Three Lessons in Work and Life

Business icon Jack Welch once told Reader’s Digest what he’d learned from three jobs he had growing up: caddying, punching holes in a piece of cork, and selling shoes.

• Caddying. The future CEO of General Electric loved being out on the golf course hearing all about the big deals being made by the businessmen and the affluent. “It was like being a fly on the wall at a meeting.”

• Cork. Punching holes into a sheet of cork for a Parker Brothers game called “Dig” was his first glimpse into monotony. “It lasted about a month,” he says, “and I concluded that I never wanted to do anything like that again—ever.”

• Shoes. It was through his third job, selling shoes, that he learned the basic tenet of business: Close the deal. “If they didn’t like a shoe,” he says, “I always tried to be thinking ahead to a pair they might like better.” Every time someone walked into the store, he said, he felt he was stepping up to the plate to swing for a home run.

“Today I believe that the worst sin in running a big company is to manage its size rather than using that size,” he says. “The advantage of size is the resources it gives you to go to bat often. You have to take risks in business. If you take a risk and fail, get up to bat and swing again.”

Always Question the Premise

After World War II, Gen. Dwight D. Eisenhower served for a time as president of Columbia University. According to one story, a committee of faculty members once asked him to issue a rule prohibiting students from walking on the grass in the main quadrangle.

Before issuing a statement, he asked, “Why do they walk on the grass?”

“Because it’s the shortest way to the central hall from the main entrance,” the committee answered.

“If that’s the way they are going to go,” he said, “then cut a pathway there.”

Eisenhower understood that telling people what not to do isn’t always the best course of action.

Borrowing from Your 401(k)

With the current economy, people are borrowing from their 401(k) plans at record levels.  When times are tough that particular pool of money begins to look very attractive.  But, deciding to access that pool might not be as easy or straight-forward as you think.

While every 401(k) plan is different, most will let you borrow as much as 50% of your vested balance up to $50,000.  The loan is paid back through your paycheck, with interest.  Most plans have competitive interest rates and the loans can be carried for up to 5 years.  If you use the proceeds of the loan to purchase a primary residence, that pay-off term may be extended.

When you are making payments back into the loan, you are paying yourself interest on the money you borrowed.  This is where it gets a bit foggy.  First, when you draw your paycheck, you pay taxes on the earnings.  Then you pay the interest on the loan out of what remains.  At a later date, say retirement, you begin drawing from the plan.  Those distributions are taxable income, therefore taxed again.  You are paying income taxes twice on the funds you use to pay interest on the loans.  (Special tax rules apply to Roth 401(k) contributions).

There is an opportunity cost with taking a loan from your 401(k) as well.  If those funds are not invested, they are not continuing to grow tax deferred.  So, what is the opportunity cost?  Well, you need to compare the interest you are paying yourself and the future tax implications previously discussed with the lost opportunities of tax deferred investment returns.

There are other considerations as well.  For instance, if there is a separation from employment, the plan may require that the loan be immediately repaid.  If you don’t have the funds to repay the loan, it is treated as a taxable distribution.  If you are not age 59 ½ or more, a 10% early withdrawal penalty may also apply to the taxable balance.

Whether or not you can afford to pay back the loan and still make contributions to the plan should be carefully considered.  Would the circumstances that have lead you to look at borrowing the funds as an option impair your ability to repay the loan?  If so, this might not be considered a viable option.

The interest you pay on alternative financing options may be tax deductible.  For example, the interest on a home mortgage often qualifies for a tax deduction.  However, the interest on a plan loan repayment often is not.  Be sure to weigh the comparisons of tax deductibility for both alternatives before making a decision.

Every plan is different and will have various restrictions.  Consult with your plan administrator before deciding to borrow from your 401(k).

Taxes and Social Security

   If you are looking forward to retirement and tax-free Social Security income, you might be surprised when the IRS comes around for a bite. Yes, way back when Social Security was a young program, President Franklin D. Roosevelt promised no income taxes would be exacted, but that promise ran out in the 1980s for some people whose income exceeds certain levels.

Now the federal government considers the retirement entitlement as taxable income when your other income plus half of your Social Security exceed an amount based on your filing status ($32,000 if you filed jointly, $25,000 for single filers). First, only 50 percent of your benefit above a certain threshold is taxable. When you exceed the first threshold, up to a maximum of 85 percent of your benefit can be taxed.

You can continue to work and still receive retirement benefits. Your earnings in (or after) the month you reach your full retirement age will not reduce your Social Security benefits. But your benefits will be reduced if your earnings exceed certain limits for the months before you reach your full retirement age.

If you work for someone else, only your wages count toward Social Security’s earnings limits. If you are self-employed, the federal government counts only your net earnings from self-employment.

Income from other sources is not counted, such as other government benefits, investment earnings, interest, pensions, annuities and capital gains.

If you work for wages, income counts when it is earned, not when it is paid. If you have income that you earned in one year but the payment was made in the following year, it should not be counted as earnings for the year in which you received it. Some examples are accumulated sick or vacation pay and bonuses.

If you are self-employed, income counts when you receive it—not when you earn it—unless it is paid in a year after you become entitled to Social Security and earned before you became entitled.

Is Your Mental Accounting Adding Up?

     The stock market drops 50 percent and comes up 50 percent, so you are back where you started, right? Not so right. After a moment of thinking about it, you probably realized the real math does not add up that way, but consumers see it that way in their “mental accounting,” a phenomenon that affects how people spend, save and invest their money.

The faulty stock market perception can be illustrated with the following equations.

If you were to ask people what the average of 3 and 5 is, they typically respond as follows: (3 + 5 = 8)/2=4. The average is 4.

If you were then to ask them for the average of a negative 50 and a positive 50 they would do the equation the same way. So the typical investors assume that if they are getting positive returns and negative returns that they are still doing fine.

So what if you were then to ask them, “What is the impact of losing 50 percent one year and gaining 50 percent the following year? Back to your starting amount, right?” Actually, that would work out like this:

·        $10,000 down 50 percent is $5,000

·        Then up 50 percent is $7,500

·        This is a 25 percent loss (13 percent annualized) after “offsetting” years.

Let’s look at an example in which the gaining percentage is greater than the losing one. A return of +66 percent followed by -50 percent would seem to add up to an 8 percent return. But actually:

·        $10,000 up 66 percent is $16,600

·        Then down 50 percent is $8,300

·        +66 percent followed by -50 percent produces a negative 9 percent annualized return.

But look at the compounding gain of two 8 percent years:

$10,000 x 1.08 = $10,800 x 1.08 = $11,664        

So, many people wrongly think that if they are getting a greater return than a loss, then they are doing well. But obviously that’s not true. Another misperception is just how deep a hole is created by losses. A 100 percent return would be necessary to offset a 50 percent loss. But a 300 percent return is required to offset a 66 percent loss. And then 400 percent for a 75 percent loss.

So, the next time you’re thinking about taking a risk, make sure you are doing an accurate mental accounting.

How Do Fees Affect Mutual Fund Performance?

    When investors consider mutual funds, they often hear warnings about the impact of fees and expenses on returns. But these seem invisible to investors, so what really is the impact?

A mutual fund’s fees and expenses may be more important than an investor might realize. Ads, rankings and ratings will often emphasize how well a fund has performed in the past. But according to the Securities and Exchange Commission (SEC), studies show that the future often is different. Fees and expenses can be a reliable predictor of mutual fund performance.

When considering a mutual fund, one of the most important numbers is the expense ratio, which tells you how much the fund costs. The ratio shows how much of the fund’s assets are paid to the portfolio manager and for other operating expenses. Typically, a fund pays an average of 1.5 percent of assets annually.

 Three things typically figure into this ratio. The investment advisory fee pays the managers of the fund, which accounts for .50 to 1 percent. Then, administrative costs cover services such as record keeping, mailing and maintaining a customer service line, which can range from .20 to .40 percent. And often a fund will charge a 12b-1 distribution fee, which covers marketing, advertising and distribution services. This ranges from .25 percent to 1 percent of assets.

 The upper range of these fees shows how high an expense ratio can be. And even though the fee seems to be just a few percentage points, it is charged in down years, when it can represent a significant slice of the return. Also, over time, the fee can cut the ultimate return by nearly 50 percent, according to one analysis. With an initial $10,000 invested after 30 years of 10 percent returns (a bit optimistic, perhaps), the fund has made $174,494, but with a 2.5 percent expense ratio, it has lost $86,944, according to an analysis by Moolanomy.com.

But even that isn’t the bottom line. There are still transaction fees incurred by the buying and selling of assets in the fund that go unreported, and that can double or triple the cost, according to Richard Kopcke of the Center for Retirement Research at Boston College.

Of the 100 largest stock funds held in defined contribution plans as of December 2007, trading costs averaged from 0.11 percent of assets annually in the quintile with the lowest costs to 1.99 percent of assets in the quintile with the highest costs, with a median of 0.66 percent, Kopcke found. But it is difficult for average investors to determine this percentage, he said.

 The SEC has not been able to develop ways to report this percentage in the same way an expense ratio is reported, partly because fund managers say the number is too difficult to determine. One way to get an indication of the percentage is the fund’s turnover. The percentage of turnover shows at what rate stocks in the fund have been replaced. A high turnover rate would mean more fees.

The SEC last year required fund managers to disclose one year of turnover at the front of a prospectus in addition to the already required five years of turnover disclosed in the financial highlights section, according to a March 1 Wall Street Journal article. Turnover of more than 100 percent can indicate trading costs may be high, the Journal reported.

Taxes Figure in Retirement Planning

    When people are working, they might not realize how big an impact taxes will have on their retirement lifestyle. Taxes end up being among the most significant expenses seniors face.

     Once you start tallying up the federal, state and local taxes, you can see you have to be aware of how to mitigate the impact. One way is to choose a place to retire that does not have onerous state and local taxes.

For example, nine states have no state income tax, according to the Federation of Tax Administrators. They are Alaska, Texas, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Washington and Wyoming. (In New Hampshire and Tennessee, income tax is limited to dividends and interest income.)

According to the Tax Foundation, the states with the highest tax impact are Maine, New York, Ohio, Minnesota and Hawaii. The ones with the lowest are Alaska, New Hampshire, Delaware, Tennessee and Alabama. The foundation also says that Americans will pay more in taxes in 2010 than they will spend on food, clothing and shelter combined. Another factor to consider, if you have a large inheritance to leave, is whether the state has an estate tax.

If you move, the good news is the tax impact of selling your home is less these days. That’s because Congress changed the rules in 1997. According to the book The New Retirement, by Jan Cullinane and Cathy Fitzgerald, “Some or all of the gain on the sale is not taxable as long as the taxpayers owned [the house] as their principal residence for at least two years during the five-year period ending with the date of the sale. The amount of gain that is not taxable is limited to $250,000 for a single taxpayer (or a single taxpayer limited separately) and $500,000 for a married couple filing a joint return. Significantly, unlike under the old law, this gain is eliminated from taxable income and is not deferred to reduce the tax basis of any replacement residence.”

Cullinane and Fitzgerald also wrote that the sellers do not have to buy a replacement principal residence, so it especially benefits those wanting to downsize.

The legal and tax information contained in these articles is merely a summary of our understanding and interpretation of some current provisions of tax law and is not exhaustive. Consult your legal or tax advisor for advice concerning your particular circumstances.

How Do Derivatives Affect the Economy?

   A central target in financial reform has been derivatives. They have been blamed for the economic meltdown, and many people are calling for their strict regulation. So what are these financial rascals, and how do they affect the economy?

Derivatives protect people from a change in prices of an underlying asset. They began, generally speaking, as a hedge against changes in commodities prices. So, if you are a corn farmer and want to be able to plan on how much you will receive for your crop, you can agree on the price with a miller. The farmer is in a sense betting that the price will be higher or at least the same as the rest of the market at harvest time, and the miller is betting that the price will be lower or at least the same – and the miller is ensured of a supply of corn. The result is stability for both parties. The agreement is derived from the underlying asset of corn. That is the essence of a derivative.

Derivatives also hedge against price changes in other financial instruments and can become far more complicated or “exotic.” An institution can buy a credit default swap (CDS), for example. Institution No. 1 would pay institution No. 2 to ensure that the value of an asset does not fall under a certain level. If the value does drop, then No. 2 would pay No. 1. When the value of real estate plummeted in 2007 and 2008, many No. 1 institutions were banging on No. 2 institutions’ doors to get paid. This was one of the factors leading to the economic collapse, when the overall value of the CDS market dropped from $62.2 trillion at the end of 2007 to $38.6 trillion at the end of 2008, according to the International Swaps and Derivatives Association.

Another factor was collateralized debt obligations (CDOs). These are packages of debts such as bonds or mortgage-backed securities. The idea is to reduce risk by spreading it around. But some in finance, such as Warren Buffett, said that they instead spread risky investments to more institutions. So when the underlying, or derived, asset plummeted, the rug was pulled out from under everyone.

 Although some, like Buffett, had sounded the alarm on derivatives, many people were surprised by the enormous impact the instruments had on the financial sector in the collapse of September 2008. Regulators were also surprised, because derivatives are often unregulated because they are essentially an agreement exchanged between parties but amount to a $400 trillion market traded over the counter (OTC).

Financial reformers want to shed more light on the market, but on April 21, a Senate committee went even further than that and approved tough standards that would force banks to get rid of their swaps trading operations. That rule might not make it to the final financial reform package, but it is certain that the eventual law will clamp down on derivatives in some way.

How Much Time Do You Devote to Learning?

It might be easy, or even convenient to think that the world’s most successful people were just born with natural abilities which the majority of individual’s don’t possess, if you were to research these men and women carefully one of the common traits that you would find would be a thirst for knowledge and a dedication to learning.  The great scientists and captains of industry didn’t just happen upon the skills and knowledge which led to their life-changing discoveries or their incredible power and wealth.  They acquired these things through devotion, commitment and continual effort.  They had a goal in sight and they worked tirelessly to achieve it without letting minor setbacks stand in their way.

Most people bemoan their fates and believe that they will never truly amount to anything and in many cases their predictions come true, not because of their lack of ability, but because of their lack of application.  It would be hard to imagine, for instance, the Richard Bransons and the Bill Gates’ of the world wasting valuable hours sitting in front of the television. 

More likely, they were immersed in learning everything they could about their fields and industries in order to build their mighty empires.

Time is precious, so why not turn off the TV for just half an hour or an hour a day and devote yourself to becoming an expert in something that you feel passionate about?

Is Twitter About to Be Knocked Off Its Perch?

Twitter, the popular micro-blogging service with around 200 million users, suspended several rival mobile applications earlier this year, but it now looks as though one of those rivals might be set to go into direct competition by setting up its own alternative service.  Reports suggest that UberMedia, which owns applications such as UberSocial for the BlackBerry platform, Twidroyd for Android devices and UberCurrent for iPhones and iPads, plans to launch its own social network service that could be in direct competition with Twitter.

Although the limit of 140 characters in Twitter messages is what has characterized the service, it seems that users are simply finding this too restrictive.  In addition, there have been complaints by newcomers that the service is somewhat less than user-friendly.  Should UberMedia decide to go ahead with a rival service, those are likely to be two areas that it addresses, which could result in Twitter users defecting in droves, especially because the company already has the attention of many Twitter members through its existing applications.       

Although it might seem inconceivable that anyone could come along and knock Twitter off its perch, one only has to look at how Facebook totally eclipsed existing social media sites such as MySpace.  Whether reports of UberMedia’s plans turn out to be accurate or not, however, remains to be seen.

Warren Buffett’s Financial Wisdom

Billionaires aren’t hatched overnight.  But there will be another generation of such men and women in the next few decades — and chances are, they will tread the same path as those who have come before.  So let’s look at Warren Buffett’s path as an example, shall we?

1) Start with a meat and potatoes small business — and be your own boss.

Buffett made his fortune by doing things his way, not by following the crowd. In high school, Buffett and a pal bought a pinball machine to put inside a barbershop. With the money they earned, they bought more machines until they had eight different shops running their machines. When they sold the venture, Buffett used the proceeds to buy stock and start another small business. By age 26, he’d become his own boss and amassed $174,000 — or $1.4 million in today’s money.

LESSON: Don’t fall for the temptations of a huge, immediate windfall business. Cut your teeth on the side, with something basic, reliable and small.

2) Mind the foxes who steal from the vineyard: small expenses.

In the famous book, The Millionaire Next Door, authors Stanley and Danko report that millionaires live well below their means. They budget, plan investments, and allocate their time, energy, and money into building wealth instead of displaying high social status.

Warren Buffett’s companies are known for watching out for small expenses. Exercising vigilance over every expense can make your profits and your paycheck go much further.

LESSON: The next time you spot a sale or online deal, check in with yourself to see if that $50 is better saved or invested than spent. It might seem like you’re spending a relatively small amount of money, but it all adds up.

3) Debt kills.

Warren Buffett advises his people to limit what they borrow. Living on credit cards and loans won’t make you rich. Buffett never borrowed a significant amount of money, not even for investments or mortgages.

The Millionaire Next Door reports that millionaires’ parents did not provide “economic outpatient care”, and their own adult children are economically self-sufficient as well.

LESSON: If you do give your teenager a credit card, make sure to set firm limits and specify use ahead of time. If they abuse the privilege, they lose the card. Do the same for yourself.

4) Leap forward.

Very often those who supply the affluent become wealthy themselves. In fact, one of the best ways to make money is to sell products or services to those who already have money. Many people don’t see these opportunities because they’re far too busy seeking money and security in the short term only.

Well, when Buffett began managing money in 1956 with $100,000 cobbled together from a handful of investors, he was dubbed an oddball. But he didn’t allow others’ opinions to keep him from leaping into a profitable venture. Over and above, I might add, others with greater private means.

Lastly, I will suggest this: Get professional advice on new ventures and ideas. We are here for far more than “just” tax planning. I would love the opportunity to sit with you, and help you evaluate the direction of your financial life … and point you in a new direction, should it be necessary.

Dan Hill

804-897-3919

dan@piwmllc.com

Cutting Out Waste to Save on Costs

Something that was truly understood by our ancestors, and is still appreciated in many countries around the world today, is the value of cutting out waste to save on costs.  Human nature is such that the more money we have, the more wasteful we tend to be.  We throw away perfectly serviceable items, only to go out and spend money on things that will do the job no better.  Only when we find ourselves struggling to make ends meet do we start to take more care in spending.  In the normal course of events, however, we could be saving a little bit here and a little bit there, which, at the end of the day, all adds up.

How many times have you thrown away an empty container and then picked up a plastic freezer box the next time you went to the store?  How many times have you printed a page from your computer, read it once and thrown it away without using the reverse side of the paper and then gone out to buy more printer paper or a new notebook?  How many times have you trashed things that could have earned you a few dollars if you had sold them in a yard sale? 

It might only seem like a few cents, but should you ever find yourself hard up in the future, you might wish you had been more careful when you had the chance.

Check Before You Check the Dependant Box

You can reduce the amount of your taxes or increase your tax refunds by claiming an additional personal exemption for each of your dependents. You may also save thousands of dollars by claiming the child tax credit, the child and dependent care tax credit, and the earned income tax credit.

However, the IRS rules for claiming a dependent – child or relative – aren’t as easy as picking a name off your family tree. Many possible scenarios make it hard to determine qualified dependents for your tax return. Here are the general tests to help you determine a qualified child dependent.

He or she can be a biological, step-, adopted or foster child; a full, half or stepsibling; or a grandchild, nephew or niece – but only if the person lives with you for at least six months and one day of the year.

Only one taxpayer can claim a child as a dependent. If the child is under shared custody, the household where he or she spends the most prescribed time gets the prize. If the child spends equal time between the two parents, the one with the bigger adjusted gross income (AGI) can claim the child as a dependent.

The child dependent must be under age 19 by Dec. 31 of the tax year. If the person is a full-time student for at least five months out of the year, he or she can be a dependent until the age of 24. There is no age limit for dependents who are totally and permanently disabled.

Generally, you cannot claim a married person who lived with you for a year as a dependent, unless the married person does not file a joint tax return.

If the child dependent is employed, he or she must have a gross income of less than $3,400 or be unable to provide more than half of his or her own support for the tax year. For instance, 17-year old Miley Cyrus would not qualify as Billy Ray’s dependent since she made something like $25 million last year.

The other category, qualifying relative, applies to individuals related to you in ways specified in the qualifying child dependent section. It also includes parents and stepparents, aunts, uncles, grandparents and other direct ancestors. You can also add your in-laws: father, mother, brother and sister. The relative must have lived with you the whole year and meet some of the requirements that apply to the child dependent.

Why Women Need to Save & Invest More

Men and women are not equal when it comes to retirement risk. Women face a higher chance of outliving their assets and experiencing poverty in old age because they have longer life expectancy, exhibit lower risk tolerance and make less income than men.

On average, a woman’s life expectancy is three years longer than a man’s, and 30 percent of women now age 65 can expect to reach age 90. That means women need to save more to fund a longer retirement.

Women are more likely to spend some of their retirement years on their own as they outlive their spouses or because of divorce. This makes retirement more expensive. Almost 40 percent of older women living alone depend on Social Security for almost all their income. If their Social Security benefits were taken away, more than 50 percent of older women living alone would be living in poverty.

Some of the challenges that women face in retirement can be traced back to their working years. Women have less income than men, earning an average of 77 cents for every $1 earned by men. This translates to a loss of more than $300,000 over a lifetime.

Women also spend fewer years working than men. In a 15-year time frame, women spend twice as much time as men outside the work force because they interrupt their careers, says management expert Marcus Buckingham. This leads to lower employer-based retirement plan benefits.

In fact, 50 percent of women workers hold relatively low paying jobs without pensions. Those who do have pension benefits receive just 50 percent of the average pension benefits received by their male counterparts, the Women’s Institute for a Secure Retirement reported.

Because the odds are stacked against women, WISER recommends the following strategy to help address gender-based retirement risk:

Consider a guaranteed source of retirement income that cannot be outlived, such as lifetime annuities.

Delay claiming Social Security benefits to increase the level of both spousal and widow’s benefits.

Purchase long-term care insurance.

Plan now for an income stream that will continue in the event of a spouse’s death, through life insurance, joint and survivor annuities.