October 2013 Newsletter

Plan Now for a Year-End Investment Review:

You might not enjoy sitting down to do year-end investment planning, but at least this fall you can make plans with greater certainty. For the last three years, investment planning has meant trying to anticipate possible changes in tax law; for tax year 2013 and beyond, you know for sure how income, capital gains, and qualifying dividends will be taxed. That gives you an opportunity to fine-tune your long-term planning, or to develop a plan if you’ve postponed doing so. Here are some factors to keep in mind as the year winds down.

Consider harvesting your losses

With tax rates settled, the question of whether to sell losing positions to generate capital losses that can potentially be used to offset capital gains or $3,000 of your ordinary income becomes a much more straightforward decision. That process is known as harvesting tax losses, and it could prove especially worth considering this year. The first half of the year produced strong gains for U.S. equities; even a mediocre second half could still have the potential to leave you with a higher tax bill than you had anticipated.

To maximize your losses for tax purposes, you would sell shares that have lost the most, which would enable you to offset more gains. Unless you specify which shares of stock are to besold, your broker will typically treat them as sold based on the FIFO (first in, first out) method, meaning that the first shares bought are considered to be the first shares sold. However, you can designate specific shares as the ones sold or direct your broker to use a different method, such as LIFO (last in, first out) or highest in, first out.

Interest rates: bane or blessing?

The Federal Reserve has said that if the economy continues to recover at its expected pace, it could raise its target Fed funds rate sometime in 2014. However, investors have been anticipating such an increase since early summer, when many bond mutual funds began seeing strong outflows from investors concerned that a rate increase could hurt the value of their holdings. As any consumer knows, lower demand for a product often means lower prices. And since bond prices move in the opposite direction from bond yields, yields on a variety of fixed-income investments have begun to rise. However, there also could be a silver lining for some investors. Higher yields could provide welcome relief for individuals who rely on their investments for income and have suffered from rock-bottom yields.

The Fed has said any rate decisions will depend on future economic data. However, now might be a good time to assess the value of any fixed-income investments you hold, and make sure you understand how your portfolio might respond to a future that could include higher interest rates. Many investors’ asset allocation strategies were likely developed when conditions generally favored bonds, as they have for much of the last 20 years. Though asset allocation alone can’t guarantee a profit or prevent the possibility of loss, make sure your asset allocation is still appropriate for your circumstances as well as the current investing climate. And don’t forget that other financial assets can be affected by potential future interest rate changes as well.

Calculating cost basis for fixed-income investments

The IRS had originally planned to require brokers to begin reporting the cost basis for any sales of bonds and options this year, as it already does for stocks and mutual funds. It has now postponed implementation of the requirements for bonds until January 1, 2014 to give financial institutions more time to test their reporting systems. However, don’t throw away your old records yet, especially if you’re considering selling any of your bond holdings. The cost basis reporting requirements will apply only to bond purchases and options granted or acquired on or after January 1, 2014, so you’ll still be responsible for calculating your cost basis for any bonds or options acquired before that date.

Estate Planning and Income Tax Basis

Income tax basis can be important when deciding whether to make gifts now or transfer property at your death. This is because the income tax basis of the person receiving the property depends on whether the transfer is by gift or at death. This, in turn, affects the amount of taxable gain subject to income tax when the person sells the property.

What is income tax basis?

Income tax basis is the base figure you use when determining whether you have recognized capital gain or loss on the sale of property for income tax purposes. (Gain or loss on the sale of property equals the difference between your adjusted tax basis and the amount you realize upon the sale of the property.) When you purchase property, your basis is generally equal to the purchase price. However, there may be some adjustments made to basis.

What is the income tax basis for property you receive by gift?

When you receive a gift, you generally take the donor’s basis in the property. (This is often referred to as a “carryover” or “transferred” basis.) The carried-over basis is increased–but not above fair market value (FMV)–by any gift tax paid that is attributable to appreciation in value of the gift (appreciation is equal to the excess of FMV over the donor’s basis in the gift immediately before the gift). However, for purpose of determining loss on a subsequent sale, the carried-over basis cannot exceed the FMV of the property at the time of the gift.


Say your father gives you stock worth $1,000. He purchased the stock for $500. Assume the gift incurs no gift tax. Your basis in the stock, for the purpose of determining gain on the sale of the stock, is $500. If you sold the stock for $1,000, you would have gain of $500 ($1,000 received minus $500 basis).

Now assume that the stock is only worth $200 at the time of the gift and you sell it for $200. Your basis in the stock, for purpose of determining gain on the sale of the stock, is still $500; but your basis for purpose of determining loss is $200. You do not pay tax on the sale of the stock. You do not recognize a loss either. In this case, your father should have sold the stock (and recognized the loss of $300–his basis of $500 minus $200 received) and then transferred the sales proceeds to you as a gift. (You are not permitted to transfer losses.)

What is the income tax basis for property you inherit?

When you inherit property, you generally receive an initial basis in property equal to the property’s FMV. The FMV is established on the date of death or on an alternate valuation date six months after death. This is often referred to as a “stepped-up basis,” since basis is typically stepped up to FMV. However, basis can also be “stepped down” to FMV.


Say your mother leaves you stock worth $1,000 at her death. She purchased the stock for $500. Your basis in the stock is a stepped-up basis of $1,000. If you sold the stock for $1,000, you would have no gain ($1,000 received minus $1,000 basis).

Now assume that the stock is only worth $200 at the time of your mother’s death. Your basis in the stock is a stepped-down basis of $200. If you sold the stock for more than $200, you would have gain.

Make gift now or transfer at death?

As the following example shows, income tax basis can be important when deciding whether to make gifts now or transfer property at your death.


You purchased land for $25,000. It is now worth $250,000. You give the property to your child (assume the gift incurs no gift tax), who then has a tax basis of $25,000. If your child sells the land for $250,000, your child would have taxable gain of $225,000 ($250,000 sales proceeds minus $25,000 basis).

If, instead, you kept the land and transferred it to your child at your death when the land is worth $250,000, your child would have a tax basis of $250,000. If your child sells the land for $250,000, your child would have no taxable gain ($250,000 sales proceeds minus $250,000 basis).

In addition to income tax basis, you might consider the following questions:

• Will making gifts reduce your combined gift and estate taxes? For example, future appreciation on gifted property is removed from your gross estate for federal estate tax purposes.

• Does the recipient need a gift now or can it wait? How long would a recipient have to wait until your death?

• What are the marginal income tax rates of you and the recipient?

• Do you have other property or cash that you could give?

• Can you afford to make a gift now?

Is College Debt the Next Bubble?

What might a 23-year-old recent college graduate, a 45-year-old entrepreneur, and a 60-year-old pre-retiree have in common financially? They may all be hobbled by student loan debt. According to financial aid expert Mark Kantrowitz, the student loan “debt clock” reached the $1 trillion milestone last year.  1  And even as Americans have reduced their credit card debt over the past few years, student loan debt has continued to climb–both for students and for parents borrowing on their behalf.

A perfect storm

The last few years have stirred up the perfect storm for student loan debt: soaring college costs, stagnating incomes, declining home values, rising unemployment (particularly for young adults), and increasing exhortations about the importance of a college degree–all of which have led to an increase in borrowing to pay for college. According to the Federal Reserve Bank of New York, as of 2011, there were approximately 37 million student loan borrowers with outstanding loans. 2  And from 2004 through 2012, the number of student loan borrowers increased by 70%. 3 With total costs at four-year private colleges pushing $250,000, the maximum borrowing limit for dependent undergraduate students of $31,000 for federal Stafford Loans (the most popular type of federal student loan) hardly makes a dent, leading many families to turn to additional borrowing, most commonly: (1) private student loans, which parents typically must cosign, leaving them on the hook later if their child can’t repay; and/or (2) federal PLUS Loans, where parents with good credit histories can generally borrow the full remaining cost of their child’s undergraduate education from Uncle Sam.

The ripple effect

The implications of student loan debt are ominous–both for students and the economy as a whole. Students who borrow too much are often forced to delay life events that traditionally have marked the transition into adulthood, such as living on their own, getting married, and having children. According to the U.S. Census Bureau, there has been a marked increase in the number of young adults between the ages of 25 and 34 living at home with their parents–19% of men and 10% of women in 2011 (up from 14% and 8%, respectively, in 2005). This demographic group often finds themselves trapped: with a greater percentage of their salary going to student loan payments, many young adults are unable to amass a down payment for a home or even qualify for a mortgage.

And it’s not just young people who are having problems managing their student loan debt. Borrowers who extended their student loan payments beyond the traditional 10-year repayment period, postponed their loans through repeated deferments, or took out more loans to attend graduate school may discover that their student loans are now competing with the need to save for their own children’s college education. And parents who cosigned private student loans and/or took out federal PLUS Loans to help pay for their children’s education may find themselves saddled with education debt just as they reach their retirement years.

There’s evidence that major cracks are starting to appear. According to the Federal Reserve Bank of New York, as of 2012, 17% of the 37 million student loan borrowers with outstanding balances had loans at least 90 days past due–the official definition of “delinquent.” 5 Unfortunately, student loan debt is the only type of consumer debt that generally can’t be discharged in bankruptcy, and in a classic catch-22, defaulting on a student loan can ruin a borrower’s credit–and chances of landing a job.

Tools to help

The federal government has made a big push in recent years to help families research college costs and borrowers repay student loans. For example, net price calculators, which give students an estimate of how much grant aid they’ll likely be eligible for based on their individual financial and academic profiles, are now required on all college websites. The government also expanded its income-based repayment (IBR) program last year for federal student loans (called Pay As You Earn)–monthly payments are now limited to 10% of a borrower’s discretionary income, and all debt is generally forgiven after 20 years of on-time payments. (Private student loans don’t have an equivalent repayment option.)

Families are taking a much more active role, too. Increasingly, they are researching majors, job prospects, and salary ranges, as well as comparing out-of-pocket costs and job placement results at different schools to determine a college’s return on investment (ROI). For example, parents might find that, with similar majors and job placement success but widely disparate costs, State U has a better ROI than Private U. At the end of the day, it’s up to parents to make sure that their children–and they–don’t borrow too much for college. Otherwise, they may find themselves living under a big, black cloud.

Will interest rates rise this year?

The Fed hasn’t yet raised its target interest rate from less than 0.25%, and it has promised not to do so before unemployment reaches roughly 6.5%, which it doesn’t expect to happen until next year. However, some interest rates have already begun to go up. For example, according to Freddie Mac, the average interest rate on a 30-year fixed-rate mortgage shot above 4% last June for the first time since late 2011, hitting its highest level in almost 2 years. In the same month, the yield on the 10-year Treasury bond went above 2.5% for the first time since August 2011.

Why are interest rates rising even though the Fed’s target rate hasn’t? Because bond investors are concerned that higher interest rates in the future will hurt the value of bonds that pay today’s lower rates. Immediately after the Fed’s June announcement, investors began pulling money out of bond mutual funds in droves, reversing a multiyear trend. If there’s less demand for bonds, yields have to rise to attract investors.

Aside from bonds, why are investors concerned about a possible Fed rate hike? Bonds aren’t the only financial asset that can be affected by potential future interest rate changes. Dividend-paying stocks with hefty yields have benefitted in recent years; more competitive bond yields could start to reverse that dynamic. Shares of preferred stock typically behave much like those of bonds, since their dividend payments also are fixed; their values could be affected as well.

Also, higher mortgage rates could potentially slow the housing market recovery, though historically they remain at relatively low levels. And if a Fed rate increase were to bring on higher interest rates abroad, that could create even more problems in countries already struggling with sovereign debt–problems that have provoked global market volatility in the past.

The Fed has said any hikes in its target rate will occur only if the economy seems strong enough. If higher rates seem likely to halt the recovery, the Fed could postpone a rate hike even longer. It also will take other measures before raising rates. Even though the timing and size of any Fed action is uncertain, it’s best to be aware of its potential impact.



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