.

The tax laws that allow married couples to take $500,000 tax-free from a sale of a personal residence have made selling the family home and moving on particularly attractive. For many, they can sell their home, buy a smaller, more manageable retirement home in a more attractive retirement setting, and pocket the gain, tax-free.

Easy access to inexpensive air transportation, cell phones, the internet, instant message, and digital cameras have made it possible to be miles away from family and friends, yet remain closely in touch. And, as my wife has discovered, shopping on the Internet gives her 24-hour a day access to her favorite shopping haunts from the comfort of home. So why would one have to live anywhere near a big mall?

Financially, having a paid for home with some tax-free capital invested makes the diminished retirement savings plan a bit more tolerable. The difference between housing prices in “working areas” such as Silicon Valley in California and many other areas of California, or inside the Beltways of cities like Boston, Washington D.C., and retirement communities in the Sun Belt or areas like Bellingham, Washington, Ashland Ore, Park City, Utah or Naples, Fla., makes this work.

Certain retirement havens have tax laws particularly favorable to retirees. Six states, Alaska, Washington, Nevada, Florida, South Dakota, and Texas have no state income tax. New Hampshire and Tennessee tax only interest and dividends. But, as Kiplinger’s pointed out, income taxes should not be the sole reason for choosing a state.

Kiplinger’s published a Tax Survey of total taxes that a household might be expected to pay in locations around the country. Taking into account property taxes, sales taxes, gasoline taxes and other local taxes, they found that the lack of a state income tax does not guarantee tax-free living. They found the least expensive total tax bills in Cheyenne, WY. And the most expensive tax bills in Bridgeport, Conn. However, states like Colorado, despite a moderate income tax, were relatively inexpensive with lower property, sales and gasoline taxes.

The Internet has made shopping for a possible retirement location and home much easier. A quick search will yield a vast number of websites that can provide valuable insights into communities, retirement lifestyles, and real estate availability for those interested in “Moving Out”.

Reagan Tax Cuts

by Bruce Fenton

Opponents to of tax cuts cite numerous reasons why tax cuts won’t work. Too much, benefits the rich over the poor, will lead to deficit spending, will waste the surplus… all concerns expressed by the doubters. However, they are ignoring history.

Somehow they forgot the legacy of the Reagan presidency. So, on the anniversary of his 95th birthday, it seems fitting to comment on his legacy and vision.

Described by economist Art Laffer as the last “real President,” Reagan brought to the office a strong, singular focus to build a better country and to shut down world communism. Without a doubt, he did both.

Upon assuming office, he immediately embraced the supply side economic policies advanced by his economic advisor, Laffer. The Laffer Curve theory held that if taxes were cut, the resulting money left in the hands of the people and not the government, would stimulate the economy and the resulting growth would actually generate more tax revenue.

The broad-based income tax cuts that Reagan pushed through did exactly that, setting off an entrepreneurial boom that has propelled the growth of the economy for the past 20 years. Certainly the Clinton Presidency benefited from the tax cuts, and to Clinton’s credit, he even added his own cut by reducing the capital gains tax.

Reagan added to the economic well being of the country by facing down communism, and for all intents, shutting down its socialistic economic system around the world. This has opened up vast parts of the world as a marketplace for our goods and services. Today, one form or another of capitalism propels the economic environment of the world.

Reagan’s detractors, and to be sure there are many, point to his lack of sensitivity for social issues and the legacy of his deficit spending on defense and the infrastructure throughout the land.

In the case of the latter, we can draw a corollary by comparing his spending with what all of us do with our homes. We buy homes, and when home values and/or our income goes up, we remodel. By remodeling, we add value to our homes and increase the livability, or quality of life that comes with having a nicer home. The money for this remodeling usually comes from refinancing… adding to our family debt with additional long-term mortgage borrowing.

But, we do so with the mindset that we will have the income in future years to pay off this debt. Reagan envisioned leaving money in the hands of the people rather than the government, where it could be put to more productive uses than government spending would provide. He was right—our economy grew, and government income increased, eventually providing cash flow capability to pay for the “remodeling” that his Presidency did over his eight years in office.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Gifting

by Bruce Fenton

The Ultimate Gift by Jim Stovall is not a thick book … and its chapters are short … but it’s very much to the point. It is the story of a rich uncle who leaves a portion of his considerable fortune to a less than over achieving family, while leaving the Ultimate Gift to a spoiled, overindulged grand nephew in whom he places all of his hopes for the future.

Charitable activities are a natural outgrowth of civilization and affluence. Certainly, in our country we see stunning examples of charitable works, whether it is the outpouring of aid to disaster stricken areas, home or abroad, or the incredible amount of wealth donated by the likes of Microsoft® founder Bill Gates and many others like him.

The Gates Foundation, with assets approaching $30 billion, lists one of its main goals as improving health care in developing nations throughout the world. Matching that level of philanthropy is out of the question for most, yet there remain many avenues for charitable works for the rest of us.

The government has provided tax incentives to encourage charitable works. They understand that it is more efficient to allow private enterprise to provide for these needs, than rely on inefficient government resources to provide the similar services.

And that is why the tax laws are structured to support charitable giving … in lieu of profits for invested dollars, those willing to give are rewarded with tax breaks.

Choosing benefactor(s) for organized annual gifting can be difficult, if not downright confusing. A solution is to form a donor-advised fund through a public charity. Many local community organizations as well as a number of mutual funds offer donor-advised funds.

Charitable contributions are considered an irrevocable gift, but the donor may choose to whom and when gifts are made. This flexibility allows the donor the opportunity to give differing amounts each year without having to stipulate the exact recipient. It greatly simplifies record keeping … instead of keeping a drawer full of receipts and cancelled checks for your tax preparer, you have one receipt. This allows the donor the opportunity to give to many different charities, but not have to track each gift.

Technically, the fund is not required to follow donor directions for distributions, although this is rarely the case. In most cases the donor can continue to advise the fund as to investment policies and strategies.

Unlike a private foundation, where 5 percent of the foundation assets must be given away each year, the donor-advised fund is not bound by a strict dispersal formula. Donor-advised funds work well in situations where the donor has fluctuating income but would like to keep dispersal of charitable donations at the same level.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Distribution in Retirement

by Bruce Fenton

Changing from asset accumulation to asset distribution takes a major shift in thought and process for those moving from pre-retirement to the retirement stage of life. The steady, every-week paycheck is now replaced by pension, Social Security and more important, discretionary withdrawal decisions from retirement investment accounts.

The latter, if handled correctly, offers the promise of a relaxed, enjoyable retirement. To get there requires a certain amount of planning.

The first step in the process is to accurately formulate a budget to live by. The process of evaluating how you spend your money is as useful as the end result. Most go through their working years spending what they make without ever really analyzing where the money goes. When examined more closely, it becomes obvious that there are fixed costs … rent or mortgage, food, transportation, insurance, etc. … and variable or discretionary expenses … recreation, eating out, gifts, etc. … over which one can exercise considerable choice.

Many who go through this process are able to cut their spending by significant amounts without materially affecting their lifestyle simply because when there is a paycheck coming every week they are inclined to be more generous spenders.

Part of the budget for retirement has to include potential capital expenses such as major home repairs or an automobile purchase.

Once a prospective budget is put together, subtract fixed payments from Social Security and guaranteed pensions … the difference is the amount you will have to make up from retirement savings.

Retirement savings come in two tax flavors … qualified money, or money coming out of IRAs or defined contribution plan distributions … and non-qualified money coming from retail investment accounts, rental income, or work related. The former is generally taxed at ordinary income tax rates and the latter will be taxed as ordinary income, rental income, dividends or capital gains depending upon the source.

The object of the game is to maximize your after-tax wealth, which implies paying taxes on retirement income at the lowest possible rates.

If you have a choice it is generally better to spend money on which taxes have been paid first, and defer spending from qualified plan accounts as long as possible. Money left in a qualified account, which is allowed to grow and compound without paying taxes benefits from the fact that a larger principal amount is compounding.

For example if you withdrew $10,000 from an IRA, paid the taxes at 28%, and invested the money to grow at 8%, after 15 years you would have a hypothetical $16,678 after taxes. The same $10,000 left in a conventional IRA would accumulate a principal sum, inside the IRA, of $31,722. If the principal sum of either account were invested in taxable bonds paying 6% interest and then distributed as income, the taxable account would generate $1,000.68 and the IRA distribution would generate $1,903.32. Since both amounts are taxed at the same rates, the value of tax deferred compounding is clear.

In general, spend first from sums on which taxes have been paid … these might include inheritances, or tax free sales proceeds from a home sale. If in a higher tax bracket, invest for income in tax-free municipal bonds. For other taxable distributions look for qualified dividends and capital gains transactions, both taxed at a Federal maximum of 15%.

Hold risky assets that could potentially produce a capital loss inside a taxable investment account. The losses can be used to offset other capital gains. This is not the case inside an IRA.

In IRA and other qualified accounts, invest in bonds paying ordinary interest. As long as the interest income earned stays inside the qualified accounts, you will pay no taxes.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Dynasty Trusts

Sooner or later it dawns on us that taking our wealth with us when we check out is not an option. Leaving it to Junior who, with various body piercings, tattoos, and questionable friends, is interested in spending, not managing, the wealth, is also not an option. The English, about the time of Robin Hood, came up with a solution they called “uses”—we know this principal of law as “trusts.”

A trust is a legal entity that can own, manage, and dispose of property, according to applicable laws and the language of the trust document. A “trustor or grantor” who places property into the trusts by changing the ownership into the name of the trust creates a trust. A “trustee” manages the trusts, while a “beneficiary” receives the benefits.

In modern context, trusts are used to manage wealth for purposes of reducing estate, or gift taxes, caring for beneficiaries not capable of managing their affairs, and providing for the health and educational needs of future generations.

In feudal England, kings taxed the transfer of property from a nobleman to his descendants. To avoid these taxes, the good lords came up with the concept of “uses,” the trusts of the times, which gave rights of usage to descendants, but not ownership. This maintained a perpetual ownership, depriving current and future kings of taxes.

Kings reacted to these trusts as you might expect, by outlawing perpetual ownership. In 1681, the Law of Perpetuities was actually codified by Lord Nottingham, who held that a trust could exist only for the lifetime of the beneficiary, living at the time the trust was created. Later, the law was modified so that the trust could extend for 21 years after the death of a person alive at the time the trust was created. This remains the modern version of our current trust law, and the rule against perpetuities.

Lord Nottingham’s ruling, besides ensuring a flow of tax revenue for the King, was well grounded in social issues. If property was held forever in trust, there could be no market for the property. There could be no opportunity for entrepreneurial development. Wealth would remain in the hands of a few, leaving the poor without opportunity to better themselves.

Trust laws in the U.S. did not allow for these dynasty trusts until 1983 when South Dakota changed their laws to allow for the creation of dynasty trusts. Today, these trusts are now legal in 13 states: Alaska, Arizona, Delaware, Idaho, Illinois, Maine, Maryland, New Jersey, Ohio, Rhode Island, South Dakota, Virginia, and Wisconsin.

Not all dynasty trusts are created equal. Some states, such as Delaware, Alaska, South Dakota, and Illinois do not tax the income of trusts brought in from out of state, while they do tax residents. Alaska has a very aggressive statute that allows the grantor (person placing the property into the trust) to receive income from the trust while at the same time allowing the assets within the trust to grow outside of his estate. This places the assets outside the grasp of creditors and some potential future estate taxation.

Just when you thought we got rid of kings centuries ago, think again. In 1986 Congress created the Generation Skipping Transfer Tax (GSTT) which taxed a trust at the maximum estate tax rate, 55%, each time the last members of a generation drawing benefits from a trust died. Congress did allow for an exemption of $1.06 million that could be used at the time the trust is set up. This allowed a couple to put just over $2 million in the trust and have the trust avoid paying the GSTT, no matter how many generations in the future draw from it.

Such dynasty trusts, properly funded and managed, could allow a family’s wealth to benefit many, many generations, effectively allowing the creator the opportunity to control from the grave.

Life Insurance and Spousal Trusts

by Bruce Fenton

Don’t throw away your life insurance trust and its expensive life insurance policy just because the estate tax is going away. Like a bad dream, in ten years it could be back.

The much ballyhooed estate tax reform and potential repeal is just that… potential. Congress made the tax law change subject to reversion to the existing law by 2011 unless modified by a future legislative act. And, the chances of this tax being eliminated, in my opinion, are very slight.

Our booming economy has deposited trillions of dollars of wealth in the hands of the Bob Hope generation. That generation came back from the world’s greatest war and set about building this country and this economy… and quite successfully. Now they are about to join the Henry Ford generation in demographer’s heaven, leaving a legacy of success and wealth to be managed by the next generation, our Baby Boomers.

There is a problem with this scenario. This successor generation is the largest single generation this country has ever known. When they pass into retirement in ten to fifteen years, they leave behind their productivity, their knowledge, and their leadership as they begin drawing upon a social security system into which they have paid all these years.

Generation X, coming next, will face the onerous task of paying the taxes required to pay the country’s bills, and, as a smaller generation, with fewer, less productive workers. Now, intuitively you should be able to get the picture: fewer workers, less wage base, more social security payouts, and more taxes.

Congress will have three choices: deficit spend and kill the economy, tax the living or tax the dead. Obviously the dead don’t complain or vote, so their first choice for raising taxes will be to go after estate transfers.

The need to estate plan is as great as ever. The uncertainty of the current laws make it imperative that larger estates take into consideration the prospect of future taxation. It would be a little tough to announce to Dad on Christmas of 2010, that his New Year’s Eve gift to the family is to check out for good since the law is coming back and there is no estate plan.

Life insurance remains one of the most important tools in an estate plan. Life insurance leverages pennies into dollars for the purposes of paying transfer and income taxes that are the byproducts of life’s success. If life insurance is owned outside of the estate of the decedent, it goes to the named beneficiary free of income and estate tax. The most common form of life insurance ownership for estate planning purposes is in an irrevocable life insurance trust.

Typical planning has the trustee of the trust applying for a life insurance policy on the life of the estate owner. The policy is payable at death to the trust. The trustee then uses the proceeds to supply liquidity to the estate for the payment of estate expenses, including taxes.

The problem with this planning is the lack of flexibility in a changing world and tax environment. Assets are usually out of reach of the beneficiaries until the insured dies and the trust collects on the policy. And, to give the spouse access to the life insurance cash value could cause the proceeds to be included in the taxable estate.

One solution is to set up a Spousal Support Trust (also known as a Spousal Access Trust) as the owner of the life insurance. This is the same irrevocable trust. However, by properly structuring and administering the trust, the assets in the trust would be accessible by the spouse and excludable from the estate of the insured, and that of his/her spouse. The non-insured spouse and the children could draw upon the assets of the trust during the lifetime of the insured for living and education expenses.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Economic Efficiency or Economic Justice?

by Bruce Fenton

Consumers are spending and business is beginning to ramp up its investment engines. Anything above a 4% growth rate is exhausting for business—capacity is exhausted, inventories are exhausted, more employees will be needed and old plant and equipment will have to be replaced.

An economic system that combines jobs for all with economic equality is the stuff of fairytales. An economy can be either efficient or just, but not both when taken to extremes.

An efficient economy operates within a free-market economic system that is blind to social justice. The economy cares only about the most efficient way to produce goods and services. It is an amoral system that, in order to be efficient, requires each of us to earn enough income to buy back what we produce.

A system driven by economic justice redistributes wealth through a tax system, giving the rewards of a few to the under-producing many. We tried this before and it didn’t work.
In the 1970s, our economic system worked somewhat the way I just described. Government policies that focused on stimulating aggregate demand had caused an economy that could not produce goods and services fast enough to keep up with demand; prices skyrocketed, interest rates were out of sight and productivity was low. Dividends were taxed at 70%, and the top earned income tax bracket stood at 50%. Accountants and lawyers devised tax shelters that had little or no economic value to allow the wealthy to avoid paying taxes. This process provided little incentive to work and produce efficiently.

By late 1980, it was such a mess that a bipartisan Joint Economic Committee of Congress recommended our entire system for managing the economy be changed. Instead of focusing on the demand side, as had been the case since the Great Depression, the focus would shift to unleashing the productive potential of the economy.

It was reasoned that by cutting taxes, but applying the tax bite in a different way, production of goods and services could be stimulated. Prices would come down, jobs would be created, and more importantly, tax revenues would increase. Investment was stimulated with investment tax credits and a lower tax on capital gains.

The Committee was right—as the history of the '80s and '90s tells us. When taxes were raised by the elder Bush and early Clinton, the economy stumbled. When taxes were cut by Clinton in 1996 and later by Bush II, we have seen our economy rebound.

Taxes provide economic justice, and for good cause. The time will come later in this expansion when the need for justice will trump the need for efficiency. When that happens, watch for the economy to come to a screeching halt. In the meantime, we need economic efficiency to put people back to work.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

IRA Management (Part 2)

by Bruce Fenton

Larger IRAs present major estate planning problems for the owner who wants to maximize the heirs’ legacy, not the federal tax system’s. Given the rate at which IRAs can grow over time, it will not be uncommon to see seven-figure IRAs as the major asset in many estates.

The federal tax system can extract a terrific bite out of such an IRA upon the death of an owner. For example, an IRA left by a decedent is subject first to the federal estate tax, which can be as high as 55% for larger estates. Then, the designated beneficiary, or the estate if no beneficiary is named, is taxed at ordinary income tax rates on every dollar withdrawn from the traditional IRA.

There are a number of planning steps that can be used to reduce some of the tax bite. Always name a beneficiary for each IRA. If the beneficiary is the spouse, two important benefits are realized.

First, a spouse who does not roll over the IRA and who is under age 59½ can draw from the IRA without the 10% penalty that otherwise applies, although income taxes must still be paid. Or the spouse can elect to roll over the IRA into his or her own name. Since this transfer qualifies for the unlimited marital estate tax deduction, there is no estate tax. Further, since the rollover is going directly into the spouse’s IRA, there will be no income tax paid until the money is distributed from the plan.

If the IRA is going to a non-spousal beneficiary, such as the decedent’s child, the beneficiary may elect to receive the IRA payments over his or her lifetime. This allows the IRA to possibly grow tax-deferred as a minimal amount is distributed each year. However, should the owner make the mistake of not naming a beneficiary, and if there is no spouse, the estate or heirs do not have the option of lifetime distributions.

Another solution is to spend the money while alive. It is counter-intuitive to think of spending dollars that represent taxable income if one has other less-taxed assets to spend first. However, keep in mind that by spending the IRA while alive, your estate will not be taxed twice at your death. Consider protecting other capital assets that will receive a step-up in basis at death. Even though these assets will be subject to estate taxation, they can be sold at the date of death and incur no income taxation. Such is not the case with an IRA.

Also consider giving your IRA to charity. If your estate plan calls for a sizable charitable bequest, make it out of an IRA. Your estate will receive a charitable deduction, reducing the value of the estate for death tax purposes. Since the charity does not pay income taxes, Uncle Sam misses out entirely.

Finally, when planning with a large IRA in your estate, by all means seek qualified tax advice. Laws are constantly changing, providing both opportunities for the informed and traps for the unwary.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

IRA Management (Part 1)

by Bruce Fenton

This isn’t your father’s retirement plan! No, tax law and company culture changes have shifted the responsibility for managing retirement accounts from the company’s shoulders to that of the employee. And judging by the size of the IRA accounts we see, the employees are doing a pretty good managing job!

It’s the very size of IRA accounts that raises planning problems, however. Where Dad’s IRA might have been for a few thousand, today it’s not uncommon for his children to have IRAs in six or seven figures.

The problems these larger IRAs pose are three-fold:

1. Managing the assets pre-retirement
2. Managing the assets after retirement, including dealing with complex required minimum distribution rules
3. Deciding what to do with an IRA for estate planning purposes.

This and my following column will speak to these issues.

Prior to retirement, the obvious objective is to manage the account to maximize growth and protect the principle. It is important not to trigger unintended taxation of the account. For example, it is not uncommon for an employee to change jobs every few years, each time leaving behind an orphan 401k plan. These orphaned plans should be consolidated into one IRA account through a trustee-to-custodian transfer.

Such a transfer will be considered a qualified rollover and not require mandatory withholding of 20% of the amount transferred—as would be the case if the employee withdrew the funds directly and then opened a new IRA account to accept the transfer.

Moreover, if an employee under age 55 attempts the do-it-yourself route and hangs on to the money more than 60 days, the rollover is disqualified and the owner will pay income taxes plus a 10% excise tax penalty for a premature withdrawal.

While you cannot borrow from an IRA as you can from many employer-sponsored retirement plans, you are allowed to roll the money over (take it out of the account and use it as you desire) for 60 days each year. Once per year per owner—but be sure it’s back not later than the 60th day!

By consolidating IRAs, the owner gains the advantage of ease of management. If set up in a brokerage account, then stocks, bonds, CDs, mutual funds, etc., may be combined in the IRA and the owner will see the entire account on one periodic statement.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Forecasting the Stock Market (Part 1)

by Bruce Fenton

Despite strong earnings reports, an improving economy and low inflation, the lack of resolute buying is indicative of some doubt concerning the market’s direction and future.

Those looking for a helpful forecast from the experts can find plenty of opinions. Since you shouldn’t be without one of your own, especially if your retirement plan is invested in equities, I’ll pass along a few to consider. In a future column, I’ll also give you a couple of ideas for a “do-it-yourself” forecast.

To start, let’s throw out the extremes, like the mutual fund president who wrote a book during the tech boom forecasting the Dow would hit 100,000, or perennial bears such as Robert Prechtor, who has been calling for the death of all bulls since the 1980s. They both may be right—I’m just not sure it will happen in our lifetimes!

Back in the bear’s den, we have Marc Faber, a Hong Kong contrarian who tells us we don’t have a chance against China and a rising Asia. He thinks we are in for a long and dark winter of economic morass. According to a recent Forbes article by Rich Karlguard, Boston investment banker Jeremy Grantham sees our recent upward surge as “the greatest sucker rally in history,” based on his assumptions that the market is overpriced at its current P/E of 24 and will fall to its trend line of 16.

Warren Buffett, recently proclaimed the “Greatest Investor of All Time” on the cover of Fortune magazine, is looking for a do-nothing, sideways market for the next ten years, reminiscent of 1972–82. Buffett is one of the few money managers who lost money in 1999, but he has been right for the past three years.

On the other side of the fence, there are more than a few supply-side bulls, like Art Laffer, economist and inventor of the Laffer Curve. He theorizes that lower taxes increase tax receipts through increased economic activity. To his credit, his 1980 theory has been correct. In January 2004, Laffer noted that American stock markets are more undervalued than they have been in forty years, selling for just 25¢ to the dollar.

Fellow bulls like Ed Yardeni, Chief Investment Strategist of Prudential Equity Group, and Larry Kudlow, co-host of CNBC’s “Kudlow&Cramer,” agree with Laffer. They point to American productivity, low interest rates and the Bush tax cuts as the jump-start of a multiyear stock rally that will lead to new highs.

While I’m not quite ready to hitch a ride on the Dow “40,000 or bust” wagon train, I would like to put some of these bearish sentiments in perspective.

From 1926 through 2003, using ten-year rolling periods, research done by the H.S. Dent Foundation™ shows large cap stocks have averaged annual returns of 11.1% with a standard deviation of +/- 5.73%. If the Dow trades sideways from now through the end of the decade, as Mr. Buffett and friends suggest, this implies an average annual return of -2.17% for the decade.

To put that into perspective, that is a poorer ten-year return than the years from 1929 continuing through the Great Depression. During those ten years, the U.S. economy suffered with violent contractions in the money supply, 25% unemployment, a drop of almost 50% in worker productivity, restrictive trade policies and an increase in income taxes.

Today, we have plenty of liquidity in the money supply, rising worker productivity, unemployment near the norms of 5–6%, lower taxes and relatively free trade.
For the bearish scenario to play out, our economy would have to be seriously disrupted for the next six years! Keep in mind that even after 9/11, consumers continued to spend and our GDP remained positive quarter over quarter.

Read More: Forecasting the Stock Market (Part 2)

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Economic Urban Myths

by Wendell Cayton

It’s urban myth time again—the rhetoric of a presidential campaign is upon us. TV market analyst Tobin Smith argues that all presidential candidates should have to pass Econ 101 before they can run for office, and I agree with him.

Last week, an email I received from supporters of one candidate noted that current economic policies would saddle each of our children with an additional $35,000 in debt.

So what? Any of us with children and a mortgage have exceeded that number many times. We pay it off by selling the home or making payments for 30 years. Instead of paying cash for homes, we borrow from the bank. This gives us the year over year cash flow we need to invest in our retirement accounts, pay for our children’s educations and improve the quality of our lives.

This is exactly the same thing our government does—the difference is that the government does not have the option of “selling the family home” to downsize and pay off the debt. It must support the debt with increasing tax revenues that can only come from a growing economy.
The bond market—the ultimate inflation barometer—has passed judgment on current policies by keeping the ten-year Treasury bond trading around 4%, an indication that bond traders do not see inflation as a threat.

Let’s take on the urban myth of job creation. Our economy is structurally designed to destroy a certain number of jobs each year. It’s called innovation, progress, capitalism at its finest, or, to quote economist Joseph Schumpeter, the natural result of “gales of creative destruction.”

Only a fraction of destroyed U.S. jobs go overseas because of an economic principle called “the law of comparative advantage,” expressed centuries ago by David Ricardo. He theorized that economic gain will increase between two nations if each specializes completely in the production of goods it has a comparative cost advantage in producing.

Ricardo also held that foreign trade may promote further accumulation and growth if wage goods (not luxuries) are imported at a lower price than they cost domestically, thereby leading to an increase in real wages and profits. His ideas have proven right for centuries—overall income levels have risen in “specialist” nations as long as comparative advantage prevailed.

The U.S. job problem is not the result of manufacturing jobs leaving; according to Holman Jenkins writing in the WSJ, only about 10% of manufacturing costs are job-related. It’s the other overhead that kills profits: corporate taxes, litigation costs, federal mandates . . . all forms of “social overhead.”

For our economy to grow and our lives to improve, we will continue to be an exporter of technology and infrastructure, things we can produce at a comparative advantage. We will buy inexpensive manufactured goods from abroad, contributing to the growth and development of nations who ultimately will have the money to buy from us.

Enacting of proposed protectionist laws against off-shoring or many other urban myths being spread today can only lead to the unintended consequences of falling corporate profits and stock prices. If this were to come to pass, those counting on 401k plans to provide retirement income will be sadly disappointed when it comes time to collect.

Divorce is a Taxable Event

Divorce, better known as the instant wealth reduction plan, hits about half of all first marriages and more than 60% of second marriages. Few things will stir emotions more in the settling of a dissolution case than the issues surrounding child custody and support.

Over the years, courts and families alike have become more civilized and sensitized to these issues, as dissolution agreements have attempted to craft solutions that seem fair and equitable to all. Unfortunately, fair and equitable sometimes doesn’t always work when money is involved.
A dissolution agreement that awards joint, physical custody and support responsibilities to both parents can work against the children when it comes to obtaining financial aid for college. If both parents share these responsibilities, typically, the joint incomes and assets of two separate households will be counted when the colleges compute the Family Expected Contribution amount. This effectively reduces the amount of aid available.

For example, assume a situation where the non-custodial parent has a much higher income than the custodial parent. Assume the divorce agreement specifically excludes the higher income parent from any responsibility for college support. As a result the two children would qualify for financial aid based upon the much lower income of the custodial parent. This would result in more financial aid than would otherwise be available if both incomes were used to calculate aid eligibility.


In a recent tax court case, a divorced couple shared support and custody of their one child. The IRS challenged their respective tax returns on the basis that both parents claimed an exemption for the child, claiming that each supplied one half of the support.

The IRS denied the dependency exemption for both parents because neither could prove that the child had spent the greater portion of the calendar year with either.
The divorce agreement provided for joint custody of their child, with physical custody split equally between the parents on a weekly basis.

In the case of split custody where neither parent could prove to the court’s satisfaction that that parent had provided more than one half of the physical custody, their documentation and testimony would not be convincing enough. In an understatement of confusion, it would be sheer unguided guesswork for the court to find otherwise. As a result the exemption would be denied.

This loss of taxable benefit could have been avoided if the parents had agreed to a specific number of days, even to the extent of alternating years taking the dependency exemptions. Another viable alternative would be for the parties to bargain for a more generous settlement that allows the other to claim the exemption every year.

Estate Tax Changes

by Bruce Fenton

An oxymoron—politics and principle—will clash when the Congress begins the full debate over President Bush’s proposal to eliminate the estate tax. Certain staunch, card-carrying Republicans who never met a tax cut they didn’t like are standing in line to fight this one.

President Bush has made repealing gift and estate taxes a centerpiece of his tax cut plan. Proponents and opponents of the repeal agree that, as proposed, it would save the wealthiest 2 percent of Americans about $236 billion over the next decade.

Estate tax lawyers and other experts are concerned that unless Congress writes conditions into the legislation, taxpayers will not realize the savings advertised, and certain government treasuries will be adversely affected

Not just the federal Treasury, but also the District of Columbia and the 43 states with their own income taxes, would lose far more revenue than they might anticipate, these experts said. They also said charities could feel the effects, since certain tax incentives for gifting would be eliminated.

The Unified Gift and Estate Tax codes assess taxes on transfers of property that exceed a one-time amount of $675,000, whether the transfers occur during a lifetime or upon death. Amounts above this threshold are taxed at rates that begin at 37 percent and rise to 55 percent on amounts greater than $3 million.

According to a report recently in the NY Times, nearly 48,000 Americans, or 2 percent of all the Americans who die each year—ranging from small business owners and professionals to multibillionaire executives—pay estate taxes. Just 4,000 people who die each year leaving more than $5 million dollars or more pay nearly half the estate tax.

Last year President Bill Clinton vetoed a bill that also would have repealed the estate tax, but it would have limited the income-tax avoidance strategies that are possible under the Bush proposal.

The proposed Bush plan will allow property to be gifted and transferred at death, escaping all capital gains and transfer taxes. This will not only impact federal taxation, but will deny the many state treasuries of their share of transfer taxes collected under current law. (State transfer taxes are deductible from federal transfer taxes and therefore appear transparent on a tax return.)

Charitable giving will be adversely impacted since transfer from an estate to a charity is also tax deductible.

Finally, a clever spouse could transfer property into a trust, without triggering a gift tax, and effectively deny their spouse access to the property after dissolution of the marriage.

Those who will be vocal in pointing out the shortcomings of the Bush plan will be none other than the life insurance industry and many estate-planning attorneys. The Bush proposal will eliminate the need for large, expensive life insurance policies that are currently used to provide tax-free funds to an estate at death which eventually are used to satisfy tax obligations.

Estate planning attorneys who specialize in arranging property ownership to avoid transfer taxation will have to find another way to use their talents.

Both of these groups will go to great lengths to point out the shortfall of revenue that will impact state coffers. Both will point to the negative impact on charitable giving this bill would have. Both have much to lose if the tax cut as proposed becomes law.

Bruce Fenton is a financial consultant, a writer, and the president and founder of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Estate Tax Repeal

The bill now being considered by Congress to reduce or repeal the estate tax is providing an interesting glimpse into the changing political landscape of our country. This bill and its amendments would phase in the repeal of estate, gift, and generation-skipping transfer taxes over a 10-year period.

Since its enactment in 1916, the estate tax has served as a capstone for our progressive tax system. Its backers view the tax as a wealth redistribution tool, designed to keep the truly wealthy from dominating our economic system by passing wealth to future generations.

Detractors call it an unfair tax on wealth already taxed by the income-tax system. Leading the fight to repeal it is a coalition of small business owners, family farmers, and real estate interests.

However, thanks to an abundance of planning techniques developed over the years to counter estate taxes, both sides are a bit off the mark.

The truly wealthy have learned how to live with the tax and pass wealth on to future generations at low or non-existent transfer costs. Moreover, because the law allows a step-up in the cost basis of assets owned by a decedent, much wealth accumulation in the form of capital growth is never taxed until transferred. Good planning makes the estate tax a truly voluntary tax! Estates that pay do so only because someone neglected to plan.

The move to repeal puts the Clinton administration—and presidential hopeful Vice President Gore—in an uncomfortable position. Clinton has vowed to veto the bill in its present form, even though it is widely backed by members of his own party. The Republican Party and presidential candidate George W. Bush could quickly turn this into a potent campaign issue.

Even ten years ago, this would have been inconceivable. But “the times they are a-changin!” Today, gift and estate taxes could potentially impact a much broader segment of the population. In California alone, median home prices in many communities put even modest estates into the taxable territory. Rapidly growing IRAs and other retirement savings plans, bolstered by stock market gains, add to the potentially taxable wealth.

Many middle Americans have seen their income creep up into higher tax brackets. As their income and Social Security taxes have increased, they are becoming more aware of the confiscatory nature of our tax system. Attitudes about wealth are changing. Traditional Democrats are finding themselves wealthier and paying more taxes. Therefore, any tax-reduction plan—even for a tax that can be avoided—makes an attractive electoral issue with broad multi-party appeal.

Vice President Gore and his fellow Democrats will be scrambling in the coming weeks to come up with their version of a plan to repeal or reduce the tax. But don’t throw away your expensive well-thought-out estate plan just yet! Even if some version of the bill passes and becomes law, it won’t take effect immediately—and it is likely to be sufficiently complex that it will provide ongoing employment for accountants, attorneys, and financial planners.

The good news is that future generations are likely to benefit from a simpler, more fair transfer-tax system that allows them to grow their wealth and keep it in the family if they choose, without having to resort to complex tax-avoidance schemes.