November 2013 Newsletter

2013 Year-End Tax Planning Considerations

As the end of the 2013 tax year approaches, set aside some time to evaluate your situation. Here are some things to keep in mind as you consider potential year-end tax moves.
1. The tax landscape has changed for higher-income individuals
This year a new 39.6% federal income tax rate applies if your taxable income exceeds $400,000 ($450,000 if you’re married and file a joint return, $225,000 if you’re married and file separately). If your income crosses that threshold, you’ll also be subject to a new 20% maximum tax rate on long-term capital gains and qualifying dividends (last year, the maximum rate that applied was 15%).  That’s not all–you could see a difference even if your income doesn’t reach that level. That’s because if your adjusted gross income is more than $250,000 ($300,000 if you’re married and file a joint return, $150,000 if you’re married and file separately), your personal and dependency exemptions may be phased out this year, and your itemized deductions may be limited.
2. New Medicare taxes apply
Two new Medicare taxes apply this year. If your wages exceed $200,000 this year ($250,000 if you’re married and file a joint return, $125,000 if you’re married and file separately), the hospital insurance (HI) portion of the payroll tax–commonly referred to as the Medicare portion–is increased by 0.9%. Also, a 3.8% Medicare
contribution tax generally applies to some or all of your net investment income if your modified adjusted gross income exceeds those dollar thresholds.
3. Don’t forget the basics–retirement plan contributions
Make sure that you’re taking full advantage of tax-advantaged retirement savings vehicles.  Traditional IRAs (assuming that you qualify to make deductible contributions) and employer-sponsored retirement plans such as 401(k) plans allow you to contribute funds pretax, reducing your 2013 income. Contributions that you make to a Roth IRA (assuming you meet the income requirements) or a Roth 401(k) plan are made with after-tax dollars, but qualified Roth distributions are completely free from federal income tax. For 2013, you can contribute up to $17,500 to a 401(k) plan ($23,000 if you’re age 50 or older), and up to $5,500 to a traditional or Roth IRA ($6,500 if you’re age 50 or older). The window to make 2013 contributions to an employer plan typically closes at the end of the year, while you generally have until the due date of your federal income tax return to make 2013 IRA contributions.
4. Expiring provisions
A number of key provisions are scheduled to expire at the end of 2013, including:

• Increased Internal Revenue Code Section 179 expense limits and “bonus” depreciation provisions end.
• The increased (100%) exclusion of capital gain from the sale or exchange of qualified small business stock (provided certain requirements, including a five-year holding period, are met) will not apply to qualified small business stock issued and acquired after 2013.
• This will be the last year that you’ll be able to make qualified charitable distributions (QCDs) of up to $100,000 from an IRA directly to a qualified charity if you’re 70½ or older; such distributions may be excluded from income and count toward satisfying any required minimum distributions (RMDs) you would otherwise have to receive from your IRA in 2013.
• The above-the-line deductions for qualified higher education expenses, and for up to $250 of out-of-pocket classroom expenses paid by education professionals, will not be available starting with the 2014 tax year.
• This will also be the last year you’ll be able to elect to deduct state and local sales tax in lieu of state and local income tax if you itemize deductions.

Buckets of Money: A Retirement Income Strategy
Some retirees are able to live solely on the earnings that their investment portfolios produce, but most also have to figure out how to draw down their principal over time. Even if you’ve calculated how much you can withdraw from your savings each year, market volatility can present a special challenge when you know you’ll need that nest egg to supply income for many years to come.
When you were saving for retirement, you may have pursued an asset allocation strategy that  balanced your needs for growth, income, and safety. You can take a similar multi-pronged approach to turning your nest egg into ongoing income. One way to do this is sometimes called the “bucket” strategy. This involves creating multiple pools of money; each pool, or “bucket,” s invested depending on when you’ll need the money, and may have its own asset allocation.
Buckets for your “bucket list”

When you’re retired, your top priority is to make sure you have enough money to pay your bills, including a few unexpected expenses. That’s money you need to be able to access easily and reliably, without worrying about whether the money will be there when you need it. Estimate your expenses over the next one to five years and set aside that total amount as your first “bucket.” Safety is your priority for this money, so it would generally be invested in extremely conservative investments, such as bank certificates of deposit, Treasury bills, a money market fund, or maybe even a short-term bond fund. You won’t earn much if any income on this money, but you’re unlikely to suffer much oss, either, and earnings aren’t the purpose of your first bucket. Your circumstances will determine the investment mix and the number of years it’s designed to supply; for example, some people prefer to set aside only two or three years of living expenses.
This bucket can give you some peace of mind during periods of market volatility, since it might help reduce the need to sell investments at an inopportune time. However, remember that unlike a bank account or Treasury bill, a money market fund is neither insured nor guaranteed by the Federal Deposit Insurance Corp.; a money market attempts to maintain a stable $1 per share price, but there is no guarantee it will always do so. And though a short-term bond fund’s value is relatively
stable compared to many other funds, it may still fluctuate.
Refilling the bucket

As this first bucket is depleted over time, it must be replenished. This is the purpose of your second bucket, which is designed to produce income that can replace what you take from the first. This bucket has a longer time horizon than your first bucket, which may allow you to take on somewhat more risk in pursuing the potential for higher returns. With interest rates at historic lows, you might need some combination of fixed-income investments, such as intermediate-term bonds or an income annuity, and other instruments that also offer income potential, such as dividend-paying stocks.

With your first bucket, the damage inflation can do is limited, since your time frame is fairly short. However, your second bucket must take inflation into account. It has to be able to replace the money you take out of your first bucket, plus cover any cost increases caused by inflation. To do that, you may need to take on somewhat more risk. The value of this bucket is likely to fluctuate more than that of the first bucket, but since it has a longer time horizon, you may have more flexibility to adjust to any market surprises.
Going back to the well
The primary function of your third bucket is to provide long-term growth that will enable you to keep refilling the first two. The longer you expect to live, the more you need to think about inflation; without a growth component in your portfolio, you may be shortening your nest egg’s life span. To fight the long-term effects of inflation, you’ll need investments that may see price swings but that offer the most potential to increase the value of your overall portfolio.  You’ll want this money to grow enough to not only combat inflation but also to increase your portfolio’s chances of lasting as long as you need it to. And if you hope to leave an estate for your heirs, this bucket could help you provide it.
How many buckets do I need?

This is only one example of a bucket strategy. You might prefer to have only two buckets–one for living expenses, the other to replenish it–or other buckets to address specific goals. Can you accomplish the same results without designating buckets? Probably. But a bucket approach helps clarify the various needs that your retirement portfolio must fill, and how various specific investments can address them. Note: Before investing in a mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing.


All in the Family: Transferring a Business to Your Children

You’ve spent years building a family business that’s a source of pride and income for both you and your family, and now you may be thinking of handing over the reins to your children. If so, consider that transferring your business interest to your children may have income, gift, and estate tax consequences. Careful planning can
help prevent the need to sell some (or all) of the business assets to pay those taxes.  Some common strategies for minimizing taxes are discussed briefly below. Remember, however, that none of these strategies are without drawbacks. Before you act, consult a tax professional as well as your estate planning attorney.
Gifting or bequeathing your interest outright

If you don’t need continued income from the business and you don’t want to retain some control, you can simply give the business to your children outright. For example, you can begin a systematic program of making annual gifts to your children in amounts that equal the annual gift tax exclusion ($14,000 per year per recipient in 2013). By transferring your interest in this manner, you may be able to transfer all or a significant portion of the business free from federal gift tax (although these transfers may still be subject to state gift tax). The disadvantage here is the amount of time that may be needed to transfer your entire interest.

If you can wait and transfer your business at your death, Section 6166 of the Internal Revenue Code allows any estate taxes incurred because of the inclusion of your family business in your estate to be deferred for 5 years (with interest-only payments for the first 4 years), and then paid in annual installments of interest and principal over a period of up to 10 years. This will allow your beneficiaries more time to raise sufficient funds to pay the taxes or obtain more favorable interest rates if they need to borrow the money. Be aware that the business must exceed 35% of your gross estate and other requirements must be met.

Selling your interest outright

If you need income from your business, you can sell your business interest (for full fair market value) to your children. This will avoid gift and estate taxes, but you may owe capital gains tax.

Using a buy-sell agreement

If you want to sell your business interest to your children but retain control over the business for a period of time, consider using a buy-sell agreement. This is a legal contract that states that the sale will happen when a specific event occurs, such as your retirement, disability, divorce, or death. When the triggering event occurs,
the children will be obligated to buy your interest from you or your estate. The price and sale terms will have been predetermined by the contract. Remember, however, that you will be bound under a buy-sell agreement: you won’t be able to sell or give your business to anyone except the buyers named in the agreement (unless they consent).

Using a grantor retained annuity trust (GRAT)

A GRAT is a trust into which you transfer your business interest, and from which you receive income for a period of time. The value of the gift is determined using the IRS’s current interest rate (published monthly by the IRS). The trust must terminate at a specified time (e.g., 10 years). You receive annuity payments during
the term of the trust, and at the end, your children will receive the business. If the business has appreciated beyond the IRS’s interest rate, the excess can pass tax free. Be aware, however, that if you die during the GRAT term, your entire business interest will be included in your gross estate for federal estate tax purposes. You will have failed to transfer your business interest and lost the tax advantages of the GRAT. Plus, you will have incurred the costs of creating and maintaining the GRAT for
nothing. For these reasons, be sure to structure your GRAT carefully.

Creating a family limited partnership (FLP)

An FLP is a type of business entity. First, you establish a partnership with both general and limited partnership interests. Then, you transfer the business to this partnership. You retain the general partnership interest for yourself, allowing you to maintain control over the day-to-day operation of the business. Over
time, you gift the limited partnership interests to your children, leveraging your lifetime gift tax exemption and the annual gift tax exclusion. You also save taxes because the value of the gifts may be eligible for valuation discounts, such as the minority interest and lack of marketability discounts.  With a grantor retained
annuity trust (GRAT), you receive a fixed dollar amount that does not change even if the value of the trust property (corpus) increases or decreases. Some other types of trusts are a grantor retained unitrust (GRUT) and a rolling or cascading GRAT.  A GRUT allows you to retain the right to receive a fixed percentage of the trust corpus (determined annually), while a rolling or cascading GRAT is a technique that involves creating a series of short-term GRATs (typically two or three years) with each successive GRAT being funded by the annuity payments from the previous ones. This technique can minimize the risk of the grantor dying during the GRAT term, and can also minimize interest rate risk.

What is asset allocation?
Each type of investment has specific strengths and weaknesses that enable it to play a specific role in your overall investing strategy. Some investments may offer growth potential. Others may provide regular income or relative safety, or simply serve as a temporary place to park your money. And some investments may even serve to fill more than one role. Because you likely have multiple needs and desires, you probably need some combination of investment types, or asset classes.
Balancing how much of each asset class should be included in your portfolio is a critical task. That balance between growth, income, and safety is called your asset allocation, and it can help you manage the level and types of risks you face.  The combination of investments you choose can be as important as your specific investments. Your mix of various asset classes, such as stocks, bonds, and cash alternatives, generally accounts for most of the ups and downs of your portfolio’s returns.  Ideally, your portfolio should have an overall combination of investments that minimizes the risk you take in trying to achieve a targeted rate of return. This often means balancing more conservative investments against others that are designed to provide a higher potential return but that also involve more risk. However, asset allocation doesn’t guarantee a profit or eliminate the possibility of investment losses.  Someone living on a fixed income, whose priority is having a regular stream of money coming in, will probably need a very different asset allocation than a young, well-to-do working professional whose priority is saving for a retirement that’s 30 years away. Even if two people are the same age and have similar incomes, they may have very different needs and goals, and your asset allocation should be tailored to your unique circumstances.  And remember, even if your asset allocation was right for you when you chose it, it may not be right for you now. It should change as your circumstances do and as new ways to invest are introduced. A piece of clothing you wore 10 years ago may not fit now; you just might need to update your asset allocation, too.

What return are you really earning on your money?
If you’re like most people, you probably want to know what return you might expect before you invest. But to translate a given rate of return into actual income or growth potential, you’ll need to understand the difference between nominal return and real return, and how that difference can affect your ability to achieve financial goals. Let’s say you have a certificate of deposit (CD) that’s about to expire. The yield on the new five-year CD you’re considering is 1.5%. It’s not great, you think, but it’s better than the 0.85% offered by a five-year Treasury note.* But that 1.5% is the CD’s nominal rate of return; it doesn’t account for inflation or taxes. If  you’re taxed at the 28% federal income tax rate, roughly 0.42% of that 1.5% will be gobbled up by federal taxes on the interest. Okay, you say, that still leaves an interest rate of 1.08%; at least you’re earning something.  However, you’ve also got to consider the purchasing power of the interest that the CD pays. Even  though inflation is relatively low today, it can still affect your purchasing power, especially over time. Consumer prices have gone up by roughly 1% over the past year.**  Adjust your 1.08% after-tax return for inflation, and suddenly you’re barely breaking even on your investment.  What’s left after the impact of inflation and taxes is called your real return, because that’s what you’re really earning in actual purchasing power. If the nominal return on an investment is low enough, the real return can actually be negative, depending on your tax bracket and the inflation rate over time. Though this hypothetical example doesn’t represent the performance of any actual investment, it illustrates the importance of understanding what you’re really earning.
In some cases, the security an investment offers may be important enough that you’re essentially willing to pay someone to keep your money safe. For example, Treasury yields have sometimes been negative when people worried more about protecting their principal than about their real return.  However, you should understand the cost of such a decision.

*Source: Department of the Treasury Resource
Center ( as of April 2013.
**Source: Bureau of Labor Statistics, Consumer
Price Index as of April 2013.



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