Equity Investment Outlook

I have reproduced for you below one from Osterweis Capital Management which is very much in alignment with our thinking for the coming year.  It’s somewhat lengthy but worth the read if you are so inclined.

Beginning in early March 2009, the stock market staged a powerful rally.  As a result, the market rose 26.5% for the year, as measured by the total return of the S&P 500 Index.  From its March low, the total return of the S&P 500 was 67.8%.  Despite this impressive gain, the market had a cumulative loss of 24.9% from its October 2007 high.

Moreover, returns for the decade ended 12/31/09 were extremely disappointing.  For that period, cumulative total return for the S&P 500 was -9.1%, making the decade from 12/31/99 to 12/31/09 the single worst decade in nearly 200 years!

Obviously a good deal of the decade’s under-performance can be explained by the fact that it suffered a three year bear market at the beginning (2000 – 2002) and another vicious bear market in 2008 and early 2009.  The first bear was a reaction to the high-tech bubble of the 1990s and the second a reaction to the recent housing bubble and orgy of wanton credit.

Note that while stocks did poorly, bonds performed rather well.  We have written extensively about both the tech and housing manias and their subsequent panics, so we won’t dwell on them here.  We do, however, want to make the assertion that following such a disastrous decade, stocks may do reasonably well going forward.

Equity valuations today are reasonable, but not dirt cheap.  The price/earnings (P/E) ratio on forward earnings is around 15x which is roughly in line with its long-term average.  Given the fact that interest rates are unusually low now, and could rise over the next few years, we believe it is unlikely that P/E ratios will expand much if at all.  Therefore, stock market returns may be driven by earnings growth and dividend pay outs.  Earnings growth could be in the mid-single digits over the next three to five years, and the dividend yield should approximate 2%.  If these conditions come to pass, we believe stocks could potentially generate a total return of 7% to 8% over the next three to five years.  While this is not a spectacular return, it would be acceptable in a low inflation environment.

Economic Outlook

The outlook for the economy is clouded by several factors related to the housing bubble and its aftermath.  Although economists debate about the strength of further recovery, most observers believe the economy began to recover in the third quarter of 2009 and may be poised for further gains.  We are squarely in the camp that forecasts a weaker than average rebound.  Our thoughts on this subject are little changed from what they were three and six months ago.

Consumer spending, which accounts for about 70% of GDP, cannot rebound strongly if unemployment continues to hover around 10% and then only slowly improves.  Consumers took on too much debt over the past decade and now need to rebuild their balance sheets.  As a result, the savings rate has risen from less than 1% in early 2005 to just under 5% today, further detracting from consumer spending.

Some 23% of all mortgages in this country are underwater.  While house prices have recently showed signs of stabilizing they are not likely to rise sharply.  In fact many analysts are expecting another wave of foreclosures which would dump a new supply of houses on the market further depressing housing prices.

Despite the best efforts of the government to create liquidity and stimulate the economy, banks are reluctant to lend.  They are more concerned with rebuilding their own balance sheet strength and still face a mountain of rotting credit card and commercial real estate loans.  Hardest hit are the local and regional banks, many of which are expected to fail over the next 12 to 24 months.  As a result, credit for consumers and small businesses remains severely constrained.

State and local budgets are in shambles, resulting in spending cut-backs across the nation.  It is unlikely that state and local budgets will improve dramatically or quickly.  We would expect many states to raise taxes.  This would have a dampening effect on local economies.

Throughout the past year the Federal government has pulled out all the stops in order to stabilize the financial system and stimulate the economy.  The Federal Reserve flooded the system with liquidity and Congress spent vast sums to jump start the economy.  The results of these efforts were (1) the financial system has indeed stabilized and (2) economic activity has rebounded.  Both of these results are, of course, salutary.  They are, however, not without serious costs.

While the stimulus is working, it will not be permanent.  Therefore, what happens when it is taken away?  Will the recovery be on a self-sustaining path or will it sink bank into recession?  Moreover, what are the long-term implications or this massive federal spending?  Clearly one answer is an exploding federal deficit.  While consumers and businesses generally are deleveraging, the federal government is leveraging.  How long it an do so is an open questions.

How long will investors — both domestic and foreign — continue to buy U.S. government debt?  At what point will they demand a higher interest rate to lend to the U.S.?  What will be the effect on the dollar?  These are not insignificant questions.  In looking for the next financial crisis, one need only look for the current financial excess.  The last cycle it was in the housing sector.  Now it is government.  We believe the next crisis will concern government debt.  The only unknowns are how extensive and how severe the crisis will be and when it will happen.  The Federal government is running massive deficits occasioned by the need to stimulate the economy, while simultaneously waging two active wars in Iraq and Afghanistan, and struggling to deal with the structural imbalances derived from an aging population.  While the deficit spending associated with fiscal stimulus programs is ultimately a temporary problem that should recede as the economy picks up momentum of its own, the other two issues are of a more permanent nature.

In and of themselves the wars in Iraq and Afghanistan could be viewed as voluntary.  That is, we did not have to invade Iraq, and history may conclude that we did so based more on ideology and false intelligence rather than on any real strategic necessity.  Afghanistan may enjoy a somewhat greater justification.  But, the rise of radical Islamism and its use of terrorism to achieve its ends, does necessitate a response on our part, a kind of permanent step-up in our defense and national security budget.  Because the goal of the radical Islamists is basically ideological and not economic, there seems little hope that we can sit down and negotiate a truce.  This battle will probably be with us a long time.

The structural problem of an aging population could soon result in a crisis of Medicare and Social Security expenses with fewer younger workers available to support the cadre of aging retirees.  A significant consequence of an older population is an inexorable growth in health care expenses, made worse by growth in medical technology, which seems to add to costs when looked at in aggregate.  Sadly, Congress and the administration failed to address the issue of health care costs when drafting recent health care reform legislation.  Rather than health care reform, their “solution” is really little more than insurance reform in which 30 million more people would gain insurance coverage and be added to our dysfunctional health care system.  This rather cynical attempt at reform will certainly add to our long-term structural deficits for years to come.

Ultimately taxes will have to be raised to pay for all of this.  Whether they will go up so far as to kill the golden goose is an open question.  Our guess is that tax increases will not prove draconian, but will exert a modest dampening effect on long-term economic growth.

The other issue associated with the current monetary easing and fiscal stimulus is whether these actions will spark inflation.  Because of high unemployment levels, and the continued impact of globalization, we doubt that inflation can move beyond an increase in commodity prices and trigger a wage-price spiral.  In other words, an economic recovery coupled with growth in emerging markets may result in higher demand prices for commodities.  Relatively weak consumer demand, however, will not allow manufacturers to pass on these commodity costs.  Wages are also likely to be constrained by surplus in labor markets.  Therefore, while the economy may experience some commodity inflation, it is not likely to see much increase in consumer prices or in wage rates.

Conclusion

Looking out over the next year, we would expect the economy to continue expanding, but in the face of some severe headwinds, including a possible double dip in the housing markets and the unwinding in the commercial real estate sector.  The stock market has recovered sharply in anticipation of further economic gains and hence profit recovery.  If the economy falters and profits disappoint, the stock market could suffer a temporary setback, especially as it is no longer dirt cheap.  We are, therefore, keeping some dry powder in the form of cash in order to cushion any downturn and also to have buying power to take advantage of bargains should they occur.

As we said earlier, we are constructive on the market over a three to five year horizon.  Given that the last decade was the worst for the stock market in nearly 200 years, it seems reasonable to expect that the new decade could be a good deal better.  Nonetheless we remain caution near term because of the possibility of a double dip in housing and general economic activity, and are concerned longer term by the structural problems contributing to the federal deficit.

2009 In Review

Highlights of some of the more memorable events of this year (sourced from The Economist, Dec 17^th, 2009):

Barack Obama was inaugurated as America’s 44th president. Mr. Obama:   overturned a prohibition on federal funding for stem-cell research, eased some restrictions on dealing with Cuba, lifted a ban on people with HIV travelling to the United States, pushed Congress to pass health-care reform, promised to close the detention camp at Guantánamo, pledged a cut in America’s emissions and promoted the first Hispanic person to the Supreme Court.

Mr. Obama also set about changing the tone of American foreign and security policy, for example by seeking to “reset” relations with a prickly Russia and by stopping the use of torture during intelligence interrogations. Speaking in Cairo, Mr. Obama’s call for “a new beginning” with Muslims was applauded by the Arab world. The new president was awarded the Nobel peace prize, though many said this was premature. He defended the use of force in “just wars”. 

Iran and North Korea remained belligerent despite Mr. Obama’s plea to tyrannies to “unclench your fist”. Iran moved ahead with its nuclear program, conducting missile tests just before it attended talks in Geneva with six leading powers. A secret Iranian uranium-processing facility was discovered. North Korea launched a rocket that the West believed could target Alaska. Two American female journalists held by North Korea were freed when Bill Clinton went to Pyongyang to meet Kim Jong Il, the Hermit Kingdom’s ailing dictator.

American troops withdrew from Iraq’s big cities in June. Earlier, Mr. Obama presented a plan to withdraw most troops from Iraq in 2010. Sporadic bursts of suicide-bombings that killed scores of people continued to plague the country. A general election will be held in March.

Efforts to stabilize Afghanistan were hampered by a disputed presidential election. Amid claims of corruption and poll-rigging, Hamid Karzai was declared the winner, but only after his remaining rival pulled out of a run-off ballot.

It was the worst year by far for coalition casualties in the war in Afghanistan. General Stanley McChrystal, the American commander there, requested more forces to fight the resurgent Taliban, but Mr. Obama came in for some flak for dithering over his response. He eventually agreed to send an extra 30,000 troops.

The violence also intensified in Pakistan, with the most savage terrorist assaults carried out in Peshawar, capital of the North-West Frontier Province. In October the Taliban attacked Pakistan’s army headquarters in Rawalpindi. Pakistani troops began a campaign against the Taliban in the tribal areas of South Waziristan.

China’s economy began to roar ahead again; imports and exports grew following a sharp decline and its returning appetite for raw materials was partly responsible for a rise in commodity prices.

Governments around the world took measures to tackle the worst economic crisis in decades as unemployment shot up. The American Congress passed a massive $787 billion stimulus package in January and the Bank of England implemented a program of “quantitative easing” that pumped £200 billion ($330 billion) of new money into Britain’s economy.

As a result of such measures Western economies emerged tentatively from recession, allaying fears that the world would enter a Depression-style slump. But worries were soon aired about the sustainability of large budget deficits: America’s hit more than $1.4 trillion. The IMF, European Central Bank and others urged countries to take steps to unwind their stimulus schemes.

With stock markets up, and after passing government “stress tests” to see how they would cope in future downturns, many banks, including Bank of America, Citigroup and Wells Fargo, began to repay the bail-out money they had received at the height of the crisis. Many financed this by offering shares through big capital-raising plans.

Bernie Madoff received a 150-year jail sentence for defrauding clients of $65 billion in his Ponzi scheme. Sir Allen Stanford, a Texan billionaire and cricket promoter, was arrested for allegedly defrauding investors out of $8 billion through his bank in Antigua.

An Air France jet en route from Rio de Janeiro to Paris crashed into the mid-Atlantic in June killing 228 people, the worst plane crash in a decade.

The Iranian presidential election brought about the Islamic Republic’s worst crisis since the 1979 revolution. Polls had suggested that Mir Hosein Mousavi, a reform-minded candidate, might defeat Mahmoud Ahmadinejad. The scale of Mr. Ahmadinejad’s victory caused millions to take to the streets to protest against what they said was a rigged election. Hundreds were arrested in Tehran and elsewhere. Dissidents were sentenced in a series of televised trials.

General Motors went bust with debts of $172 billion, America’s biggest-ever industrial failure. The American government took a majority stake in the carmaker as it emerged from bankruptcy protection. GM and its rivals benefited from “cash-for-clunkers” subsidies schemes, which encouraged consumers to trade in their old bangers for more fuel-efficient models.

Chrysler also went bankrupt and was eventually rescued by Fiat. Other companies of note that went to the wall included Nortel Networks, a telecoms-equipment maker, Reader’s Digest, Six Flags, an amusement-park operator, Trump Entertainment, a casino-owner in Atlantic City, the publisher of the Chicago Sun-Times, and Waterford Wedgwood, a maker of crystal and china. 

What To Do Now

I spent the morning of Christmas Eve in a car dealership waiting for my Christmas present to be ready.  While there, I was privy to a conversation that I think a lot of people are having right now.  There was one gentleman who had worked in the banking industry for a number of years and now was with the Gwinnett Transit Authority and the other was a long-haul truck driver, typically driving from Miami to Los Angeles.  The key part of the discussion revolved around whether they could retire now or if they would have to wait, etc. 

What had happened is that the former banker had watched his investment assets decline in value, decided to sell out at one of the low points and missed out on the subsequent run-up.  Now he doesn’t know whether to get back in since it is going up again.  While it might have been tempting for me to wade into this conversation with some advice, I refrained since I may have lost some credibility with my “woolly-booger” identity at the time – no shower, shave or suit that morning. 

The direction of the stock, bond, real estate and alternative markets may certainly be important, but more important are answers to questions that are even more critical to this type of discussion:  1) What are my Goals  2) What Assets are available to meet those goals  3)  What is the purpose of the investments that I have and how will they help me meet my goals

It’s important to have a plan to help answer these questions.  Plans are certainly not foolproof and will need to be adjusted over time.  But making important financial decisions without a plan is like trying to do a jigsaw puzzle without having the picture as a reference.  We tend to become too focused on one individual piece without any sense as to where it fits in the overall scheme.  We waste a tremendous amount of time and raise our mental anxiety level to unhealthy states.

To finish up the story, I was at the dealership waiting for the new key to my old car. 

2005 Dodge Durango

My electronic keyfob had stopped working several months ago so it appeared as though I was stealing my car every time I opened it; opening the door with the actual key sets off the security alarm until you start the engine.  One unfortunate sign of the times is that I was never once stopped or questioned, let alone did anyone even seem to notice the blaring alarm going off as I got into the car.

Roth IRA Conversions

To Convert or Not To Convert…That is the Question

We are all about to be inundated with media and financial industry chatter regarding Roth IRA conversions.  What is happening is that in 2010 the Roth conversion modified adjusted gross income (MAGI) limits will be eliminated.  MAGI limits for Roth IRA contributions will still be in effect but not for conversions from a Traditional IRA or other qualified plan.   Roth conversions have always been available for households who make less than $100,000.  The way a Roth conversion works is that the balance that is converted from the Traditional IRA is considered as ordinary income, and is a current year taxable event for the owner.  This converted amount is added to your income prior to the tax calculation.  So the federal government gets paid now instead of when the money would have come out of the Traditional IRA in the future.   With a Roth IRA conversion, someone is essentially making a decision that income tax rates will be equal or higher in the future than what their marginal income tax rate will be in the current year.  The conventional wisdom has always been that your marginal tax rate will be lower after you stop working and that deferring paying taxes until then made sense.    The first step in determining whether a Roth IRA conversion makes sense is whether the taxes that will be paid can come out of nonretirement plan assets.  If not, then it generally will not make sense to convert.  Paying the taxes from non-IRA money allows for a larger amount to benefit from the long-term tax-free growth potential of the Roth.     Roth IRAs already make sense for young people and those in lower income brackets because of the long-term tax-free growth potential and also the likelihood of their being in equivalent or potentially higher tax brackets in the future.  Roth conversions will now likely be extremely appealing to the very wealthy, where wealth is defined by annual earnings.  If someone is already in the highest marginal income tax bracket and expects to remain there in the future, then there is little downside to the conversion.    The middle ground is where it is a more difficult decision, and where most investors will find themselves.  A Roth IRA conversion could be used as a hedging strategy where you have multiple accounts where the taxes on distributions are calculated differently:  non-retirement funds, Traditional IRA, Roth IRA, and annuity.  While tax rates are anticipated to increase, there is no way to know how much and who will be most affected.   There is going to be the temptation (and pressure) for some to convert the entire balance of a Traditional IRA.  The thing to remember about a Roth conversion is that it is considered a distribution from a Traditional IRA and thus a taxable event.  So there could be some unintended consequences such as pushing you into a higher marginal tax bracket and also a phaseout of certain allowable deductions.  It could also have tax consequences for those that are already collecting Social Security by potentially making that income taxable in the year of conversion.  It is also important to be careful on conversions of annuity accounts.  The present value of the annuity’s riders, or additional benefits, could be added to the conversion amount.   The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) will permanently eliminate the limits, so it is not expected to be a one year opportunity.  Early conversions have some advantages due to the extra time for potential growth in the account, opportunity to recharacterize the conversion, and ability to spread the tax payments over a two-year tax filing period.  But it may make sense to do partial conversions to limit the impact in any one year as well.   The key takeaway is that it is vitally important to do the math first before doing any conversions.  As my wife reminded me over the weekend while I was hanging some pictures:  measure twice, drill once.

Friends Don’t Let Friends…

Friends don’t let friends buy gold coins in their IRA.  We’re not sure exactly where the push is coming from, but several clients have asked us recently about buying gold coins within their IRA.  This may be a good strategy if you think that civilization is coming to an end and we will be living in a permanent Renaissance festival.  The problem with buying actual gold coins is that you are going to have to pay someone to store them and then also figure out how (and who) you are going to sell them to at some point.
 
There are better ways to get exposure to gold within your investment portfolio if that is your desire.  Even then we would not recommend more than a 5-10% allocation at the most; use for portfolio diversification, not speculation!  You never want to be purchasing anything out of fear which is how some brokers and purveyors are positioning their sales pitch.
 
The falling value of the dollar and worries of potential inflation are also stoking the flames of worry.  What’s interesting is that the dollar actually rose in value during the financial crisis last year as investors around the world were searching for a safe haven, still proving the U.S. dollar’s status as a reserve currency.  There are many reasons for the recent drop in the value of the dollar versus other currencies, with low interest rates being one of them.  In a recent Barron’s article the argument was made that the U.S. economy could handle short-term rates of 2% (versus the virtual 0% for T-Bills right now).  We are seeing the extremely odd juxtaposition of some money market funds offering higher yields than 2-year CD’s.  Normally you receive a premium for locking up your money versus immediate liquidity.
 
The continuation of extremely low interest rates in the U.S. is finally forcing savers out of cash positions and into other asset classes in an attempt to achieve some rate of return.  Stocks, bonds and gold have all risen double digits over the last three months; this has only happened twice before in the past 50 years, both instances in the 1980’s.  No matter what happens, it is still important to maintain proper portfolio diversification and make rational decisions rather than fear-based ones. 
 
If you are interested in a smarter way to add alternative asset classes such as gold to add additional diversification to your portfolio, please don’t hesitate to contact us for more information.  

Warren Harding and The New Normal

You will be hearing (or have already heard) of the popular new economic buzzword/phrase, the new normal.  This has been coined to describe the type of economy that we are expected to see going forward.  Most of the ink written about this subject suggests two distinct possibilities:  One possibility is a world economy which returns roughly to its pre-crisis rate of growth, without regaining the ground that was lost (this is what typically has happened after financial crises).  The other possibility is that growth stays at a permanently lower rate, with investment, employment and productivity growth all more feeble than before.  

The difference between these two outcomes is rather large; the higher growth outcome will only be achieved if policymakers can do enough to stabilize financial markets and promote free trade without putting in too many burdensome regulations; and also without promoting policies that are politically popular but do not allow economies to reinvent themselves and replace dwindling industries with new thriving ones.  Protectionism and lack of R&D (research and development) are real dangers to a growing world economy. 

But getting back to the new normal term, what exactly was the old normal?  Warren Harding said that normalcy is what people call normality when they no longer take it for granted.  Looking at normal from a statistical viewpoint (my academic background) means that the expected outcomes from a process or event will take the shape of a normal distribution (the bell-shaped curve with the line for average/mean when graphed).  If you can determine the shape of the distribution, then it is easier to describe/predict. 

Over the long-term, the economy and financial markets may indeed be normal but the difficulty is that a person’s lifetime is rather short, and the relevant time period may not be normal since it consists of only a relatively small sample size.  So what to do? 

There are four items within our control:  How long we work, how much we spend, how much we save, and how we allocate our assets.  All of these elements are critical data for creating a financial plan. 

Within our process, there are four major topics that we cover; two are definitely normal, one is for the abnormal and one that is everywhere in between.  The two normal (and certain) items are Death and Taxes, these are covered through proper Estate Planning and Tax Management.  Risk Management is for the abnormal things that may occur (the outlier events) which can wreak irreparable harm if not provided for via some type of insurance coverage or other contingency plan.  Proper Investment Management is critical for any environment, whether considered normal or not. 

Have an old normal week. 

Source(s):  A “new normal” for the world economy.  The Economist, October 3^rd-9^th 2009, page 11

Boys of Summer

I want to take the opportunity to congratulate the Gwinnett Braves on a very successful and memorable inaugural season.  I made the decision to buy season tickets as soon as I heard the Braves’ AAA team was moving to Gwinnett, especially since the new stadium was going to be close by in Buford/Lawrenceville.  This probably was not the most financially sound decision since we ended up attending only about half of the games; weekday games were tough, made all the more challenging by accommodating the needs of 3- and 1-year old boys.  But it’s one of those deals where the time spent with your loved ones is something that you can never regret.  So there was some sadness when we found out their playoff run came to an end over the weekend. 

This does, however, afford me the chance to integrate two of my passions, baseball and financial planning.  A professional baseball game has nine innings and it’s not too big of a stretch to imagine someone’s lifespan consisting of nine innings as well, where each inning represents a decade. 

The ideal strategy in a baseball game would be knock out the opposing team’s starting pitcher early on by putting some runs on the board.  Getting ahead early puts pressure on the other team, forces them to use relief pitchers and puts you in a better position to ultimately win the game.  It is extremely difficult to come from behind in a modern day professional baseball game, given the way that specialized players for pitching and defense are used.

This has some obvious parallels with financial planning, where putting away money early on in life leads to a compounding effect that puts you in a much better position in the later years (or innings).  This is easier said than done and most headway is usually made in the middle innings, 40s-60s.  It is also difficult to come back if you fall behind in financial planning; you are left relying too much on market returns or some other risky strategy to make up the difference.  The question then becomes, how many runs are going to be enough, and how long is the game going to last?  

This is where financial planning really comes in to play; making sure that the best players take the field and are ready to step in when called upon.  The savings and investment accounts are going to do most of the heavy lifting when it comes to putting runs on the board and playing defense.  However, the game can be cut short due to unexpected circumstances or it can also go into extra innings.  It is this variability that makes planning so difficult, and why additional players (in the form of insurance) are needed to come off the bench. 

As circumstances change, the team and strategy need to be reevaluated.   One of the most interesting things about the game of baseball is that it is a team sport comprised of individual battles, opportunities and decisions.  When you look at the entire spectrum of a financial plan, it is also made up of individual battles, in the form of daily financial decisions, which taken together decide the ultimate outcome. 

We are here to help our clients make smarter decisions throughout their lifetime.

Jobs Pipeline Backing Up

I read a recent article in The Economist which illustrated the disproportionate impact this economic downturn has had on young workers.  This group has always had a lower percentage of participation in the workforce due to the fact that many are still improving their skills through pursuing a college education, etc.  But unemployment in this age group has risen sharply recently. 

There are several possible reasons for this increase.  The first and most obvious reason is the economic recession which we are currently working through in the U.S.  This has certainly impacted businesses that typically hire new entrants into the workforce.  Another reason is the increase in the minimum wage; increasing the minimum wage makes it more costly for businesses such as fast food, retail stores, to hire additional employees so most are trying to get by without that extra body that they may have been able to afford in the past.

In addition, we could also be witnessing the effect that longevity and poor retirement planning are having.  Workers at the other end of the spectrum are choosing to stay in the workforce, either out of necessity or out of an interest to stay active and engaged.  This is potentially crowding out younger workers due to seniority and also a lack of general work experience.

What happened in the equity and fixed income markets over the past year has caused many people to reconsider whether they can now afford to retire.  It has also caused some that retired to move back into the workforce to supplement their income, now that they are trying to live from a much smaller nest egg.  Add low interest rates on top of a reduced balance and it has become difficult to generate significant income from a portfolio of financial assets.

To avoid becoming someone who is forced back into the workforce when you are expecting to “finally enjoy life”, it is more important than ever to take control of your finances and create a plan for financial independence.  Long gone are the days when you could expect the company you work for to take care of you in retirement, and government programs will only supply a small income, if any.  The traditional 3-legged stool model of retirement security has been replaced by a ladder; a ladder which is built upon your ability to manage both your human capital and financial capital throughout your lifetime.

Saving for College

The beginning of another school year is a reminder to parents, grandparents and caretakers that their kids/grandkids are getting older and will sooner than you realize (if not already) be heading off toward college.  The question is what tools are available to help prepare for that event, at least financially?  

While there are several choices available, each with unique pros and cons attached to the particular type of account or plan, the one which has been growing the most quickly over the past several years has been the Section 529 plan.  So I am going to outline the basics of a Section 529 plan for you.  

Most of these plans are state-sponsored plans and are now available in most every state.

There are two types of these plans; one is a prepaid tuition plan which lets you lock in future tuition at certain universities at today’s rates.  The other is a qualified tuition plan; the qualified tuition plan is typically going to be the more attractive type since it allows for much more flexibility. 

University of Illinois - Altgeld Hall

Contribution Limits:  Depends upon the state program, but the IRS has ruled that contributions cannot exceed 5 times the average cost of covered institutions.  The Georgia limit right now is $235,000. 

Who can contribute:  Anyone. 

Tax Benefits:  Earnings are tax-deferred and withdrawals are tax-free if used to pay for qualified educational expenses.  Contributions may be tax-deductible at the state level under certain income limits.  

Qualifying Expenses:  Tuition, fees, books, supplies, room and board, and equipment required for enrollment or attendance at a college eligible to participate in federal financial aid. 

Financial Aid Effect:  Treated as parents’ assets. 

Estate Tax Treatment:  Contributions are completed gifts and will be removed from the donor’s estate in most instances. 

Investments:  Donors cannot make any direct investment decisions, as they must select from a list of investment options.  This is why the options are typically professionally managed mutual funds.  Choices can be made between which state plan to use and changes can be made between options annually (exception for 2009 where two changes can be made). 

Withdrawals:  Withdrawals not used for education expenses are subject to a 10% penalty tax, and earnings are included in the gross income of the recipient.  Amounts may be rolled over to another beneficiary from the same family (broadly defined) without penalty. 

Hidden Costs:  Varies by state but may include a fee to establish an account, account maintenance fee, and asset management fees. 

A Section 529 Plan is a great option for saving for college and can be established by anyone for a child’s (or your own) benefit.  When considering a 529 Plan account, it may make sense to first look at your own state’s plan to see if it is competitive from an investment and fee standpoint.  If not, then there are several good alternative plans to choose from.

We still advocate saving for your own retirement goals first before putting yourself at financial risk by funding college instead.  Please don’t hesitate to give us a call if you would like to discuss saving for a child’s college education and we will be happy to inform you of all of the alternatives in addition to a 529 Plan.

Happy schooling!

Temporary Tax Benefits and Market Benchmark Review

“Cash for Clunkers” has been the most talked about of temporary government tax benefits/stimulus programs, but it is not the only one of which to be aware.  The American Recovery and Reinvestment Act (ARRA) stimulus bill offers several other important tax benefits in 2009 and 2010.  Three of these are the First-time Homebuyer Credit, Sales Tax Deduction for new vehicle purchases and American Opportunity Credit.  I have outlined some of the details below:

 

First Time Homebuyer Credit

First-time Homebuyer Credit

• Targeted at young adults who haven’t owned a home before and whose income falls below $75,000 (for individuals) or $150,000 (for married couples).
• $8,000 tax credit for homes purchased after 12/31/2008 and before 12/1/2009.  It is actually a credit of 10% of the purchase price, to a maximum of $8000.
• You can help children and grandchildren take advantage of this credit.  As long as the home is in the child’s name and the child lives in the home, parents can help with financing and even make the mortgage payments; the child, however, is the one who receives the credit.
• You can claim the $8000 credit this year.  If someone qualifies and purchases a home in 2009, they can file an amended return for 2008 and get the money back now instead of waiting until they file their 2009 return.  This was part of the stimulus bill so it is an attempt to get the economy stimulated as soon as possible.
• More details:
  • The credit does not have to be paid back.
  • The credit is refundable (the government will issue a check for difference over tax bill).
  • Escrow must close before 12/1/2009.
  • The home cannot be purchased from a close relative.

 

New Vehicle Sales Tax Deduction

Sales tax deduction for new vehicle purchases

• Vehicle must be purchased after 2/16/2009 and before 1/1/2010.
• The deduction is limited to the tax on up to $49,500 of the purchase price of an eligible vehicle.
• There is no limit on the number of vehicles that may be purchased.
• The deduction is phased out for individual with modified AGI between $125,000 and $135,000; and joint files with MAGI between $250,000 and $260,000.
• The deduction may be taken regardless of whether a taxpayer itemizes deductions; it may be added to the standard deduction.
• It is taken on the 2009 tax return.
• Purchases made in states without a sales tax also qualify.  The deduction is based on fees or taxes assessed on the purchase of the vehicle and must be based on the vehicle’s sales price or as a per-unit fee.

 

American Opportunity Credit

American Opportunity Credit

• This is for people (or parents of) paying for college.
• The amount of the credit is 100% of the first $2000, plus 25% of the next $2000, spent each year on tuition, fees and course materials, for a maximum credit of $2500.
• The credit applies to all four years of college.
• The credit phases out for individuals with MAGI of $80,000 to $90,000, and for joint filers with MAGI between $160,000 and $180,000.
• The credit cannot be claimed for any expenses paid using funds from other tax-preferred vehicles, such as 529 plans and Coverdell savings accounts.
• On a related note, the ARRA expanded the definition of qualified higher education expenses for 529 plans to include expenses for computer technology and equipment or Internet access and related services.  This applies to 2009 and 2010 only.

Market Benchmarks

This week I want to take a moment to review how the markets have fared, as measured by some of the most commonly reported indices, both year to date and since 3/6/2009 which appears to be the most recent low point.  These indices can sometimes serve as gauges for certain portions of the securities markets and also as a measurement of the general level of stock prices.

These can serve as certain indicators of the overall market’s health, but the more important measurement for anyone’s investment portfolio is whether or not they are on track to meet their own personal financial planning goals.  With that distinction in mind, following are how some of the more common stock and bond market indices have performed, listed in three columns (Performance Year to Date, since 3/6/09, and description):

 Year to Date    Since 3/6/09   Description

+10.97%         +45.99%         S&P 500

+4.50%           +39.08%         Dow Jones Industrial Average

+11.66%         +46.50%         Dow Jones Wilshire 5000

+17.95%         +53.86%         S&P Mid Cap 400

+11.07%         +60.23%         S&P Small Cap 600

+17.81%         +55.16%         MSCI Developed EAFE

-7.22%             +62.16%         Wilshire REIT

+10.27%         +12.40%         Barclays US Aggregate Credit Bond

+0.09%           +0.07%           Citigroup 3-Month US Treasury Bill

While the stock market returns since the low in early March have been spectacular, it is important to remember that there is still a long, long way to go to reach the high points that were achieved in October of 2007.  It would take another 50% return from here to get us there.

S&P 500:  Value-weighted index of the 500 largest publicly-traded U.S. companies.  DJIA:  Price-weighted index of 30 of the largest publicly-traded U.S. companies.  DJ Wilshire 5000:  Market capitalization-weighted index of the market value of all stocks actively traded in the U.S. (6300+ components).  S&P Mid Cap 400:  Index of 400 U.S. stocks with market capitalizations between $2 billion and $10 billion.  S&P Small Cap 600:  Index of 600 U.S. stocks with market capitalizations under $2 billion.  MSCI Developed EAFE:  Index of stocks from 21 developed markets/countries, excluding the U.S. and Canada.  Wilshire REIT:  Index of publicly traded real estate securities.  Barclays US Aggregate Bond:  Market cap-weighted index of U.S. traded investment grade bonds (excluding munis and TIPS).