I usually don't wax politics in this blog, but I can't help myself when is comes to the current administration's proposal to cancel the Tax Code break called the "stepped-up in basis." I want to share my point of view on this matter because it sends chills down my spine. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion. WATCH THE VIDEO
Ole Joe has had plenty of questionable moments in his half-century of “service” in Washington, D. C., and it’s hard to pick out the worst. But right up there with the best of the worst would be his proposed elimination of the century-old tax exemption for investment appreciation, which is triggered when an American passes on, whether affluent or not. It's the much cherished Tax Code break called the “stepped-up in basis.” Under current law, regardless of an investment's original cost, the basis of an investment “steps up” to current market for heirs of the deceased. In short, no taxes are due.
The change proposed by the Biden administration involves the currently untaxed gains on investments – stock, bonds, land, business property, your home, etc. – held at death. Joe wants to tax those gains at the top rate of 39.6%. Of course, because he’s a generous man with your money, he’s talking about exempting $1 million of assets per individual plus $250,000 more for a home (for married couples, that would come to $2.5 million of gains).
And Joe’s generous management of your estate shines even brighter in that the higher tax rate wouldn’t be imposed on retirement accounts such as 401(k)s, 403(b)s, and IRAs. Well, maybe I’m giving him too much credit for generosity in those instances. Withdrawals and conversions to Roth accounts are considered ordinary income, not capital gains, which excludes them from the clutches of our newest D.C. investor advisor. But don’t hold your breath, he’s got very sticky fingers when it comes to taxation.
This elimination of stepped-up in basis is a really big deal. Based on calculations by the Congressional Joint Committee on Taxation, the stepped-up provision collectively saves heirs more than $40 billion a year.
The current federal tax rate on such investment gains is 0% (unless, under current law, an individual has a larger than $11.7 million estate at the time of death). Combined, those current two provisions eliminate most folks from having to pay federal estate taxes. Above the $11.7 million level, an estate tax of up to 40% might be imposed on the full asset value at death.
Another potentially negative impact of Joe’s proposal is that unless special exceptions accompany the change, an estate that owes this onerous tax might be forced to sell assets to meet the obligation. The sale of liquid assets is one thing. The sale of family farms or family-operated businesses is quite another. Deferments on inherited farms and/or businesses might…might…be available until the heirs no longer own or operate them. Or in the case of illiquid businesses, a timeframe over which to pay the tax bill might be granted, but right now, who knows.
The impact on gifting is unclear. Currently, a gift of appreciated stock to a grandchild under today’s law doesn’t trigger a capital gains tax because the recipient takes over the deceased’s stepped-up cost-basis. Joe’s proposal doesn’t explicitly mention impacts on gifting. Thus, without a specific exemption, the proposal could very well trigger a capital gains tax on such gifts.
Let’s do an example. I’m going to assume the role of a well-heeled property owner for a moment (just like in Monopoly) and that my sad and untimely demise has occurred. No doubt, it’s a melancholy time, but at the reading of the will, my executor has determined that I possessed assets of $4 million, including $3 million of stock accumulated over a period of many years…during good times and bad, including normal inflation (i.e., loss of spending power). After spending countless hours trying to determine my cost basis in the stock, my executor finally arrived at a “number” - $1 million. Under existing stepped-up law, my beneficiaries would owe no tax…zilch…nada. However, under Joe’s stepped-up elimination proposal, my final income tax return would show a net of $1 million of taxable gains at the proposed new rate of 39.6% plus Obama’s 3.8% surtax on higher earners’ investment income (note how these taxes stack on top of each other over time). The final tax bill? $1 million of taxable capital gains x [39.6% + 3.8%] = $434,000 in taxes as a result of this proposed new provision. This also depends on my other income in that sorrowful year. And it's not just sorrowful because of my untimely death - it's sad because my estate’s income tax will increase from $0 to at least $434,000, and the fact that most of the new tax my heirs must pay will be on assets whose value has been eroded over time by inflation.
In short, Joe views capital gains as if they are current earnings, not the inflation-riddled appreciation of assets over long periods of time…that there has been absolutely no “purchasing power” lost to inflation over the years. We all know better than that, don’t we? Joe simply doesn’t seem to understand that long-term gains are, more often than not, heavily eroded by inflation…and because of this erosion, “patient investors” have historically been incentivized to finance, create, and build businesses with lower tax rates. In fact, not one of the globe’s 10 largest economies tax long-term capital gains at or close to ordinary income tax rates. Why? Competition. Capital seeks out its highest reward, and in today’s world, capital is very mobile. Our new president would argue that the loss of purchasing power has at the very least been offset by asset appreciation. Sure, Joe.
Because of the magnitude of Joe’s stepped-up elimination proposal, this change in the tax code is not likely to come easy. Nor should it. But don’t sell him short. Soaking the rich has a certain appeal to lots of folks in this country. Even though the soaking always…always…trickles down. Case in point, the alternative minimum tax (AMT) was originally designed to tax about 200,000 wealthy taxpayers who, back in 1982, were “using” the tax system to pay little or no taxes. Due to inflation and cuts in ordinary tax rates, taxpayers owing AMT steadily rose to $5.2 million by 2017, most of whom were not rich. Thanks to a Republican Congress, the number was reduced back to $200,000 in 2018. Our new president is considering a reversal of that relief, too.
Joe, haven’t we suffered enough unrecoverable learning…enough physical and suicide-inducing despair…enough economic destruction…and enough social discord inflicted on us by COVID-19? Do we really need more of the same during the current recovery? Enough already!
If this outrages and scares you as much as it does me, I urge you to take action. How? Write your members of Congress and ask for their continuation of stepped-up basis. Heck, let's start a petition effort - it can't hurt, right?
Retirement means no more work - at least no more 9-to-5, 50 weeks a year with a brief vacations, commute-type of work. But some folks reach retirement and need a little extra to pay the bills - or to fund the fun stuff. There are money-making options in retirement that don't involve getting a job. Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
A: A job… consulting or pursuing a full- or part-time job is your best bet if you are willing and able to work. However, that means you won't necessarily be "retired" anymore, so let’s consider several broad categories of normal investment options that a retiree’s choices might include. And because we’re dealing with a retired person, I’m going to travel the more conservative route primarily for “preservation of capital” purposes with emphasis on liquidity.
First, if you’re anticipating a specific need by some relatively specific date, then a simple savings account (including that Rainy Day fund money) might be a viable option for a portion of your portfolio. To further enhance the yield of this very conservative approach, CDs might be part of the cash or near-cash mix – but CDs have obvious downsides, including penalties for early withdrawals, and should interest rates rise during a CD’s term, you’re not in a “without penalty” position to capture the higher rates that a more flexible savings account offers.
For potentially greater yet still conservative yields, you might consider bond index funds. More risk, certainly, but since that long-ago 1930’s Depression era, the “average annual yield” of 10-year U.S. Treasury bonds has approached 5%. However, despite the safety of government-backed Treasuries, those annual rates have vacillated from a high of 33%, to a low of -11%. Therein lies the risk… not loss of capital, but the possibility of bad timing. A bond ladder could moderate some of this timing risk.
Another bond consideration might be Treasury Inflation-Protected Securities (TIPS). Unlike other treasury securities, TIPS pay interest and additional principal to compensate for inflation over periods of 5, 10 or 30 years. Annual inflation adjustments are based on changes in the consumer price index (e.g., the percentage change in the value of the security is added to the principal value, rather than being paid out like interest). And upon maturity, the bondholder is paid the higher value based on the CPI. A caveat is that the value of a TIPS could also drop in the event of deflation. And due to the inflation adjustment, TIPS pay lower interest rates than other Treasury bonds of comparable terms, but the inflation adjustment can produce more attractive results.
As mentioned in previous blogs, I’m a proponent of stock index funds. Not necessarily an “all-in” position for the 5-to 10-year medium term we’re discussing here, but still, investing a meaningful portion of the portfolio to provide an opportunity for some enhanced upside. Yes, like bond index funds, the risk here is an ill-timed loss, just when you’re needing the money, but records indicate that since just before the Great Depression, the average annual return of the S&P 500 has been around 9.65%, the caveat being that although the highest annual return was a hefty 52.56%, the lowest was a mind-boggling -44%.
And the index fund option brings to mind the use of Target-date funds, those popular “all-in-one” mutual fund of funds that provide a highly diversified, age-based mix of stocks and bonds (including international exposure if that appeals to you).
Considering the full range of the aforementioned options, if you desire to take a more conservative approach, shift some (or all) of the stock allocation options to bonds and some (or all) of the bond allocation options to savings accounts or CDs. But if you’re inclined to be more aggressive, shift some of the suggested bond allocation to stocks.
I personally like the idea of investing in highly-diversified index funds, and in this mid-range scenario, lean toward Target-date funds, which are periodically reallocated for you.
Many people view their retirement plans as one-dimensional portfolios, but that couldn't be further from the truth. Your plan can be multi-dimensional with several components - including annuities. Let's discuss the role annuities play in your retirement BIG PICTURE. Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion. WATCH THE VIDEO
A: An annuity is another way to get tax-deferred growth outside of IRAs or other employer-sponsored retirement plans. It's a useful tool that provides additional income upon retirement – but only one of many. Let's talk annuities.
Fixed annuities are life insurance company products that provide minimal insurance protection during what is called the "accumulation phase." During this phase, they earn interest which compounds until it reaches the annuity's "cash value." If the owner dies, the cash value will be paid to beneficiaries. In retirement, the annuity owner selects a life income option that is paid as long as the owner lives…a guaranteed income benefit for life.
Annuities have no upfront sales charges or commission. However, annuities do have early withdrawal fees that the insurance company keeps if money is withdrawn during a certain period, usually 5-7 years after the annuity is purchased. These withdrawal fees are in addition to any taxes or tax penalties that may be due when money is taken out of an annuity prematurely. Of note, if the interest rate paid after the guarantee period is no longer competitive, the annuity can be exchanged for another fixed annuity from a different insurance company.
Interest earned by fixed annuities is income tax deferred until payments are received from the annuity. Each payment includes a partial return of principal, thus, only the interest portion of the payment is taxable income. But like IRAs, if withdrawals are made before age 59 1/2, extra tax penalties may apply.
I’ve had a personal experience with a variable annuity, which is also a contract with an insurance provider but includes both a self-directed investment component and an insurance component. Its intended purpose is for retirement. Unlike the earlier mentioned fixed annuity in which the insurance company invests your funds and provides you with a specific guaranteed return, a variable annuity lets you decide how the money is invested. Obviously, the return on a variable annuity will vary depending on the performance of the investments you choose.
During the accumulation phase of the variable annuity, investment money goes into various pre-selected investment choices, ranging from aggressive to conservative. I chose three mutual funds: a total stock index fund (50%), an REIT index fund (25%) and a balanced fund (25%)…heavily weighted to equities (I was younger then). Because the annuity qualifies as an insurance contract, all investment earnings are tax-deferred until you start taking withdrawals.
To qualify as an insurance contract, the annuity must also provide some form of insurance; thus, most annuity contracts guarantee that your initial investment will be paid out as a death benefit (e.g., that upon your death, even if your investments incur a loss, your named beneficiary will receive the original amount you invested…less any withdrawals you may have taken). And because the annuity qualifies as an insurance contract, all investment earnings are tax-deferred until you start taking withdrawals.
The safety of all annuities – fixed or variable – is based on the financial stability of the issuing insurance company. And with specific regard to variable annuities, your return will vary based on the performance of the investments you choose. Admittedly, in my case, dumb luck prevailed. First, I chose Vanguard to deal with. Second, I chose Vanguard mutual funds to invest in. And third, I chose to remain invested in those three funds during a 33-year period of extraordinary market appreciation. My original investment grew by a factor of 12 during those 33 years, largely thanks to Vanguard’s financial management skills… and maybe a little bit to my patience as an investor (remember those PDQ Principles).
As to the question about losing money in the long run, fixed annuities earn tax-deferred interest on the initial principal investment without the risk of market value loss. Some caveats: Annuities are available with the interest rate guaranteed for 1 - several years. After the guarantee period ends, the insurance company will pay interest based on the company's own investment results.
Despite my own good luck with a variable annuity, I would not recommend a wholesale devotion to annuity contracts. To me, their greatest value is to serve as one of several components designed to replace your paycheck when you retire. Bills don’t stop coming after retirement.
Cash flow sufficient to cover those ordinary expenses is very comforting, and a bucket of liquid assets providing those funds often includes (1) for the lucky few, a company pension fund, (2) for most, an inflation-adjusted social security check or two, (3) for many, a monthly distribution from a 401(k), 403(b), or IRA account, and (4) a gap-filling monthly annuity check.
Use annuities wisely. They aren’t a panacea.
The investment game is a curious and thrilling game of playing it safe while taking risks. This week we explore the stability of bonds, but not James Bonds (apologies - it was too tempting not to type), and how and when they might fit into your portfolio. Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion. WATCH THE VIDEO
A: For the uninitiated, bonds are instruments of debt issued by local, state and federal governments and by business entities that guarantee the holders of those bonds a fixed amount of interest paid monthly, quarterly, semi-annually or annually. In short, if you buy bond(s), you are making a loan in the amount of the bond principal to the issuing entity.
Bonds have long been touted as “safe” investments because they guarantee the return of principal while generating periodic interest payments.
Revenue streams generated by bond investments are stable and predictable, which makes them popular investments for folks – often retirees – looking to generate regular income. In other words, the Silent and Boomer generations probably have investment portfolios heavy on bonds about right now.
A 100% bond investment portfolio is a bit too conservative for a young investor preparing for retirement several decades hence, but don't rule them out altogether.
Though deemed a "safe" investment, bonds carry varying degrees of risk depending on their maturities, which range from a few months to several decades, and the credit strength of the issuing entity. Bonds issued by the U.S. Treasury are the safest because the risk of a national government default on its financial obligations is minimal. Municipal bonds - those issued by local and state governments - are also low-risk and not subject to federal income tax, which often makes them one of the more tax-efficient investments available. Also, bonds issued by successful, highly rated U.S. corporations are low-risk investments.
Interest rates paid on "safer" bonds are usually less than rates paid on lower-rated companies’ “junk” bonds. But don’t eliminate junk bonds out-of-hand. The bond issuer’s stability just might be worth the trade-off depending on the circumstances.
You can choose which type of bonds to invest in based on your goals and risk tolerance.
Bonds provide interest income that often, but not necessarily, meets or exceeds the rate of inflation. Fluctuating interest rates impact the value of a bond positively or negatively, depending on the coupon rate. This becomes a factor if you sell the bond ahead of its maturity date. But once a bond matures, the issuing entity pays the bondholder the par value of the bond regardless of its original purchase price.
Bonds offer the potential for capital gains if a bond is purchased at a discount, as well as its normal stream of interest income.
In the long-term, a good quality equity investment (i.e., company stocks and associated dividends) often outperforms a good quality bond. For this reason, younger investors should probably hold a greater percentage of equities vs bonds in their portfolios. But keep a close eye on your equities/bonds mix because as you grow older- and we all do - your bond allocation percentage should adjust more toward bonds.
Target-date funds are growing in popularity because they make adjustment to bond vs. equities allocations automatically over time. Check it out to see if your retirement fund offers this option.
An angel investor is not necessarily a heavenly creature in white framed by a glow of soft light handing out money to entrepreneurs in need. This week's Q&A focuses on the realities of the angel investor and what their role typically is in the money game. Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion. WATCH THE VIDEO
A: An angel investor (also called a private or seed investor) is typically a wealthy individual or retired entrepreneur that has capital available to invest in a risky new business - a type of venture most investors aren’t willing to or probably shouldn’t back.
Individuals often participate in angel investing for reasons apart from pure monetary yield – reasons like the positive feedback of mentoring new entrepreneurs or perhaps simply keeping abreast of developments in particular business environments.
The angel investor usually does so in exchange for ownership equity or convertible debt. Convertible debt is typically a type of bond that an angel investor can convert into a specified number of shares of the new company or cash of equal value. Ownership equity is the ownership of company assets that too often comes burdened with debt or other liabilities attached.
Becoming an angel investor depends in large part on an individual’s financial condition, contacts, and depth of experience in business. Angel investors typically fill the “seed funding” gap between family and friends' assistance and the more robust financing acquired through formal venture capital. There is no minimum investment amount for individual angel investors - investment amounts can range from a few thousand to a few million dollars depending on the financial strength of the individual angel donor.
Angels typically and solely invest their own funds,but some prefer investing in equity crowdfunding – the online offering of private company securities to a group of people for investment. Crowdfunding is often subject to securities and financial regulation, but it enables broad groups of investors with varying degrees of financial strength to fund startup companies in return for a small pieces of those businesses.
Occasionally, an angel investor is part of a founding group and might later actively engage in management of the start-up, but usually in a non-executive position. Why get bogged down in the daily minutiae of running a business?
With little question, start-up investments are generally extremely risky, and if success does come, are often diluted by future investment events; thus, they require a very high ROI. According to studies, typical angel investors give less than 10% of their portfolio to start-up endeavors. And because of the frequency of high front-end losses, most professional angels seek target returns of at least 10 or more times their original investment obtainable within five years through some previously defined exit strategy such as an IPO or an acquisition.
The stakes are high… as are the occasional rewards.
I am always happy to hear from youngsters who, when money starts burning a hole in their pockets, are looking for ways to invest it rather than just spend it. I am quite intrigued by fractional investing, which is drawing many young investors to the market. In this week's Q&A, I talk about why this bite-sized investing method is gaining traction. Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion. WATCH THE VIDEO
A: To be a wise investor, you have to start somewhere, hopefully at a young age. A good place to start - particularly if your saving and/or spending power is limited - is fractional investing. This type of investing is growing in popularity, particularly among younger stock buyers.
In fractional investing, people buy affordable "bites" of high-value or high-priced stocks for a fraction of the cost of purchasing a full share of the stock. Because some markets, like the New York Stock Exchange, require investors to buy whole shares of securities, brokerage firms purchase the full shares up front and then sell partial shares to investors, allowing them to purchase quality stocks at lower prices.
Fractional shares themselves are not new. They have long resulted from stock splits and other corporate actions and from DRIPS, or reinvestment plans. And, of course, mutual funds have long dealt in fractional shares.
Fairly recently, brokerage firms started selling fractional shares online, including Acorn, Betterment, M-1 Finance, Public, Schwab, Robinhood, Stash, Folio Investing, Montif, Stockpile, etc. They all have their good and bad points - the key is finding the one that best fits your young investor’s needs.
Buying fractional shares helps build a diversified portfolio that was previously unaffordable for many. For example, if a stock trades for $500 per share, you’d need at least $500 to buy a single share. If you wanted to buy more than one share of that stock, you’d have to purchase in increments of $500 ($1,000 for two shares, $1,500 for three shares, etc.). Not so with fractional shares. This type of buying allows a “cash-limited” investor to buy the amount of stock she or he can afford, whether it’s $5, $50, or $500.
As most tech-savvy youngsters know, today’s most popular stocks are also some of the most costly to buy. Building that necessary diversified portfolio consisting of a few shares of each would require… gasp… thousands of dollars in upfront money. Using the fractional shares approach, you can allocate a relatively small portion of your cash to each company whose shares you want to buy. If that’s 10%, you could invest $50 in 10… yep… 10 different companies, regardless of their share price.
Buying fractional shares allows you to build a more diversified portfolio than if you invest all of your money in a single company.
To explain further, let’s review some investing fundamentals. There are three general asset classes within a typical investment portfolio:
* Stocks (also called equities) which represent tiny bits of ownership in companies and which offers the highest – but likely more volatile – yields.
* Bonds (or fixed income) which pay interest to investors who lend money to a company or a government. Bonds generally have an inverse relationship with stocks – often, when stock prices increase, bond prices decrease.
* Cash (or cash equivalents) is the money in your savings account or pocket. Cash provides the least risk and, accordingly, the lowest return. In fact, it often loses value due to Izzy the Inflation Monster. And there are other asset classes, including real estate (property), commodities (natural resources, precious metals), etc., that can provide additional diversification.
It's important to build a diversified portfolio through asset allocation, which is achieved by spreading your investment dollars across a broad range of assets to reduce investment risk. In other words, it's important to invest your money in a mix of the above asset classes (stocks, bond, cash).
Although I’m a proponent of mutual fund investing for young investors because of its built-in diversification, I think there are more effective avenues to learn the fundamentals of saving and investing for youngsters with little or no investment skills and little money - such as fractional investing.
The primary reason fractional investing is so beneficial for those with limited cash is diversification. Diversification is the simplest way to boost an investor’s return and reduce risk. And by pursuing a fractional shares approach, a diversified portfolio can actually be simple to achieve for new investors with limited resources.
Of course, it all begins with saving, so start hoarding a small percentage of that allowance and those birthday and Christmas gifts… and do some research on the purchase of fractional shares.
For more information on brokerages that sell fractional shares, read this.