MaineBusiness.com

Previously Stung by the Alternative Minimum Tax? Potential Relief

On December 20th, President Bush signed the Tax Relief and Health Care Act of 2006 (TRHCA). Earlier this month I discussed how this act extended tax deductions that were set to expire. For those who were subject to the alternative minimum tax (AMT) in the past, there also may be some good news.

In the past, when you are subject to the AMT due to an event that altered the timing of recognizing income or an expense item, you got a credit. This credit can be used against the person’s regular tax liability to the extent that its use would not cause you to be subject to the AMT. The problem with the credit is that people who are perpetually subject to the AMT would not be able to use this credit because it could only be used to the extent the person is not subject to the AMT. Or a person whose income situation is so close to the AMT, they may hold this credit for an extended period of time.

With the new legislation, the credit can be partially used regardless of whether the individual is subject to the AMT beginning in 2007. The portion of the individual’s long term unused credit would be made a refundable tax credit. Those with more than $25K of unused credits, the refundable amount will be 20% of that. For those who have less than $25K but more than $5K of credits, the refundable amount will be $5K. For less than $5K, the remaining amount can be used. This benefit would begin to phase out if your adjusted gross income exceeds $234,600 if married filing jointly and $156,400 if filing single. Each incremental $2,500 in income over these figures would phase out the credit by 2%. These unused credits would remain available to use in future years. This law will begin in 2007 and expire at the end of 2012.

This legislation will be particularly attractive to those who got hurt by the AMT due exercising incentive stock options (ISO) during the tech boom as many individuals have not been able to fully enjoy these credits. This will be a windfall to some of you out there. For others, trying to avoid the AMT so you can exact the credit is now a non-issue. Even though this will not apply until the 2007 tax year, I suggest planning for it now and since there is some complexity to it, discussing this with your planner and tax professional come January.

Dirigo Health: A Blue Ribbon Reality Check

Tuesday, a commission appointed by Governor Baldacci released its recommendations to provide funding for Dirigo, its state sponsored health insurance program. The report recommended a variety of things including raising “sin” taxes on such items as tobacco and alcohol as well as snack items and soft drinks. It also suggested becoming self insured, not relying on a commercial insurer such as Anthem to provide the service. Finally, it recommended mandating business to insure their employees, force individuals who can afford insurance to retain it and require insurers to cover dependents on their parents policy until age 30.

What do I think of these proposals? Two words: Good Luck

It’s pretty clear for those living in reality that residents of Maine need “real” tax relief, not increases. The commission tries to sneak around the issue, relying on “sin” taxes on alcohol or tobacco as well as snacks and soda to fall back on (funny that they don't propose raising Megabucks lottery tickets to $1.50) There’s only so many times you can run to this well. When it runs dry, it’s going to reach your pocketbook.

Second, who out there really thinks that the state government can effectively and efficiently run a business, not to mention an insurance company? Who thinks that the state can do this with less bureaucracy than a “for profit” entity? If you answered “yes’ to each of these questions, I have a wonderful bridge spanning Portland to South Portland to sell you.

Finally, the “mandates” that have been forced on us by the state government have only made insurance more unaffordable. In 1993, Maine imposed mandates to individual insurance policies to increase access for the uninsured population. Premiums were not permitted to vary by gender, health status, claims experience, or length of time with coverage. Insurers were permitted to adjust premiums by 20 percent more or less than the community rate for age, occupation, and geographic area, and could be adjusted for smoking and family status. Insurers were required to issue coverage to any applicant who had resided in the state for at least 60 days. What happened? When insurers couldn't reject or adjust charges for anyone based on certain risk factors, everyone began paying more. To exacerbate things, higher premiums forced healthy individuals to take their chances and drop coverage, while unhealthy individuals stayed. The increased risk made it unprofitable for some insurers and as a result, they stopped doing business in the state. Now, one insurer is a monopoly in the state and health insurance costs are higher than the national average. The mandates made more people eligible for health care, but now less people can afford it. Do you really think any additional “square peg in round hole” mandates are going to solve the problem? History suggests not.

The problem is that a free market system for individual health insurance doesn't exist in Maine. A free market is a business environment that has little artificial restrictions, allowing for market forces to efficiently dictate pricing and stimulates competition. Within the system there is a healthy relationship between financial risk and reward. With insurance; the higher the risk, the higher the premium expected (and the opportunity to not insure the risk if it is not worth taking that risk). When you mess with a free market system, bad things happen. And that's exactly what Maine's state government did. There is always a need for regulations and safeguards to a certain level, but they shouldn't interfere with a free market system. And yes, there should be a safety net to provide for those who can not afford health care, but this didn't happen. And Dirigo isn’t the answer. If it was designed to rein in health care, I’m not seeing it yet. The longer this boondoggle continues, the harder it will be to get rid of.

Next time we have a Blue Ribbon Commission, maybe they should examine how state interference has created higher health care costs. That’s something that I’m sure Augusta won’t be doing anytime soon.

Is an Immediate Annuity Right for You?

Often viewed as an archaic investment vehicle, immediate annuities deserve recognition. Like any financial tool, they aren’t for everybody. But in the right circumstances they can mean the difference between running out of money during your lifetime and having income for life.

An immediate annuity is an insurance contract that promises a set amount of payments for a certain time period. Payments can be over the lifetime of the annuitant or a fixed term; they can also be paid over joint life expectancies; the payments can be adjusted periodically with inflation. All these riders come with a cost that is in the form of a lower periodic payment. The way to view a immediate annuity is as a type of insurance policy; to protect against the risk of longevity and transferring the investment risk to the insurer. So if you buy a immediate lifetime annuity, you can live beyond 100 and the payments will still keep coming, reducing the risk that you deplete your lifetime savings.

The key here is that an immediate annuity can be used as a psychological tool to manage one’s risk tolerance. Immediate annuities in the simple form can be expected to produce a rate of return similar to a bond portfolio. But the value of the bond portfolio can rise and fall with interest rates. And there is re-purchasing risk where a bond or CD can mature at the low end of the interest rate cycle with the funds reinvested at a lower interest rate. By buying an immediate annuity, you are eliminating the re-purchasing risk. With the knowledge and comfort that they are going to get a guaranteed payment on a periodic basis, this allows some to take more risk in their portfolio as a whole.

With any financial vehicle, there come trade-off’s. And there are several negatives. The biggest risk with an immediate annuity is pre-mature death; once it’s gone there is nothing left to the estate. So essentially when you are transferring the risk, you also transfer the terminal principal. Also inflation is a consideration as the value of the guaranteed payment will lose it’s purchasing power over time. So what could of bought you a months worth of household expenses today may not do the same five or ten years from now. Some of a retiree’s larger expenses, leisure and travel in the early years, medical costs in the later years and potential long term care costs all are growing at rates 2%-3% above inflation. Now there are riders that you can attach to the annuity for spousal survivorship or a guaranteed fixed period if you die prematurely or inflation adjusted increases in the payment over time. The only problem is this becomes costly as inflation adjustments can reduce the payments for a 60 year old by 30%; survivorship clauses can reduce it another 10%-20%. Also a portion of the annuity is taxed as ordinary income, which eats away at the monthly payment. This is less efficient than capital gains or qualified dividend taxation at this time. Also with our tax structure, I expect that ordinary income tax rates will go higher rather than lower in the future. Also we are still on the low side of the long-term interest rate cycle. Buying a fixed immediate annuity today may not look so good down the line if we have a secular period of gradually increasing interest rates. You could buy several contracts over time, but sometimes this isn’t the most optimal solution. Finally, you lose flexibility once you buy the annuity, because you lose the opportunity to adjust that portion of the portfolio if needs change, if the portfolio needs to be rebalanced or if there is a tactical opportunity to enhance your risk adjusted return; once it’s done, you own it.

So when do immediate fixed annuities make sense? I like them in situations when:

-The investor is extremely risk averse and needs additional growth in the portfolio to meet their needs. For example, if the client would have left the money in a cash equivalent, the annuity may provide them with better return characteristics while allowing them to sleep soundly at night. Or if the comfort of a certain payment to cover their essential ongoing household cash flow needs today would make them more willing to invest in stock, which will provide the higher real returns take care of their long term needs or

-If the investor has a significant amount of funds to more than take care of their lifetime needs, the fixed immediate annuity is a good tool to provide funds to help keep them within a certain budget or offer an additional layer of diversification to the overall portfolio and……

-If the investor is not concerned about leaving an inheritance. So for the person who’s main goal is principal preservation, buying an annuity may be counterintuitive because they will give up their principal, but in turn it may increase their chances of not running out of money during their lifetime. For the conservative investor, it may be a nice diversifier within your portfolio allocation towards bonds.

In the end, something to consider. Just don’t confuse this with a variable annuity because that is a vehicle better off avoided in most cases.

Ramifications of a Dollar Decline

With the dollar recently hitting lows against many major currencies, I’ve seen a great deal of activity in the financial press on the subject. Recently I had the opportunity to comment about how investing in commodities would be attractive in a severe situation in a BusinessWeek article, Ways to Weather a Weaker Dollar by Marc Hogan.

Although currency issues are an extremely difficult to predict, personally I do believe that we are exiting a strong dollar environment to a more neutral dollar. What are the ramifications of a declining dollar? Earlier this year I wrote an entry on the subject and discussed the impact depending on the severity of the decline. Here is what I had to say back in January:

Ramifications of a Dollar Crash

Unless you run a business that is heavily reliant on international trade or if you live or travel overseas, currency issues don't really fly on most people's radar screens. But as time passes, more and more we are becoming a global society and the events of the world are affecting our daily lives. With that, I think everyone would want to hear what Bernard Lietaer has to say.

Lietaer is the author of The Future of Money and is one of the individuals credited for creating the Euro currency. He was the keynote speaker at the Financial Planning Associations Retreat in Tampa, Florida earlier this year. In his discussion, Lietaer discussed four mega-trends that will come about and need to be resolved over the next fifteen years. One was the aging population, another involved the global economy growing faster than job growth and technology taking up the slack, the third was the climate change and the loss of biodiversity.

But it was the last mega-trend that got the audience on the edge of their seats. He predicted that there was a 50% chance the dollar would collapse and that the U.S. government would take actions that would remove the dollar as the world's reserve currency, creating a vacuum in the global economy.

Leitaer cited several different factors that could influence this type of crash. The U.S. and its "twin deficits" involving our trade imbalance along with our federal budget deficit was an obvious issue. He also cited that the stability of the U.S. dollar is not in the hands of the U.S. Federal Reserve, but in foreign hands. He stated, "Every single working day, the world has to invest 2.8 billion dollars in the United States to keep the system going; that represents 80% of global savings." And as an example, he discussed how China with its billions of Treasury debt in reserves, could potentially use this as a bargaining chip to keep the world from interfering with its ongoing friction with separatist Taiwan; threatening to dump its reserves on the market and cause a crash. Leitaer also mentioned that back in the 70's, Kissinger made a pact with the royal family of Saudi Arabia to make the global oil trade denominated only in dollars. No matter if you were China, France, or Japan, if you want to buy oil you have to do this in dollars. He warned, "This cannot go on forever" because of the potential for regime change and waning influence of Saudi Arabia on the other OPEC nations. Finally, the world could simply lose faith in the U.S. economy. As a result of the crash, he predicted the U.S. would experience a large decrease in consumption, a potentially higher income tax structure, and much higher interest rates.

Now personally, I'm always a bit of a skeptic when it comes to "doom and gloom" scenarios. I feel that most catastrophic economic crisis arise from things that aren't anticipated. But as a financial planner, my responsibility does entail contingency planning and how these contingencies could affect my client's livelihoods and portfolios. What would happen if we actually experienced a "dollar crash"? I'll discuss this later this week. Earlier this week, I discussed what Bernard Lietaer theorized could cause a crash in the U.S. dollar. What would happen if the dollar did actually plunge in value? I think there are several paths that this can take:

The Soft Landing: This scenario doesn't involve any dramatic drop off in the dollar; rather the dollar would slowly depreciate to a more balanced level. Imported goods (particularly from the Far East) would be more costly for us to purchase. Meanwhile our export economy would slowly revitalize since our goods will become cheaper and be more in demand with the increased wealth that the people living in developing nations are beginning to experience. Our trade balance would slowly disappear and higher tax revenues would rebalance the deficit. The threat of outsourcing would slowly turn around. The domestic stock market would appreciate as a result, in particular large multinational corporations and those within the manufacturing sector. Smaller (non-multinational) foreign stocks would also do well along with bonds denominated in foreign currency. Larger, dollar reliant multi-national foreign companies wouldn't fare as well.

The Hard Landing: This would happen when one event creates a chain of events, leading to panic and crash in the financial markets. For instance, a geopolitical event such as China invading Taiwan could trigger this. Or sudden changes in the market makes a hedge fund go under; leaving exponential obligations and a huge sell off of assets around the world to fill the gap. Commodities, long term interest rates, and inflation would take off. Ironically, the rust belt would come alive and become a boom area of the country with its cheap manufacturing capability and attractive asset prices to overseas buyers. The domestic stock market would crash along with the housing market. Seeking safety, short term debt and money market accounts would be earning close to nothing. Foreign stocks and foreign denominated bonds would do exceptionally well in light of the immediate event. Eventually, the results will be the same within the soft landing, but this scenario would be accompanied by more extreme market conditions, panic, capitulation and pain that would amplify the situation.

Worst Case: This is what Lietaur suggested. This is where the U.S. government takes action that creates artificial market conditions with regulations and reneges on its obligations to its debt holders around the world. Essentially there would be two dollar's, a foreign and a domestic dollar. It would spark a new era of global protectionalism and currency restriction. The global economy and financial markets would in a prolonged recession or depression and the U.S. would experience higher interest rates, deficits, taxes, and the real estate market would bust. Wal-Mart wouldn't have anything on their shelves because all the foreign goods would be too expensive to buy.

Overall, the export nations of the Far East will continue to buy our Treasuries as long as they see their return on investment (in the form of jobs and economic growth) exceed the cost of holding these bonds at historically low yields. Remember, they have a vested interest in keeping their export machines going. Eventually the economic disparity will have to rebalance with the dollar depreciating. But barring any irrational event, the soft landing is what I expect and hope for. Now, I wouldn't go to extremes and start storing gold bars in your basement. By conducting a scenario analysis such as this, it at least allows you to be ready if the unexpected happens. And it allows you to approach things in a rational manner. But this analysis does shed light on the importance of having an investment strategy that is global in nature.

Quick Tip: Congress Extends Tax Breaks

Earlier this fall, I wrote an entry indicating that three tax deductions were set to expire unless Congress acted. These breaks were:

1.) Deduction for tuition

2.) Deduction for teachers who buy classroom materials

3.) Deduction for state and local sales taxes

Early Saturday morning, the lame duck Congress approved measures to extend these breaks which are expected to be approved by President Bush. If passed, for those who could benefit from these deductions, just be aware that the IRS will now have to update the printing of the 2006 tax forms to reflect the changes. So you may have to wait until the updated form is printed and available and/or updated in your tax software program. Once these forms become available, the quickest way to get the updated tax form will be going to the IRS website.

Real Estate Revisited: What I Said in May of '05

Recently I was at a networking function where I was talking to someone who was trying to sell their home. When they originally bought the house, they didn’t necessary like it. But they figured that they would turn around and “flip” the house for a nice tidy profit. Now the house has been on the market for just under a year and they are worried that they won’t be able to afford the monthly mortgage payment once the interest rate on their adjustable rate mortgage is re-priced.

The Federal Reserve dried up a lot of the cheap money by raising interest rates; ending a lot of irrational speculation that was going on in the real estate market. Unfortunately it took a few victims along with it like the people I discussed above. But the real estate bubble didn’t come without warning. This is one of my original entries that I made in May of 2005. Although I see some of what I discussed already in process, I still believe that the person considering or involved with real estate still can find value in what I had to say back then:

Are We In a Real Estate Bubble?

It always works like clockwork. Whenever there is a euphoria, mania, or bubble about a certain investment class, I get a lot of inquires about it. Real estate appears to be the heir apparent to technology and questions such as "do you know any good tech names" have been replaced with "what do you think about buying rental property". With the allure of low mortgage rates, homes in Maine appreciated 12% in 2004 and this has been an ongoing trend for the past several years. Real estate in other areas of the country have appreciated even more. For instance, the Gulf Coast of Florida experienced a 40% increase in home values over the past year alone. With prices rising beyond the historical norm, it would suggest that we are in bubble territory.

How will this pan itself out? Robert Shiller has some ideas concerning this. Shiller who wrote the book Irrational Exuberance; accurately predicting the stock market bubble of the late 90's is currently writing a new book arguing that real estate is now on the bubble. His rationale is that home prices have increased beyond historical proportions. This coupled with unfounded consumer optimism for future returns has created this environment. He predicts a gradual process that will look nothing like the stock market a few years back. When rates rise and the economy stalls, there will be fewer buyers and those buyers will be bargain hunters. Homeowners will be more and more reluctant to sell at bargain bids since they are holding on to mortgages with low interest rates. Supply and demand will work itself out where real estate values gradually deflate in a slow ongoing fashion for a long period of time.

How do you protect yourself? First I suggest that you shouldn't panic. Bubbles usually take longer than expected to run their course so there is no need to make any rash decisions, especially if it is in the manner that Shiller suggests.

Second, it really depends on your situation. If you are a current homeowner and don't plan on selling your home anytime in the near future, don't worry about it. A home is a "use asset", a basic necessity, not an investment. Over the past few years I've heard the mantra of people bragging about how much their home has increased in value. If you sold, where are you going to go? Few people will be willing to move far away from where they currently live, downsize to a smaller home, or are willing to go back to renting. Also, people tend to fail to factor in all the costs to buy, finance, maintain, improve, and pay real estate taxes; not to mention the sweat equity, potential income tax, and costs if they ever sold. If you factor these costs in, it is not as much of a windfall as originally thought. If you are planning on downsizing to a smaller home, it may make more sense to do it sooner rather than later. This also may apply if you currently have a home in an overheated area and plan on moving to an area where the market hasn't risen as dramatically. In the end, needs should dictate your actions.

If you are shopping for a new home, you really need to determine if it makes economic sense to buy at this time. Renting does have its advantages in some ways as you don't incur closing costs, repairs, maintenance, real estate taxes, and renters insurance is cheaper than homeowners insurance. Home ownership is a great qualitative issue that provides peace of mind. But if buying is really unaffordable, it is not worth the risk to your financial health. For those that who do buy a home, it would probably be best to find property that appears to be good value such as the more modest home in the better neighborhood. I would also avoid the areas that have appreciated beyond the average over the past few years.

For those who are interested in directly owning rental property; buyers beware. Buying rental property is especially attractive now with the allure of investing little money down coupled with the large gains in value over the past few years. With prices on the rise, anyone buying rental property now is more likely to get a lower return on their investment. If property prices do gradually decline, this means that their returns will need to come from net rental income, not appreciation. Second, along with rental ownership comes the headaches associated with it. Ongoing management and maintenance requires time and money. Add tenant problems and the effort may not be worth the hassle if you are not doing this as your full time job. If you really want ownership in real estate, buy a real estate investment trust (REIT) or mutual fund that invests in REIT's. REIT's trade like stocks, usually own a diversified pool of different real estate holdings in a specific sector, and are required to pay out 90% of their income as a dividend annually. In return, you can get cash flow, professional management, and a lot less headaches. This option may be a more attractive than direct ownership.

For those who work directly in the housing market with finance, construction, and real estate; Shiller felt that these industries and its employees would be exposed. All of these industries have benefited and grown over the past several years, but it may be reaching the peak of its cycle. For those employed in these industries, this means that you should evaluate your plans and if you are going to stick it out for the long haul. If so, appropriately plan for these contingencies and don't over-leverage yourself whether done personally or with your business.

Finally, individuals should really be watching their use of home equity. If you are using your home equity for appreciating assets, such as improving the home or for college education, that's appropriate. If you are using home equity for buying a boat or taking a vacation, you are taking a higher level of risk as your home is the asset securing the loan. If you lose your job and have an auto loan where you fail to make the payments, you lose your auto. If you have a home equity loan and you can't make the payments, you can lose your house.

I'm sure that there are a few individuals that dismiss my thoughts. I can only say that over the past, investments that appeared to be the rational choice at the time didn't necessarily produce as advertised. In the late 70's it was gold, in the late 80's it was Japan, and in the late 90's it was technology. Is real estate the rational alternative now?