Volume 7 Number 1

From The Corner Office By Mitchell Freedman, CPA/PFS

The financial markets are still causing investors a pain in the pocketbook. Stocks and equity mutual funds as a rule are not providing the gains that we had become accustomed to seeing during the ‘90s. And while valuations of bonds and fixed income mutual funds have been rising, their yields, as well as those of other interest bearing instruments, such as money market funds and certificates of deposit have been shrinking, thus posing problems for individuals who depend on interest and dividend income for their cash flow needs.

I have recently observed several situations with new and prospective clients who were at or near retirement and who have experienced significant erosion in the values of their portfolios over the past 18 months or so. Not long ago these investors were sure that they had secure futures and now they are concerned that they will outlive their assets. Statistics even showed that in the year 2000, for the first time, assets in 401 (k) plans declined. How did this happen? We all acknowledge that nobody can control or consistently predict how the financial markets will go. Yet many investors chased securities which by historic standards were terribly overpriced. The technology boom of the 90's is over and the “dot bomb” era has arrived. Now investors truly know what risk means. They also now hopefully will be more responsible regarding their investment portfolios.

Most investors thought they understood risk... They could quote that history illustrated that the more risk that you took, the higher your returns would be. What they forgot to learn were the meanings of the following three phrases: “Based upon past history,” “over long periods of time,” and more importantly, “with increased volatility.” Now they know. Another generation of investors has learned the hard way that “what goes up must come down.” And, it came down fast.

Our clients and readers of The MFAC Report have read and heard me posture about using dollar-cost-averaging for investing new money into the markets. They also heard and read my mantra about diversification into different asset classes and different investment styles. It’s at times and in markets like we have had for the last year and a half that the true value of such philosophies and techniques are illustrated.

Don’t lose heart. But, tweak that portfolio to make sure that it truly fits your needs.

They Call it Tax Reform - We Call it the Shell Game By Karen Cho and Tom Trent, EA

On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Act of 2001 (the Act), calling it "the first broad tax relief in a generation." While the Act's relief measures form the largest tax cut in more than two decades, it also imposes a complicated array of unprecedented back-loaded (time delayed) benefits with varying effective dates. Some of the provisions are retroactive, some start next year, and others won’t phase in for another five or even ten years! To further complicate matters, in order for the Act to come within budget, all of its tax benefits (including lowered tax rates and the estate tax repeal) are officially eliminated after 2010. And it is widely believed that Congress will not resist temptations to tinker with the Act's provisions in future years. Let's see a sampling of what we're getting:

Income Tax Cuts
Central to the Act is a $958 billion reduction in personal income taxes. By now some of you may have already received the much publicized “advance refund” checks resulting from the new 10% tax bracket. However, this payoff is minuscule compared to the potential tax savings over the next ten years. All the income tax rates except the 15% rate drop one full percentage point starting July 1st of this year (effectively meaning a .5% drop for 2001). These rates will gradually fall through 2005 until they reach their "permanent" levels at 25, 28, 33, and 35 percent in 2006.

Taxpayers in the higher income tax brackets will also see a back-door tax cut through the elimination of the phase-outs of personal exemptions and itemized deductions. These phase-outs will be reduced by 1/3 beginning in 2006, by 2/3 in 2008 and eliminated altogether in 2010. (However, as we pointed out earlier, under the provisions of the Act, this elimination is itself eliminated in 2011.)

So, who wins in the new tax law? For the first half of 2001, it doesn’t matter if you make $12,000 or $12,000,000; the tax benefit is the same ($600 for a married couple filing a joint return, $500 for a head of household and $300 for a single taxpayer). However, beginning July 1st, taxpayers above the 15% marginal tax bracket will see additional savings.

Marriage Penalty Relief
Another centerpiece of the original proposal was relief from the so-called “marriage penalty.” This relief has been granted, at least partially, but it doesn't start until 2005. Under the Act, joint filers will be entitled to a standard deduction that is twice that of the standard deduction for a single taxpayer. This will be phased-in over a four-year period, ending in 2008. Additionally, the upper-end of the 15% bracket will be increased to an amount equal to twice that of single taxpayers, phased in over the same four years. Therefore, married taxpayers in the 15% bracket who itemize deductions will see no relief.

Child-Related Provisions
The new law doubles the current child tax credit over the next ten years, beginning with a $100 increase for 2001. This amount will increase by $100 in 2005 and 2009, and by $200 in 2010. The Act also increases the dependent care and adoptions credits. Both of these provisions are effective starting in 2002.

Education Provisions
The new law contains some substantial tax relief for education expenses, including a temporary college tuition deduction and a more generous student loan interest deduction. Also, Section 529 Tuition Savings Plans became more beneficial. Anyone with children or grandchildren should consider this vehicle.

Education IRAs have been renamed “Coverdell Education Savings Accounts” and the contribution limits have been bumped from $500 to $2,000 per year, effective in 2002. And, for the first time, these funds will be able to be used to cover elementary and secondary school costs.

Retirement Savings and Pension Reform
Pension reform comprises over a third of the text of the new tax law and the retirement savings incentives are projected to cost $50 billion. The new law permits greater contributions to tax-advantaged savings plans (IRAs, 401(k) plans, etc.) Those with 401(k) and 403(b) retirement accounts will be able to contribute an additional $500 in 2002, increasing by $1,000 a year up to $15,000 by 2006. Participants in SIMPLE plans will see a $1,000 increase each year from 2002 to 2005. Also, starting in 2002, the limit on annual contributions to a company's defined contribution plan will rise $10,000 (to $40,000) and the annual limit on benefits under a defined benefit plan will rise from $140,000 to $160,000.

Contribution limits to both traditional and Roth IRAs will rise from the current $2,000 cap to $3,000 for 2002-2004, $4,000 for 2005-2007, and $5,000 for 2008 and thereafter. Taxpayers age 50 and above will also be able to make special "catch-up" contributions of an additional $500 in 2002-2005 and $1,000 in 2006 and subsequent years.

Estate Tax Relief
The much heralded elimination of the estate tax (aka the death tax) is finally a reality. But only for one year – 2010. After that, the new law ends, allowing the current (pre-Act) estate tax rules, rates and exemptions to return in 2011. Under the Act, the top estate tax rate will reduce 5% in 2002, dropping 1% per year through 2006, remaining at 45% until the supposed elimination in 2010. Likewise the exemption amount will increase to $1 million in 2002 and 2003, and will continue to increase to $3.5 million in 2009.

Complicating matters further, once the estate tax is fully repealed, a modified carryover basis rule will go into effect, effectively turning the death tax problem into an income tax problem. Under current law, the bases of assets inherited from a decedent receive a step-up (or step-down), to their fair-market value. Under the Act, the bases of inherited assets will be the same as the decedent’s basis. This means that when the inherited asset is disposed of, tax will have to be paid on the difference between the sale price and the carryover basis. Just imagine the record keeping nightmare this will cause.

However, some property may escape this treatment, thanks to two exceptions in the new law. First, a bump-up of $1.3 million will be allowed to the basis of certain assets. And an additional $3 million bump-up will be allowed to the basis of assets transferred to a surviving spouse. However, not all property will be eligible for this increase so careful planning will be required to ensure that the estate is able to take advantage of these special provisions. One can also envision estate beneficiaries fighting over which assets get the stepped-up basis.

In order to prevent the significant use of gifts to transfer income producing property from higher to lower rate taxpayers, individual taxpayers will also continue to be subject to a modified gift tax. Starting in 2010, taxable gifts in excess of a lifetime $1 million exemption (in addition to the annual $10,000 per donee exemption) will be subject to a gift tax equal to the top individual income tax rate at that time.

These are just highlights of some of the provisions of the Act. It bears repeating that this Act has an extremely long implementation period and there is a great deal of uncertainty as to whether we’ll see many of these provisions come to pass in their present form, if at all. It is noteworthy that politicians tend to run on a platform of tax reform and some have suggested that if true tax reform were to come to pass, politicians wouldn’t have anything to run on: therefore true permanent tax reform is unlikely. But, who knows? Time will tell. In the meantime, if you have any questions as to what the Act means to your personal tax situation, either in the near or the long term, please contact us.

Heard in the Hall

For the fourth consecutive time Mitch Freedman has been named to Worth magazine’s list of ‘Best Advisors’ in the United States and for the second consecutive year Accounting Today has added him to its list of ‘50 Names to Know in Financial Planning.’ Ticker magazine published a two page profile on Mitch in its August issue.