Kimmunications

Tax Cuts Explained

A friend emailed this to me the other day, and I thought it was worth sharing. The piece has been attributed to several people, but nobody seems to know the original author. In any event, I found it interesting:

Tax Cuts Explained

Because it's the election season, let's put tax cuts in terms everyone can understand.  Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this: 

• The first four men (the poorest)  would pay nothing.
• The fifth would pay $1.
• The sixth would pay  $3.
• The seventh would pay $7.
• The eighth would pay  $12.
• The ninth would pay $18.
• The tenth man (the richest) would pay $59.

So, that's what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement until one day the owner threw them a curve ball. 'Because you are all such good customers,' he said, 'I'm going to reduce the cost of your daily beer by $20.'

Drinks for the ten now cost just $80.  The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his 'fair share?' 

They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer.

So, the bar owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay.  And so:

• The fifth man, like the first four, now paid nothing (100% savings).
• The sixth now paid $2 instead of $3 (33% savings).
• The seventh now paid $5  instead of $7 (28% savings).
• The eighth now paid $9 instead of $12 (25%  savings).
• The ninth now paid $14 instead of $18 (22%  savings).
• The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant the men began to compare their savings.

"I only got a dollar out of the $20," declared the sixth man. He pointed to the tenth man, "but he got $10!"

"Yeah, that's right," exclaimed the fifth man. "I only saved a dollar too.  It's unfair that he got ten times more than I!"

"That's true!!" shouted the seventh man. "Why should he get $10 back when I got only two?  The wealthy get all the breaks!"

"Wait a minute," yelled the first four men in unison. "We didn't get anything at all.  The system exploits the poor!"

The nine men surrounded the tenth man and beat him up. The next night the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our Tax System works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

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Kim Snider is the President and Founder of Snider Advisors, an investment adviser registered with the SEC, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 888-6SNIDER to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Am I on target with target date funds?

Lately, I have been getting a lot of questions about target date funds. No wonder. Target date funds are being touted as the answer to our retirement investing conundrum. They are being proposed as the default choice in a 401(k) plan. And they are sprouting up like weeds. So should you put your money in a target date fund?

 

The short answer is ... only as a last resort. But first things first.

 

A target date fund is a mutual fund with an asset allocation tied to your target retirement date. If you think you will retire in 20 years, you would pick a 2030 target date fund, with 2030 being roughly the year you plan to retire.

 

These funds are really funds of funds. The fund manager chooses other funds, from the same fund family, in percentages that make up a reasonable asset allocation given your time until retirement. It is the fund managers job to adjust those percentages for you automatically as your retirement date approaches, becoming progressively more conservative. These funds typically hold a mix of stocks, bonds and cash and will often include an allocation to foreign equities as well.

 

It's no wonder I have been getting so many questions about target date funds lately. In 2000, there were only 23 target date funds in existence, with just about $8 billion in assets. Today, there are over 250 target date funds, with $160 billion in assets, and more being brought to market every day. But should you plunk your retirement savings in a target date fund and forget it?

 

I don't think so and here is why …

 

1. One size doesn't fit all, with any investment.

2. Target date funds are too conservative.

3. There are better ways.

 

Target date funds are being touted as one stop shopping. Just pick a retirement date, pick the fund with your retirement year in the name, and let the fund manager do the rest. But does it really make sense that the CEO of a company should have the same asset allocation as a clerk in his Accounting Department? Not likely!

 

An investor has to put together an asset allocation based on his or her long-term objectives, risk tolerance, time horizon and temperament. You choose the combination of investments that has the highest probability of satisfying each of those criteria over your anticipated time horizon. It is possible that is a single investment but often it is not.

 

My biggest gripe with target date funds is they are too conservative. Let's make some assumptions about your retirement. The first is your retirement will last thirty years. That is the joint life expectancy of a 65 year old, non-smoking couple.

 

Second is that inflation will average 3.5% over that 30 years. Forget for a moment that seniors experience inflation at a greater rate than the nation as a whole, largely because of the cost of healthcare. We'll just use the historical average.

 

Third is that you will begin withdrawing funds from your portfolio at the rate of 4% a year. And fourth, let's assume your marginal tax bracket will be 25%. Now, what is the return required over your 30 years in retirement to pay Uncle Sam, pay you, and still get enough growth in your portfolio to keep up with inflation?

 

The answer is 10%. That is (4 + 3.5) / (1-.25) or your withdrawal rate plus inflation divided by one minus your marginal tax rate. Which means we have a gap. Our current way of thinking about investments is too conservative.

 

If you model the traditional 60%/40% retirement portfolio, the expected rate of return over 30 years is only 8%. A 4% withdrawal rate may give me a high probability I won't run out of money but it almost assures that I won't be able to buy anything with the money I have left. In order to protect against conversion risk, target date funds, because they are based on asset allocation models designed for our parents and grandparents, get too conservative too fast.

 

What worked for previous generations will not work for ours. We are the first generation solely responsible for funding our own retirement. Unfortunately, no one told us that until, for many of us, it was too late. On top of that, we are living longer. Life expectancy has increased by ten years. That is both good news and bad news. That's ten more years to travel, play golf and spend quality time with our family. But it is also ten more years without a paycheck.

 

Like it or not, we have to come to grips with the idea that our investment time horizon isn't our retirement date. Our time horizon extends over our entire lifetime. Moreover, it seems plainly obvious to me our lifestyle in retirement is going to be a function the amount of our portfolio we leave in stocks. Unless you are one of the few with more than enough money, that is the only way our portfolio can keep up with inflation, taxes, and still support a reasonable lifestyle over 30 years.

 

Target date funds don't do that. They are by nature too conservative.

 

My regular readers and radio show listeners know I don't like mutual funds, as a rule. I especially don't like actively managed mutual funds because their high fees guarantee over time you will under-perform the market itself. The only time I would ever use a mutual fund is in an employer-sponsored retirement account, like a 401(k) or 403(b) and that is just because I don't have a choice.

 

Most plans are adding target date funds as an investment option. Should you choose it?

 

Only as a last resort. I believe a well-thought out asset allocation of low-cost index funds, like the one in our 401(k) course, is the much better plan. But if your plan doesn't offer low-cost index funds, or you aren't willing to spend the time and money required to learn how to maximize your 401(k), (which is minimal BTW), then target date funds are far better than just picking the funds with the best historical performance and/or allocating between stocks and bonds based on what you think the market is going to do. That is a sure fire way to waste your retirement funds.

 

Bottom line on target date funds … they aren't the panacea the fund industry would like us to think they are. Do the work. You can do better.

 

Kim Snider Financial Communications makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk, including possible loss of principal. Individual results may vary. Individual performance depends on individual savings, investment time frame and market conditions. Diversification does not ensure a profit or protect against loss in a declining market.

 

 

Mortgage Mess

I am still traveling so this will be short and sweet. I'd like to point out an excellent article by Laura Rowley over on Yahoo Finance. It is titled, "Footing the Bill for the Subprime Fiasco."

And while we are on the topic of messes, you might also have a look at Scott Burns' article on the federal deficit. (Free registration required) According to government figures, the entire deficit problem boils down to unfunded liabilities in the Social Security and Medicare programs. He goes on to point out t"if the federal government confiscated all the land in the United States along with all of its improvements – buildings, highways, plants and equipment, and other durable assets built on it – and sold them at auction to foreign investors, it would still fall more than $20 trillion short in present value of the monies required to satisfy its future budget."

Give these a read and let me know what you think. Gotta go. I have a plane to catch!

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

11-17-2006 - Items of Interest to Family CFOs

Taxes

 

Under the tax law, inheriting money in an IRA was better for your heirs than inheriting it while it was in a 401(k). 401(k) money was not subject to the "stretch" provisions like an IRA was. That will change in January, 2007 when the Pension Protection Act of 2006 goes into effect. From now on, beneficiaries will effectively get the same tax treatment with both IRA and 401(k) money. (Financial Advisor)

 

Investing and Retirement

 

Canadian income trusts have been one of the best income investments in recent years. Dividends have ranged from 6% to 9% over the last few years and have been a favorite of in-the-know income investors. These trusts were able to pay such high dividends because of the very favorable tax treatment they received from the Canadian government. No more. In a surprise move, the Canadian government has proposed a tax on distributions that has investors up in arms and sent shares of the income trusts reeling. (London Free Press)

 

Participation rates in retirement plans is down from 2004! Only 55% of 24-64 year olds participate in a retirement plan. The message is not sinking in. I fear it won't either until younger people begin to see the impact of inadequate retirement savings affecting their parents and grand-parents. But by then it will be too late for tens of millions of people. Call me chicken little but I worry how we are going to pay for all these people. (Employee Benefit Research Institute)

 

Great chart courtesy of Barry Ritholtz. Great illustration that experts don't know what is going to happen any more than you do. (The Big Picture)

 

Good commentary by Michael Mauboussin, Chief Investment Strategist at Legg Mason, on why chasing what's hot is a fool's game. (Time)

 

EBRI looks at the data on the increasing level of debt in families with a family head age 55 or older. The long and the short of it is that we are retiring with more debt than ever before. (Employee Benefit Research Institute) The study is available at www.ebri.org .

 

Chuck Jaffe, MarketWatch columnist, gives some ideas about financial gift giving this holiday season. MarketWatch

 

Thoughts on any of these? Feel free to leave your comments below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Top Ten Lies Financial Advisors Tell

What passes for investment advice is a pack of lies being told by a band of thieves. They keep telling the lies because you keep buying them. Here are ten perennial favorites, in no particular order:

 
1. "Buy and hold: You can't go wrong in the stock market if your time horizon is long enough." So … if my time horizon is thirty years, the last ten of which is a secular bear market, then what?

 
2. "You are diversified." Retail money managers are closet indexers, regardless of what their stated investment style is. Having a 10% return when the market goes up 25% because your "style" is not hot right now is death to a fund manager.

 
3. "Options are risky." Options can't be inherently risky. For every transaction there is one winner and one loser. The problem is not with options but with the way people are taught to use them.

 
4. "The S&P will be at x by year-end." Stock prices are random. No one can accurately predict where they will be tomorrow, next week, or next year. No one can consistently pick tops and bottoms either. It can't be done - except by liars.

 
5. "You can afford to take more risk while you are young." The days of being able to take market risk are gone forever. We now live in a world where we must all fund 30+ years of retirement. Capital losses, at any age, are no longer acceptable.

 
6. "Our analysts believe this company has great potential." That would be great if stock prices actually reflected the true value of a company. They don't.

 
7. "Defer taxes until later in life when you will be in a lower tax bracket." Tax deferred investments are a suckers bet. First, they convert tax advantaged capital gains into ordinary income. Second, most people are in the same or even a higher tax bracket once they retire, not a lower one. Third, you'll pay far more in fees to your advisor than you will in taxes to Uncle Sam. Why don't they tell you to focus on reducing those?

 
8. "Everything you need to know is in the prospectus." What a joke. Prospectuses are written by lawyers. Lawyers don't get paid to be clear and forthright or speak in plain English. They get paid to cover the firms' ass in case something goes wrong. Where do I read about all the stuff the firm isn't legally required to disclose?

 
9. "Leave the investing to an expert - in other words, us." Financial advisors are expert in one thing - selling.

 
10. "We pick the investments best suited to meeting your objectives." The one thing financial advisors are most expert at selling is the investment best suited to meeting their financial objectives, not yours.

 

I am sure you have heard these and many more. What lies have I left out? Help me complete the list. Leave your thoughts and comments below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Ditch your money manager

Everybody focuses so much time and attention on minimizing taxes. But guess what? Taxes aren't the biggest drain on your returns. It's the fees and commissions being collected by those same advisors who are talking about all those nasty taxes. The fact is you'll pay four times more to your fund manager than you will to Uncle Sam in taxes. How, you might ask?

 

This is how: suppose you and your wife don't have any dependents when you reach retirement and you're at that 1 million mark and you decide you can live off $40,000 a year. And suppose the $40,000 is ordinary income so you'll have to take the standard deduction. The government gets around $4000 but your money manager will get four times that amount.

 

You see the fund industry gets about 1.60 percent in expenses from you - the consumer - in order to pay for things like marketing, taxes, tools and the occasional piece of advice. You and your spouse will be paying your friendly fund manager $16,000 every year based on your million dollar portfolio. That's four times what you're paying in federal taxes! And for what? Certainly not for performance since two-thirds of all actively managed funds under-perform the benchmark indexes.

 

Now let's pretend you and your spouse have an investment advisor in addition to your mutual fund manger and he's convinced you to wrap up your retirement assets in a high-commission insurance product like a variable annuity. Remember that expense ratio of 1.60? Well, it could climb to as much as 2.50 percent or more!

 

Now you and your partner are paying an outlandish $25,000 a year to your fund manager and advisor to manage a portfolio that could be managed by you, with better results, for next to nothing. $25K is over HALF of what you've taken out to live on every year. I don't know about you, but retirement is supposed to be fun and engaging and I can have a lot more fun on $65,000 than I can on $40,000.

 

The saddest part is that's about $20,000 more than what you really have to pay. So why do brokers and financial advisors continue to harp on taxes and never on fees? It doesn't take a rocket scientist to figure that one out, does it? It's a canard - a smoke screen - and we fall for it!

 

Now look, I'm not pointing fingers at you. Many of you know that I went from rags to riches back to rags again in less than two years because I didn't know what was going on in my portfolio. Like many of you, I trusted my broker to handle my money partly because I believed he was more qualified than I was to do it. That assumption cost me a whole lot of money.

 

The fastest way to improve the returns in your portfolio without taking on one ounce of additional risk is to lower your fees. The best way to lower your fees is to ditch your money managers. You don't need them, and in spite of what you might think, you don't have to spend countless hours to do manage your own money.

 

Let me know if you agree or disagree. Do you think your money managers are worth what you pay them? Do you really know how much you pay them? Leave your thoughts and comments below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Financial Advisor Symposium: Choosing Which Retirement Account to Tap First

Choosing Which Retirement Account to Tap First

2nd Annual Financial Advisor Symposium - Las Vegas, NV

Saturday, April 28, 2006

 

 

David Carter, President, Carter Asset Management, Inc.

 

There is NO one formula that fits everyone's solution.

 

Some Deciding Factors in Choosing Which To Tap First

Qualified accounts and tax sheltered annuities will be taxed as ordinary income

Dividends and long term capital gains are taxed at 15%

Tax on social security benefit

Roth IRA money is not taxable

Is client over 70 1/2 and into required minimum distributions

Is client under 591/2 and taking 72(t) distributions

Clients desire to reduce income for their decedents

Clients desire to leave an estate for charity or heirs

 

Some people are really resistant to taking RMD's but if you look at the tables, the amounts are really very low that you are required to withdraw

 

Fredrick Adkins, CEO, Arkansas Financial Group

 

What's deducted?

What's taxed?

How is it taxed?

 

The problem with tax deferred accounts is they convert long term capital gains and dividends to ordinary income that could be taxed as high as 35% in the top tax bracket. Variable annuities do the same thing. Tax deferral is a "sucker bet"

 

Asset classes that were shunned in the accumulation phase are now favored in the distribution phase.

 

Peter Lynch, years ago, got a lot of press for suggesting that you should never own bonds in an investment portfolio. When you got to distribution, you just took capital gains and lived on those. Anyone who followed that advice was devastated in 2000 - 2002.

 

If you put qualified versus non-qualified on a pie chart and equity versus fixed income on another chart, the closer those two charts match up, the easier distributions are. Ideally you would prefer equities in the non-qualified and fixed income to match up to the qualified.

 

Bond interest is tax neutral - it is taxed the same whether it comes form qualified or non-qualified accounts. (True of Snider Method income as well.) That is not true with equities. Rule of thumb is to take fixed income assets first and move towards equity.

 

Gregory Sullivan, President, Sullivan, Bruyette, Speros & Blayney, Inc.

 

There is a world of difference between a plan that assumes linear returns, in other wrods, just takes the average return and running it out to some estiamted longevity number. In the scenario Greg showed, using the average return, the client could live to 95 and still have 1.2M left.

 

But if you run a Monte Carlo simulation, which takes into account volatility, or non-linear returns, there is a very real possibility that same client could run out of money, even while achieving the average assumed in the linear. As I demonstrate in all my speeches and information sessions, this is the hidden cost of risk.

 

If you simply look at taxes, you may get the wrong answer. It is a broader question than tax. Letting tax rule the decision making could run the client out of money.

 

If you have a $1M IRA and a $1M taxable account, you cannot have the advisor withdraw the fees for both from the IRA. IF the fee was $10K per, and you withdrew $20K from the IRA, $10K of it would be considered a withdrawal. In the other hand, you could take all $20K from the taxable to pay fees on both. It goes one way but not the other.

 

Interesting side note, all three speakers were adamantly opposed to the use of variable annuities.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

Sunset Provisions in the Tax Code

I do not believe in letting the tax tail wag the investment dog. I see too many people tripping over a dollar trying to save a dime. That said, I don't like paying them any more than the next person and I want the applicable tax rates being applied to my various forms of income to be as low as possible.

 

Not to mention, I think lower tax rates are good for the economy. I think I spend my money much more wisely than the government ever could.

 

Which makes the following item from the January 2006 Nick Murray Interactive (subscription required) of interest:

 

The bad news – and it is potentially very bad news indeed – is that virtually all of these phenomenally effective pro-growth tax cuts are about to "sunset" over the next several years. Moreover, there is a massive tax increase coming in the form of the Alternative Minimum Tax, the threshold for which is scheduled to fall to $33,750 from $43,500 on January 1, 2006 (as I write in mid-December). Residents of high income/high local tax states like NY, NJ, MA and CA will be hit hardest – exactly the kind of productive, job-creating, high-investing citizens you least want to mess with. 

 

 

This is not, I assure you, a political statement. It is a statement of the most primal, most inexorable economic law: people respond to tax rates. And, as we speak, tax rates are all about to go the wrong way. Maybe you didn’t read it here first, but I wanted to make sure you read it here, too: tax policy is, by far, the single gravest risk to the economy and the markets in 2006. Write your congressperson; write your senator. And stay tuned. This one’s gonna be close. 

 

What are your thoughts? How much do you take taxes into consideration when considering investment strategy? Do you think Congress should allow these to tax rates to revert back to the higher levels? Do you think lower tax rates are good for the economy? Would you spend less if you were taxed more? Leave your comments below.

 

SOURCE:

 

1. Nick Murray "Tax Rates Matter - Critically" Nick Murray Interactive; January 2006 (Subscription Required. http://nickmurrayinteractive.com/secure/articles/jan2006_tax.html

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

Will Tax Reform Kill the 401(k)?

Let's hope so! I vehemently dislike 401(k) plans. Actually, let me be clear. I don't dislike 401(k) plans. I dislike the fact that they are now the dominant vehicle for retirement savings and the investment choices within them are total crap. How can you tell people they must now fund 100% of their own retirement but only give them a limited assortment of high cost, high risk, under-performing mutual funds?

 

That being said, it is pretty hard to tell someone not to invest in their 401(k) when 1) the account is tax-deferred; 2) they are more likely to save and less likely to spend because of the set it and forget it feature; 3) they are less likely to rob it so long as they remain employed and can't get to it; and 4) there is usually an employer match.

 

Now comes a very interesting paper from the Center for Retirement Research at Boston College which asks, "Could Tax Reform Kill 401(k) Plans"? The report concludes:

 

Today's employer retirement plans are to a significant extent supported by their favorable tax treatment. But tax rates on investment income outside of employer plans, and thus the relative advantage given employer plans, has sharply declined. And they could decline even more in the near future. Lower tax rates on investment income could result in an increase in saving outside of employer plans. But narrowing the tax preference afforded employer plans could result in a significant decline in the share of the workforce participating in employer retirement plans.

 

The issue is this: As late as 1996, investments outside of retirement plans were highly taxed. Prior to 1997, the top tax rate on ordinary income was 39.6%, on capital gains was 28% and dividends were taxed at the marginal tax rate, which at the time, had a top rate of 39.6% as previously stated. Since then, tax rates have fallen dramatically as you can see in the table below:

 

 

Tax reform proposals would further reduce the tax burden on individual investment:

 

In November 2005, the President's Advisory Panel on Federal Tax Reform presented two proposals

to the Secretary of the Treasury. The Simplified Income Tax Plan eliminates the Alternative Minimum Tax, transforms a number of deductions to credits, and simplifies major features of the existing tax system. The Growth and Investment Tax Plan builds on the first proposal but moves closer to a consumption tax by allowing businesses to expense all new investments.

 

So the question becomes whether, as the tax advantage of 401(k) plans narrow, should we stop putting money in 401(k) plans and begin investing outside of those plans instead? The paper draws a comparison between the two alternatives, given what I believe to be a somewhat "goldilocks" set of assumptions:

 

1) the worker earns $1,000 and wants to save the proceeds; 2) the proceeds are invested for

30 years in equities with a 6 percent return — 2 percent paid out in dividends and 4 percent in the appreciation of the price of the stock; 3) the worker is in the maximum tax bracket; and 4) the worker does not trade the stock during his working years so capital gains taxes are due only when gains are realized at retirement.

 

 

Under those assumptions, the difference in the annual rate of return is minimal. Therefore, we have to ask ourselves, from a behavioral standpoint, which makes more sense? Clearly, most people don't set their investments and forget them. They continually buy high and sell low - a tendency that tends to be dampened in 401(k) plans. It is also not reasonable to expect an investor to buy index funds and hold them for 30 years, although, they would be far better off than what they are doing now.

 

But on the other hand, investing outside the 401(k) gives us many more investment alternatives and control over our own savings. For some people that may be a good thing. For most, I hate to admit, it is probably not - they are not educated enough or disciplined enough to have that much control.

 

Of course, my objective is to teach people the discipline and give them a rigid investment structure within which to invest so they can get far better results with less risk than traditional investments provide but we only reach a small number of people. What about the other 200 million?

 

So what do you think? Let's just assume for a moment that 401(k) plans were no less or more tax advantaged from investments outside the 401(k) plan. Do you think people would or should stop contributing to their 401(k)'s? Are you disciplined enough to manage money outside an employer sponsored plan? Which of your accounts has done better over the years, your self directed accounts or your employer sponsored plan? As always, I'd like to get a conversation going. Leave your thoughts and comments below.

 

SOURCE:

 

1. Munnell, Alicia H. "Could Tax Reform Kill 401(k) Plans?" An Issue In Brief: Center for Retirement Research at Boston College, Number 38.

http://www.bc.edu/centers/crr/issues/ib_38.pdf

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

FICA Taxes Will Increase in 2006 for Higher Paid Employees

Highly-paid wage earners will see an increase in the Social Security wage base for 2006. The 2006 wage base of $94,200 is $4,200 higher than the 2005 amount and the maximum additional Social Security tax that might be collected from someone earning above the 2005 wage base is $260.40.

 

This is the largest increase since 2002 in both dollars and in percentage, and reflects the largest increase in national average wages since 2000. The tax increase will show up in the amount of FICA (Federal Insurance Contribution Act) tax deducted next year from the paychecks of those earning above the 2005 wage base.

 

Although the tax rate for the Old-Age, Survivors and Disability Insurance (OASDI) portion of FICA has held steady at 6.2 percent since 1990, the amount of wages subject to the tax can, and usually does, increase each year, based on a national wage index. The taxes paid by employees are matched by identical amounts paid by employers into the Social Security system.

 

SOURCES:

 

3. "For High Earners, FICA Taxes Increase in 2006" Financial-Planning.com 24 October 2005.

http://www.financial-planning.com/pubs/fpi/20051024101.html

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

Are You Letting the Tax Tail Wag the Investment Dog?

Your boss calls you in his office. "Jones, you've done great work for the company. We are going to promote you. Your salary will double over what you are making now. So, do you want the job?"

 

"Gee, I don't know," you reply. "Let me have a little while to think about it."

 

As you walk back to your office, you are thinking about all those things you have been putting off that you can now afford. You've been waiting to finish the new deck. You and your spouse are in dire need of a vacation. And you know you need to get going on your kids college education fund. All of these are now possible given the salary you have been offered.

 

But before you call home with the good news, you sit down and do some calculations. Your income right now is $80,000 a year. You are paying about $9500 a year in taxes, leaving you with about $70,500 after taxes. Now when you look at your new salary, you see that you will be paying about $30,300 a year in taxes, leaving you with just a little less than $130,000.

 

You walk into your bosses office and tell him "Sorry. I don't want the job."

 

"What? Why not. This is a great opportunity for you."

 

"It is", you say. "And I really appreciate your faith in me. It's just that I don't want to pay the taxes on the increase!"

 

You would never do this, right? It is absurd. Yes, your effective tax rate has jumped from 11.5% to 19% and the actual dollars in taxes you are paying has increased, but so has your net income after tax. Who cares that you are paying more in taxes?

 

And yet, many people do exactly this when it comes to their investments. I call this "letting the tax tail wag the investment dog" and nine times out of ten, it is an investor train wreck waiting to happen.

 

The tax tail wagging the investment dog usually takes one of three forms. The first is holding on to an appreciated security so you don't have to pay the capital gains tax. Second is the person who chooses a terrible investment over a better one because the bad one is tax deferred. Third, is the person who holds cash because they don't want to pay the taxes on any gains they make if they invest it.

 

When I am giving speeches, one of the questions I often ask the audience is, "How many of you are holding stocks that you once had a profit, but now they are underwater?" Always there are groans and at least half of the hands in the room go up. How many of you didn't sell them because you wanted to wait at least a year from when you bought them to get the cheaper long term capital gains rate? Not all, but many hands stay up.

 

Unfortunately, stock prices don't watch the calendar. They don't know how long you have owned them, and usually, they don't wait until it is convenient for you to head back down again. When a stock hits your target price, you have to sell, tax consequences be darned. One of the most common investor mistakes is turning a winner into a loser - and often the rationale was taxes.

 

Now as much as I hate it when I see someone do this, I can at least understand it because we are dealing with an unknown - the future price of the stock. And we are by nature optimistic, so we always think our stocks will keep going up. But what I absolutely cannot understand, is the person who chooses to put money in an annuity to avoid taxes. Well, I take that back. I do understand it. Most investors are lied to about what they should expect from their annuities.

 

We know that annuities are terrible investments which don't do anywhere near as well as the market overall. We also know that when you cash out of an annuity, the gains will be taxed as ordinary income, not as capital gains. So let me give you a real life example. I received an email the other day from a gentleman who put $200,000 in an annuity eighteen years ago. Over that time period, his investment has doubled. That is about a 4% return over 18 years. So he cashes out, he will pay 35% on a $200,000 gain or $70,000.

 

Now let's suppose that instead of that annuity, he had just put his money in an S&P 500 index fund 18 years ago and hadn't touched it since. Instead, he would have an annualized return of 11.25% per year, a gain $676,333 which he would pay long term capital gains taxes of 15% or $101450, leaving him with an after-tax gain of $574,883!

 

To make matters worse, he is compounding the problem. He was looking at the Snider Investment Method because he could get a 13% annualized yield (on average) using the Snider Method but he doesn't want to pay the tax on the gains in the annuity. The only way he can avoid that tax is by leaving it in the annuity, so instead, he will settle - and I do mean settle - for 4% a year. That is why I call annuities the "Hotel California" of investment products - once you get in you can never get out - at least not without some pain.

 

The last example is perhaps the craziest of all. This is just like turning down the job offer because of the additional taxes. We have a family friend who has literally millions sitting in cash. We have approached him several times about investing that money, or at least some of that money, using our Snider Investment Method. He has declined, because if he did, he would have gains that he would have to pay taxes on. Now this is not a dumb man. He made that money. It was not handed to him - and he knows that inflation eats away at that money by about 3% each year, but still, he would rather lose purchasing power than pay taxes - even on a perfectly safe investment like US Treasuries!

 

Sometimes, I just shake my head.

 

We have been brainwashed by the financial services industry to think of taxes as the great evil that eats away at our nest egg, when in fact, the amount we pay in to them each year in fees, dwarfs what we pay in capital gains taxes. It is one of the world's greatest diversionary tactics and it has worked so well that people now do silly, silly things just to avoid them.

 

I take the opposite approach. I pay a lot of taxes. A lot of taxes! I hope I have to pay a lot of taxes for the rest of my life. Now don't get me wrong - I don't pay any more than I have to, but at the end of the day I have to remind myself - paying taxes means I am making a lot of money and after all, isn't that what this is all about?

 

So when you find yourself getting all twisted up about taxes, ask yourself this question - "Am I letting the tax tail wag the investment dog?"

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.