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Tax Tips for Handling Real Estate in Divorce

Case Study:  First-Time Buyer Credit & Divorce

In 2008, Chris and Jenny purchased a home that qualified for the $7,500 first-time homebuyer credit.

They were married at the time of purchase and applied for the credit on a joint return.

In 2009, they divorced and Jenny received the house. Chris gave up ownership in 2009 and filed Form 5405 stating that he transferred the house to Jenny incident to the divorce [Form 5405, Line 13(e)].

In 2010, Jenny sold the house at a gain of $9,300.

Who repays the credit and how much?

Since Jenny received the home in the divorce, she has to repay the credit. In this example she must repay the entire $7,500 because her gain from the sale was $9,300.

The $9,300 gain was calculated by reducing the basis of the home by the $7,500 credit. If the gain had been less than the $7,500 her repayment would be limited to the amount of the gain.

If she sold it for a loss then none of the credit would have to be repaid.

According to the instructions to Form 5405, Line 13(e), the spouse who owns the residence after the divorce is responsible for the repayment, if any, of the entire first-time homebuyer credit.

Jenny will file the Form 5405 in 2010 and fill out Parts III and IV to repay the credit.

ViewPoint Newsletter for June

TAX HELPLINE:  978-388-0020 or 978-416-4107

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A key component of a diversified income-oriented portfolio is dividends. This is what I have noted in the past during my presentations, blogs and online musings. They are a key part of a solid retirement income strategy.

The total return from stocks is derived from two key components:  price appreciation and the cash flow from dividends.

Most investors are certainly familiar with the concept of price appreciation (or depreciation as was evident during the financial crisis and Flash Crash for instance).  This is what the media each night focuses on when they report on “The Market.”

But less noticed is the value of dividends to the longer-term success of an investor.

The Value of Dividends to An Investor

Below is a chart of various recent periods of stock market performance compiled by Thornburg Investment.

The “Dividend Aristocrats Index” refers to an index of companies that consistently lead the market in paying dividends and regularly increasing their dividends.

Annualized Total Return Period Dividend Aristocrats Index S&P 500
1990-94 12.58% 10.4%
1995-99 19.48% 28.54%
2000-04 9.79% -2.29%
2005 – 9/2009 2.32% -0.08%
1990 – 9/2009 10.97% 8.41%

Dividend-paying stocks have shown these positive attributes over this period:

  1. Historically higher yields than bonds
  2. Historically higher total returns compared to bonds because of the stock appreciation potential of the dividend-payers.
  3. Higher income, capital appreciation and total return compared to the S&P 500 Index in almost all of the periods noted above and a near 20-year annualized total return of nearly 11% versus 8.4.

Dividend-paying stocks are probably not as sexy as most aspects of the stock market.  They are part of “value investing.” They are the stuff of “conservative” portfolios built for “widows and orphans.”  They are the basic building blocks used by Benjamin Graham, the author of Intelligent Investing and the principles on which Warren Buffet built Berkshire-Hathaway.

But for an income-oriented investor (such as a retiree) looking at ways to manage income in retirement, they should not be overlooked.  In fact, recent research reveals that those companies that pay out higher dividends also tend to have higher stock prices because they also have higher earnings growth. And earnings growth is another key component in valuing stocks.  This research indicates this as a global tendency.

Searching for Yield

Unfortunately, seeking out high dividend-paying companies in the US is not so easy.  Unlike managements of Euro-based companies where paying dividends is a sort of badge of honor, US companies tend to be much more stingy in paying back earnings to owners of the company (the stockholders).

And the trend in dividend yields is one that continues to decline. A research note by Vanguard (May 2011) shows this trend.  From 1928 through 1945, the average dividend yield was around 5.6% and dividends represented about 67% of company earnings (aka dividend payout ratio). From 1945 to 1982 the average yields dropped to 4.2% and the payout ratio to 53%.  In the more recent period from 1983 through 2010, the average dividend yield has dropped to 2.5% with a payout ratio of about 46%.

As you can see finding “Aristocrats” that pay out higher than these averages makes a big difference.  And the higher payouts may also portend higher future earnings as well as stock price appreciation.

But even those companies which are “stingier” will still help out a portfolio.

Do Lower Dividends Mean Lower Stock Prices?

The question that investors may be asking themselves now is “will these lower dividend yields (historically and compared to Europe for instance) be an indicator of lower stock prices?” Because the market’s dividend yield is below its historical norm, is that an indicator of lower total returns in the future?

While the stock market is certainly not without bubbles and crashes, it is unlikely that this is a factor in possible future stock price levels. Lower dividend yields are not necessarily an indicator of lower total returns.

There are other reasons that are more likely the cause of this trend toward lower yield payouts.  Part of this is based on US tax policy.  Another is the culture of US corporate management that has opted toward share repurchases instead.

In the US, there is a bias in favor of long-term capital gains over receiving dividends and paying income taxes.

When dividends are paid out all stock holders receive the income and are subject to tax. When management opts for a “share repurchase” program, only those who tender their shares are paid out.  So this may be more agreeable to investors who are trying to manage their tax bill from investing. For those who are longer-term stock holders, they may receive more favorable capital gains treatment by holding the stock and waiting simply for appreciation.

Admittedly, there may also be an incentive by management not to declare dividends so that they can hold onto the capital to “reinvest” in the business – which may or may not be a good thing.  (The same argument can also be seen in political terms in Washington when both parties are arguing about whether or not to have tax cuts).

And management may also have an incentive to repurchase stock because such programs provide the company with flexibility to change the terms – something that is frowned upon if management were to lower or cancel a declared dividend.

How to Use Dividends in Your Portfolio

In any event, using dividend-paying stock is something that makes sense in retirement portfolios.  To provide tax efficiency, it makes sense to include these in your qualified accounts (like IRAs).  And to boost income, it makes sense to add global dividend-paying stocks which tend to have higher yields and payouts.  Nothing in these current research notes indicates that the lower US yields and payouts are an indicator for lower future stock prices.  There are enough other things going on in the economy locally and globally that can impact do that.

To Build a Better Mousetrap or Get More Information

For more ways to build a retirement income portfolio, please feel free to give me a call directly at 978-388-0020 and stay tuned to the company website for upcoming webinars that will cover this topic too.

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The other day I was contacted by Evan Lips, a reporter from the Lowell Sun who was doing a timely article on financial planning tips for the new year.

He had spoken to other financial planners and investment representatives and he had a wide range of opinions provided by them.  These included ways to manage credit to savings to kinds of investments to use for a retirement account.

Because everyone is at a different place in his or her life, some of these tips may not really help now. For instance, how you take money out of retirement accounts when retired is a tip that is less important to someone recently graduated looking to pay off student loan debt.

But there is something common that really can help anyone of any age.

Number One Tip for 2011 and Beyond

So my Number One tip for any consumer of any age:  Control What You Can and Leave the Rest.

What do I mean?

Consumers are usually their own worst enemy.  Too distracted by daily affairs, it’s easy to become overly focused on the news of the moment.  And this can lead to an emotional reaction that can otherwise sabotage long-term financial health.

Things You Can Control

1.      Investors have control over certain things: Their emotions (and reactions to the crisis of the day), investment expenses, asset allocation and amounts they save.

2.       Investing is long-term but the financial media is fixed on short-term crises of the moment.  Be mindful of that and try to tune out the noise.

3.       Your mom was right: Live beneath your means and you’ll have extra cash to save; build up your emergency reserves (minimum 3 months of fixed expenses for married couples working; 6 months for couples with one-earner and nearer 12 months for someone with variable income).

4.       Pay yourself first.  Make it automatic. Have a portion of your paycheck directly sent to a high-yielding savings account.

5.       You can lower your investing expenses and improve your diversification by using Exchange Traded Funds.  ETFs are investments that can trade like stocks but represent a broad basket of investments.  (Sort of like an index mutual fund but with even less expense). If you have less than $100,000 to invest and are looking for efficient core holding for global stock diversification, consider something like the OneFund® ETF from US One at www.usone.com (ticker symbol: ONEF) which is composed of 5 other ETFs from Vanguard and costs less than 0.35% per year while providing 95% exposure to 5,000 large, small and medium-sized companies throughout the world.

6.       Develop good money habits: Reconsider that fancy coffee or fast-food lunch and pocket the savings for a more meaningful goal (i.e. vacation, paying off debt, down payment for a house).

7.       Pay off your debt by snowballing payments.  This technique will help you see progress toward paying off debts.  Start with the ones with the lowest balances and pay above the minimum.  Then when this debt is paid in full apply the amount you were paying toward the next debt.  Eventually, like a snowball rolling down hill, you’ll be applying all these payments in large lumps toward the highest balance debt.  And this will help accelerate paying the debts off and lower your interest expenses.  Then when everything is paid off you can direct this toward your emergency reserves or investing goals.

8.       Position yourself to qualify for more student financial aid: Skip the allowance and put your kid to work.  See my post on this here.

Want Some Low-Cost Globally Efficient Ways to Invest?

What is an ETF?  Go to https://moneylinkpro.wordpress.com/?s=exchange+traded+fund or http://www.investopedia.com/terms/e/etf.asp

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Whatever your retirement dreams, they can still be made a reality.  It just depends on how you plan and manage your resources. On any journey it helps to have an idea where you’re going, how you plan to travel and what you want to do when you get there.

If this sounds like a vacation, well, it should. Most people invest more time planning a vacation than something like retirement.  And if you think of retirement as the Next Act in your life and approach it properly, you won’t be so easily bored or run out of money to continue the journey or get lost and make poor money decisions along the way.

It’s How You Manage It That Counts

How much you need really depends on the lifestyle you expect to have.  And it’s not necessarily true that your expenses drop in retirement. Assuming you have an idea of what your annual expenses might be in today’s dollars, you now have a target to shoot for in your planning and investing.

Add up the income from the sources you expect in retirement.  This can include Social Security benefits (the system is solvent for at least 25 years), any pensions (if you’re lucky to have such an employer-sponsored plan) and any income from jobs or that new career.

Endowment Spending: Pretend You’re Like Harvard or Yale

Consider adopting the same approach that keeps large organizations and endowments running.  They plan on being around a long time so they target a spending rate that allows the organization to sustain itself.

1. Figure Out Your Gap:  Take your budget, subtract the expected income sources and use the result as your target for your withdrawals. Keep this number at no more than 4%-5% of your total investment portfolio.

2. Use a Blended Approach: Each year look at increasing or decreasing your withdrawals based on 90% of the prior year rate and 10% on the investment portfolio’s performance.  If it goes up, you get a raise.  If investment values go down, you have to tighten your belt.  This works well in times of inflation to help you maintain your lifestyle.

3. Stay Invested:  You may feel tempted to bail from the stock market.  But despite the roller coaster we’ve had, it is still prudent to have a portion allocated to equities.  Considering that people are living longer, you may want to use this rule of thumb for your allocation to stocks: 128 minus your age.

If you think that the stock market is scary because it is prone to periods of wild swings, consider the risk that inflation will have on your buying power.  Bonds and CDs alone historically do not keep pace with inflation and only investments in equities have demonstrated this capability.

But invest smart. While asset allocation makes sense, you don’t have to be wedded to “buy-and-hold” and accept being bounced around like a yo-yo.  Your core allocation can be supplemented with more tactical or defensive investments.  And you can change up the mix of equities to dampen the roller coaster effects.  Consider including equities from large companies that pay dividends.  And add asset classes that are not tied to the ups and downs of the major market indexes.  These alternatives will change over time but the defensive ring around your core should be reevaluated from time to time to add things like commodities (oil, agriculture products), commodity producers (mining companies), distribution companies (pipelines), convertible bonds and managed futures.

4. Invest for Income: Don’t rely simply on bonds which have their own set of risks compared to stocks. (Think credit default risk or the impact of higher interest rates on your bond’s fixed income coupon).

Mix up your bond holdings to take advantage of the different characteristics that different types of bonds have. To protect against the negative impact of higher interest rates, consider corporate floating rate notes or a mutual fund that includes them.  By adding Hi-Yield bonds to the mix you’ll also provide some protection against eventual higher interest rates. While called junk bonds for a reason, they may not be as risky as one might think at first glance. Add Treasury Inflation Protected Securities (TIPS) that are backed by the full faith and credit of the US government.  Add in the bonds from emerging countries.  While there is currency risk, many of these countries do not have the same structural deficit or economic issues that the US and developed countries have.  Many learned their lessons from the debt crises of the late 1990s and did not invest in the exotic bonds created by financial engineers on Wall Street.

Include dividend-paying stocks or stock mutual funds in your mix.  Large foreign firms are great sources of dividends. Unlike the US, there are more companies in Europe that tend to pay out dividends. And they pay out monthly instead of quarterly like here in the US.  Balance this out with hybrid investments like convertible bonds that pay interest and offer upside appreciation.

5. Build a Safety Net: To sleep well at night use a bucket approach dipping into the investment bucket to refill the reserve that should have 2 years of expenses in near cash investments: savings, laddered CDs and fixed annuities.

Yes, I did say annuities.  This safety net is supported by three legs so you’re not putting all your eggs into annuities much less all into an annuity of a certain term. For many this may be a dirty word.  But the best way to sleep well at night is to know that your “must have” expenses are covered.  You can get relatively low cost fixed annuities without all the bells, whistles and complexity of other types of annuities.  (While tempting, I would tend to pass on “bonus” annuities because of the long schedule of surrender charges). You can stagger their terms (1-year, 2-year, 3-year and 5-year) just like CDs.  To minimize exposure to any one insurer, you should also consider spreading them around to more than one well-rated insurance carrier.

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Remember leisure suits? Remember bell bottoms? How about skinny ties?

Fashion sense changes. And so has money sense over the last couple of decades. But like the old song title: Everything Old Is New Again.

Over the past couple of decades we loaded up on debt, used our homes as piggy banks and became part of the “ownership” society investing more in real estate, mutual funds, stocks and our 401(k)s.

Like a pendulum, things change and old fashions that fell out of favor seem to come back into style.

Unfortunately, some of those fashions when it comes to money should never have been forgotten.

1.) Live Below Your Means: Easier said than done especially if living in a high tax or high cost state. But it’s worth remembering mom’s advice on this one.

2.) Skip the McMansion: They cost too much to heat, furnish and maintain. And they don’t produce any income for you (unless you consider taking on roommates). And who are you gonna get to buy the McMansion anyway when you want to downsize?

3.) Protect Your Credit: Use it sparingly and only if you can pay it off soon. Consider using a snowball method to get yourself out of debt (focusing on a credit card balance and then as that one gets paid off redirecting your payments to the next balance). And keep your credit score high by not closing out accounts. Use them every once in a while to keep them active. This will help maintain your credit score and allow you to qualify for better terms.

4.) Pensions Are A Thing of the Past: Secure your retirement income by saving in whatever tax-efficient options are available to you. This includes your 401k and IRA. Add a Roth IRA to stay diversified regarding future income taxes. Consider a lifetime income annuity – no frills, no bells and whistles, low expenses, laddered and divided among different insurers to reduce your risk.

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I would suggest something that can be added to over time by you and other friends or relatives. In this category, that would include the following:

  • UGMA/UTMA accounts
  • 529 Savings Accounts
  • Zero-Coupon Bonds
  • EE Savings Bonds
  • Individual Corporate or US Treasury Bonds
  • Dividend Reinvestment Plan (DRiP)

1.) UGMA/UTMA accounts that can invest in a diversified fund(s) or use proceeds to buy shares of some large diversified companies – Warren Buffet’s Berkshire Hathaway would work here;

2.) 529 savings account with maybe a target date allocation (tied to when the child is 18 y.o.);

3.) Zero-coupon bond (target face amount could be equal to part of an expected year of college tuition expense for example);

4.) EE Savings Bonds (as mentioned before, the taxes are zero when used for education and you can always buy more of them in reasonable denominations);

5.) Specific company or US Government bonds would have maturities that are close to the time frames you noted.

6.) Participate in a company-sponsored dividend reinvestment program (DRiP) by buying a single share of stock.  When the company issues its dividends, the proceeds will be used to buy shares (even fractional shares) in the company.  Over time, this is a cost effective way to build a stock position.  And since most companies that offer such plans are ones with brand names that children may know, it’s a great way to help kids gain an interest in savings and investing.

On a separate note for longer range thinking, you may also want to consider contributing to a Roth IRA once the child gets older and starts earning his own money from odd jobs, paper routes or the local grocery. If the rules don’t change and the child has earned income, he can contribute some of his earnings (or parents can consider it as long as it doesn’t exceed the total earnings).

Roth IRA proceeds can be tapped to pay toward college or toward a house down payment and if not used can at least be great seed money for retirement. (Yes, the rules could change but something to keep on the radar screen for when the time comes).

Now consider that as a way for a gift to really have a long term impact.

CAUTION: Giving the funds to a child when they reach a certain age without any strings could backfire. That’s why others here have mentioned things like the 529 or a UGMA account. Short of paying for a trust at least these structures allow you to place some restrictions on the use of the funds for the benefit of the child or for education specifically in the case of a 529. So if opening up any type of mutual fund direct with a fund family or even a brokerage account to hold the stocks or bonds suggested, consider having it titled in one of these forms.

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Investing Mistake #1: Treating Investments Like a Part-Time Job and Not a Business.

“When a man tells you that he got rich through hard work, ask him: Whose?” Don Marquis

While you may be investing for a child’s education, a vacation home or retirement, the common ingredient for success really is the process, approach and mindset you bring to making investing a success.  Take it seriously and you get serious results.  If you are fearful, your results will reflect it.  If you are a daredevil, your results may reflect that, too.

All your personal goals are important, aren’t they? You’ve worked hard for your money, didn’t you?  So why not find a better way to make your money work smart for you?

Why Mindset Can Really Harm You

Too often, investors simply think that what and how they save won’t really matter.  They don’t have enough money to make it worth it and they don’t have the time to really focus on the whole investing game. I know, life gets in the way when you’re doing other things and making other plans.

Thinking of this made me remember visiting an underground cave with my friends John and Lisa on a trip through the Blue Mountains. We entered the caves on a tour and saw all these fantastic, awe-inspiring formations created by the centuries of slow drips of water and mineral from the cave ceilings.  The stalactites and stalagmites formed bridges and statues of animals and even formations reminiscent of the craftsmanship used to build the cathedrals of Medieval Europe.  Small, incremental and consistent efforts produced such grand results.  If it can happen in nature, why not for something like a college savings account?

Too often, investors simply throw up their hands and take the easy road.  They do nothing, make no changes and for fear of making a mistake or because they don’t know who to trust, they avoid working with a professional.

They may hear the media report that a monkey throwing darts at a list of mutual funds or stocks may have beaten a professional money manager. Another favorite topic in the financial press is how most money managers do not bear their index.  But on the other hand, other stories will focus on the fantastic results of quick trigger investment schemes of the day-trader variety.

Let’s face it:  How well your investments perform from day to day will not likely make a big difference in your lifestyle now.  But how well you plan and invest may determine if, how and when you can retire, build a legacy to pass on and do all the things that are on your personal “bucket list.”

Two Categories of Investors

So investors will fall into two categories:  Those who focus exclusively on performance and those who focus on process.

Most investors, despite repeated warnings in small print at the end of the ads,  will focus on past performance as reported by the popular press and websites.  So despite the daily constraints on time because of family and work, these same folks will pick up an occasional financial newspaper or magazine or troll some financial websites and pick up a few ideas. They’ll see a Top 10 list of investments from last quarter or last year and then buy them because they performed well over some arbitrary time frame.

The Part-Time Investor in Action

Those who are more well-to-do or successful or affluent are either too busy making money to focus their time on investing or they believe that they have the skills to handle things on their own because they are successful in their careers.

I’m reminded of a woman I met on several occasions to discuss a way to bring some order to her investments.  She was a single mom raising a teen and worked in a fast-paced, deadline sensitive business.  Whenever we spoke, we were regularly interrupted by ringing phones and a buzzing pager.  Although she barely had time for lunch, much less research basic investment concepts, she ultimately decided that she would go it alone and master an online trading strategy to buy and sell stocks and options.

If you’re a successful surgeon or restaurateur or engineer or banker, do you really think that the same skill set that got you to the top of your profession, will also mean you can invest the time needed to properly manage and protect your wealth – not just your investments, but the whole set of tax, asset protection, retirement strategy planning, credit and cash management concepts?

Highly successful people may have achieved enviable incomes but can tend to be haphazard or casual about investing and integrating a financial plan.  Often, they may think that their incomes are secure, their career path certain, and they have skill and time to handle things on their own.

In reality, most may not really know what it takes to get to their goal.  For a 49-year old executive with a good $400,000 annual income and a $1 million investment portfolio trying to target for a retirement lifestyle at age 65 without much down scaling, he has to grow his nest egg to $6 million within a mere decade and a half.

And there is the equally disturbing statistic that the Great Recession has been hard on white collar professionals.  Those with college and advanced degrees make up more than 20% of the unemployed and long-term unemployed.

Be the CEO of Your Own Investment Company

Investing at any level and especially at this level requires a business mindset. The same sort of principles that apply to business success apply to your own investing. And just like any other CEO, you need to make sure that your assets are managed in a systematic, disciplined and prudent manner.

  • Business Plan: You need a business plan for your investments that covers the short and long term.  This means having a clear road map for your goals with appropriate benchmarks tied to achieving them. Instead of using the arbitrary indexes quoted by the media, you need to have a personal benchmark so you’re more likely to stay on target.
  • SMART GOALS: You need clear goals: Specific, Measurable, Achievable, Realistic and Time-Specific
  • Commit to a Realistic Strategy: You need a clear strategy for meeting those goals – a 20% annual return might sound nice but is it realistic given historical norms and your own experience and peace of mind
  • Don’t take it personally: As in business, don’t take the ups and downs in the market personally and don’t be afraid to review
  • Surround yourself with a professional team: If you’re serious about investing for success, then take the time to assemble a proper team of professionals who can help and who you can trust.  No business succeeds long term without a good team.

Don’t be too focused on your career to ignore this.  You can’t afford to treat your family’s future security as a part-time job or hobby.

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