Halloween is here; the cold of winter is approaching and farmers are all clearing their fields, harvesting the last of the year’s crops to prepare for next year’s planting. Between now and year-end, we need to consider some harvesting of our own to take advantage of the year’s tumultuous markets and minimize any losses remaining in our portfolio. Losses in taxable accounts can be “harvested”, resulting in significant income tax savings that will mitigate the huge losses we have all seen the last two years in our portfolios.

All too often investors have a tendency to hold on to their winners and losers too long. They don’t want to part with losers because they’re sure that as soon as they do, the losing investment will rebound. They can’t stand the thought of selling and then missing out on a miraculous recovery. They overlook the fact that if they sold the loser, they could mitigate their loss by writing off the loss on their tax return and then replace the poor-performing asset with one that has a better probability of providing a good solid return going forward.

As for holding on to winners too long, investors have similar fears; what if they sell a winner and then lose out on future gains? Or, they hold on to winners to avoid having to pay taxes on their gains. Letting taxes get in the way of doing what’s right from an investment standpoint, is a common mistake. You need to establish a target selling price when you purchase a stock. When it reaches that price, you should sell the stock unless you can make a sound argument as to why that stock remains undervalued. Keep in mind too, that a significant increase in the capital gains tax is highly likely going forward.

So, with the 2009 tax year coming to an end, it’s time to “harvest” your winners and plow up your losers. Even though the market has risen sharply in recent months, you may still have significant losses in your taxable accounts. And, if you haven’t rebalanced your portfolio recently, trimming over-allocated asset classes could reduce your portfolio risk significantly. With the economy still facing high unemployment and more real estate foreclosures, many worry about another market pullback. Selling some winners may be a wise move.

If you focus on the tax savings from selling losers and the current low capital gains rate, it will help motivate you to take action. Often the losses will offset the gains and eliminate the potential capital gains liability.

Review your portfolio and look for assets with significant losses. It may be that the asset is worth keeping but has a significant loss that can be used to offset the gains of a winner that needs to be sold. Due to what’s called the “wash-sale rule”, you can’t just sell the asset and then re-purchase it. IRS rules require you to wait 30 days before re-buying, else you lose the right to write off the loss. There may be a way around this rule, however.

For example, let’s suppose you have a substantial holding in the Fidelity Spartan 500 Index fund that is still down significantly from your purchase price. You’d like to sell the fund but want to maintain your position in large domestic stocks, in case the market continues its upward swing. You can sell the Fidelity fund and immediately buy a somewhat similar fund (such as the Vanguard Total Stock Market Index Fund). You may want to check with your tax advisor to be sure the new fund is not essentially the same as the one you sold. IRS rules are unclear as to what they consider to be essentially the same fund. This is a gray area that you need to be pay attention to. In the case where the holding is a stock, you may be able to find a similar stock in the same industry in order to maintain your position in the market.

You also need to analyze your winners to determine those that have reached their target selling price and should be sold. You should also look for stocks that have done so well that they now represent more than 5% to 10% of your total portfolio’s value. Often these holdings are in stock of the company you work for or for which you have strong emotional ties (e.g. inherited from your parent). Nevertheless, a stock holding of more than 5% to 10% of your portfolio adds significant risk that should be avoided. Having too much stock in the company you work for is a big mistake. When times get bad, companies layoff people or give early retirements. At the same time, your company’s stock price will likely be low, just when you may need it the most. ”Harvest” time is a good time to trim those holdings too, since losses from losers can help mitigate the taxes from possible gains.

So, as we point out every year to our clients at this time, let the falling leaves be a reminder to take a look at your portfolio and do some “harvesting”!

For those of you over age 70 and ½, who have been required to start taking minimum required distributions from your non-Roth IRAs and defined contribution plans, there may be an opportunity to save on income taxes for 2009. Many of you are likely aware that minimum required distributions were suspended for 2009 for any defined contribution plan or IRA.

While this was good news for retirees, some were not able to take advantage of the waiver, since their retirement plans kept making distributions regardless of the IRS waiver. In many cases the retirement plan documents required that distributions continue. In other cases, individuals were unaware of the waiver and failed to take action to stop distributions.

A recent IRS notice, IR-2009-85, Sept. 24, 2009, allows a participant or surviving spouse to roll over required minimum 2009 distributions from an IRA or defined contribution plan to another plan or IRA. The deadline for rolling over the distributions is November 30th, 2009 or 60 days after making the distribution, whichever is later.

Not everyone can roll over distributions taken. Non-spouse beneficiaries cannot roll over distributions. And, if you took several distributions from your IRA (e.g., $1000 a month from January through September), you may only roll over one of the distributions. Therefore, if you took only one, large distribution, the waiver may be of significant benefit. For multiple smaller distributions, the benefit of the waiver is less significant.

There is no extended due date for rollovers for distributions in excess of the minimum required distribution. And, those who are taking a series of substantially equal periodic payments (e.g. 72(t) payments) from a 401(k) or IRA cannot apply the waiver. If you think you might benefit from the IRS notice, we strongly recommend you discuss your situation with your tax advisor.

Sometimes we lose track of time. It seems like we’ve been in this economic crisis for eons, yet it was only March 9th of this year that the Dow Jones Industrial Average hit 6,440, closing that day at 6,547. Recently, on October 19, 2009, the Dow reached 10,092, a 54.1 percent gain. That took only seven months!

And here we sit with the unemployment near 10%, residential real estate still suffering and commercial real estate a worry for many. Over 100 U.S. banks have now gone under.

While many believe that stocks are becoming over-valued and are worried about a market correction, the market has continued to hold ground. Many times we’ve seen it go down a bit and then shortly reach a new high.

We sense that the continued rally may be fueled to a significant part by those who pulled out at the bottom and have, until recently, been sitting on the sideline watching the market recover. They panicked as the market went down and sold at or near the bottom. Now, worried that they will miss the rally, they are buying as the market reaches new highs, even as the economic news still gives one much cause for worry. In short, many who are perhaps fueling the rally have a habit of buying at market highs and selling at market lows.

We can all remember many times when the market has gone through such gyrations before. The tech stock bubble and 9-11 are still fresh in our memory. There will be many more such market gyrations in the future. So why can’t people learn? They continue to follow the crowd as stocks get over-priced; overloading their portfolio in the latest hot investments, only to lose a substantial portion of their gains overnight as the market comes crashing down. They then panic and pull it all out or perhaps just don’t take advantage of the buying opportunities at the market lows.

We tell our clients that they don’t want to be what we call the “typical investor”. The “typical investor” lets his or her emotions drive their investment decisions. Their fears of missing out at market highs and losing as the market dives cause them to buy high and sell low.

During the recent market lows, Warren Buffett, renowned investor invested billions in G.E and Goldman Sachs. One of our favorite quotes from Warren: “I will tell you the secret of getting rich on Wall Street. You try to be greedy when others are fearful, and you try to be very fearful when others are greedy.” In other words, Warren Buys low and sells high, just the opposite of our typical investor.

So how can you avoid the “buy high and sell low” characteristics of the typical investor and remember what the market does time and time again? You need to select a widely diversified target portfolio (six to eight asset classes, at a minimum) with an equity/bond mix that allows you to ride out wild market swings. Then, periodically (at least annually) rebalance your portfolio, selling those asset classes that are over-allocated and buying those that are under-allocated. If you can be disciplined to do this, it forces you to buy low and sell high, just the opposite of the typical investor.

This kind of discipline will help you take advantage of the market cycles that repeat, every so often. You won’t always rebalance at the perfect times (that’s tough to do) but you’ll do better over time since you’ll still have positions in all asset classes. And if you choose to do an extra rebalance during extreme market conditions, you’ll be buying low and selling high. Such a discipline will guide you, should you forget what the market does, time and time again!

In our last article we discussed some of the basics of liability coverage. We discussed the need for primary coverage through homeowners and auto policies and recommended additional coverage by means of an umbrella liability policy.

We are often asked the question: “Who needs an umbrella liability policy.” As litigious as our society has become, we believe that all but those of very modest means should have an umbrella liability policy. We feel this way because not only do you need to protect your current assets but also your future income. Even if you don’t have a large portfolio or a big house, a law suit could have significant impact on your future earnings.

Affluent individuals need significantly more. They likely have second homes, boats, employ domestic staff, travel frequently and perhaps maintain a high public profile. All of these factors increase their liability exposure and increase the probability of a lawsuit.

Those who operate home-based businesses and have children who drive a car or surf the internet have increased exposure. Serving on the board of a non-profit organization adds to your liability risk. An affluent individual could easily need $5 million to $10 million in coverage, or more.

There is no easy way to determine how much excess liability coverage you need. It will depend on the value of your physical assets (homes, boats, cars, and personal property), your investment portfolio, future earnings and potential inheritances. And, the legal environment where you live can also have an impact on your risk exposure.

In selecting an insurer, we suggest you check with several providers including an independent agent. Find out what excess liability limits are available. Check the financial rating of the company by going to the web site http://ambest.com . Ask about how the company handles defense costs and access to legal counsel.

Some facts from a presentation by Stacy Silipo, Strategic Development Manager for Chubb Personal Insurance at the Financial Planning Association of Michigan’s recent Fall Symposium, help put the need for liability insurance in perspective:

•“Personal lines lawsuits comprised $82.5 billion of the $219 billion of tort costs
in 2003
• One of every six jury awards tallies $1 million or more.
• The 6th largest verdict in 2004 was larger than the 1st largest verdict in 2003”

As you can see, risks are very large and they are growing. Make sure you review your liability coverage with your insurance representative or financial planner in the near future. It will be time well spent.

When we do comprehensive financial planning for our clients we find that their liability coverage is often lacking. In today’s litigious society, it is extremely important to have adequate liability coverage to protect you from a broad range of risks. A presentation by Stacey Silipo, Strategic Development Manager for Chubb Personal Insurance was recently given at the Financial Planning Association of Michigan’s annual fall symposium. Ms. Silipo covered a broad range of risk exposures that we need to be aware of.

Liability coverage protects your assets and future earnings from lawsuits or settlements. Most individuals have liability coverage included in their auto and homeowners’ policies. Such coverage is called primary coverage.

Ms. Silipo discussed three types of coverage: Tier 1, Tier 2 and Tier 3. Tier 1 coverage includes bodily injury, defense costs if you’re sued, deductibles and medical payments. Legal (defense) costs may be included in the liability policy limits or outside of the policy limits. Defense costs also may be capped or uncapped. The best scenario is to have defense costs uncapped and covered outside of the policy limits. You need to understand exactly what coverage you have. Tier 1 coverage may also include personal injury coverage for extortion, defamation of character, libel, mental anguish and invasion of privacy. This is not universally included.

Tier 2 coverage includes worldwide coverage, protects Directors and Officers of non-profit organizations and provides excess uninsured/underinsured motorist’s coverage.

Tier 3 coverage includes identity fraud, credit card coverage, rented or borrowed vehicles, kidnap expense and employment practices liability coverage.

Most people carry around $300,000 liability coverage on auto and homeowner’s policies. Significantly higher liability coverage can be acquired in a couple of ways. You can acquire excess liability coverage, which extends the liability coverage on an underlying policy.

Another approach that we commonly recommend to our clients is an umbrella liability policy, which covers a broad range of liability exposures in addition to your underlying auto and homeowner’s coverage. Umbrella liability insurance requires that you have a minimum of underlying liability insurance on your individual auto and homeowners’ policies (usually $300,000 to $500,000 of liability coverage).

Umbrella liability policies are generally sold in multiples of a million dollars (e.g. $ 1 million, $2 million, $3 million, $5 million, $10 million, etc.). The cost of an added million dollars of umbrella liability insurance is often minimal (It can be as little as $200 to $250) but obviously depends on your specific risk profile. We believe everyone with significant assets or earning power should seriously consider an umbrella policy.

In our next article, we will discuss in more detail who needs higher liability coverage and how much is enough. We will also share with you some recent facts presented by Ms. Silipo to give you an idea of the magnitude of the current level of liability claims.

Back in July we wrote about changes in the tax law that will make converting regular IRAs to Roth IRAs much easier (“Roth IRA Conversions Will Be Easier in 2010”, July 14th, 2009). After attending the Financial Planning Association of Michigan’s annual fall symposium and listening to a presentation by IRA expert James Lange, we thought it would be worthwhile to re-emphasize the benefits of Roth IRA accounts.

If you have earned income you may contribute $5,000 annually to a Roth IRA and $5,000 for your spouse, if you are married. If you are over age 50 you can contribute $6,000, annually. As you probably know, contributions to Roth IRA accounts are not deductible but grow tax free until withdrawn if certain conditions are met. For 2009, to make the maximum contribution, you must have Adjusted Gross Income less than $166,000 if you are married and less than $105,000 if single. Earned income must be at least as much as the amount you contribute to the Roth IRAs.

Generally speaking, withdrawals made after age 59 and ½ and held in the Roth account for at least five years are tax free. Contributions to Roth accounts can be made at any time, tax free. The rules regarding distributions can be a bit complex and warrant a separate article dedicated to that subject.

Another benefit to Roth IRAs is the fact that distributions do not have to be made at age 70 and ½, as is the case with regular IRA accounts. This makes it possible for Roth IRAs to grow tax free much longer than regular IRAs.

In Mr. Lange’s presentation, he gave examples of the benefits of Roth IRAs. One example showed the benefit of converting your $100,000 IRA to a Roth IRA. Mr. Lange projected that you would be $51,227 ahead after a 20-year period (reasonable assumptions were made).

Mr. Lange then went on to consider the scenario where you die 20 years later but leave the Roth IRA to your 55-year-old child. The benefits to your child would be $1,537,493 in future dollars or $260,963 in today’s dollars adjusted for 3% inflation! The benefits for a grandchild would be even greater.

The bottom line is that if you haven’t considered contributing to a Roth account, you should give it serious consideration. And with the new rules in affect starting in 2010, it will be even more cost effective to convert regular IRAs to Roth IRAs. With the income cap eliminated in 2010, anyone will be able to convert their regular IRAs. Just make sure you have enough money outside of the regular IRA to pay the taxes due.

Our last blog article focused on safe retirement withdrawal rates. We explained the well-known study by Bengen that predicted a 4.1% withdrawal rate from one’s portfolio (with annual adjustments for inflation) would last through a 30-year retirement in all types of markets.

At a recent Financial Planning Association of Michigan’s fall symposium, two different presentations addressed retirement portfolio withdrawal rates. Various studies, including Bengen’s study recommend withdrawal rates in the 4% to 5% range (with inflation adjustments).

Studies subsequent to Bengen’s study showed that with broader diversification the withdrawal rate can be increased by 0.5% or more. Other studies have shown that adjusting annual returns upward and downward as a result of various rules can increase the safe withdrawal rate to more than 5%.

A more recent study by John Harris, CFP®, titled “Market Cycles and Safe Withdrawal Rates” (Journal of Financial Planning, September, 2009), discussed the fact that “financial markets move in long-run cycles. These long-range patterns of the U.S. financial market – called secular cycles, significantly affect safe withdrawal rates.” If you are lucky enough to retire at the beginning of an up-market cycle, you’ll be able to withdraw a higher percentage of your portfolio annually. If you are unlucky and start retirement at the beginning of a downward market cycle, your safe withdrawal rate will be lower.

Unfortunately, it’s very difficult to know where you are in one of these cycles. Harris’ study found that safe withdrawal rates varied in a range of 2% to 4%, significantly lower than rates quoted in previous studies.

For planning purposes, it seems clear that you should not plan to withdraw more than 4% in any case. Other factors that can impact safe withdrawal rates are the portfolio stock/bond mix, life expectancy and expected spending decreases as you age. Regardless of what the future holds, the larger you can grow your investment portfolio, the better off you’ll be.

Last week we attended our annual Financial Planning Association (FPA) of Michigan fall symposium. One of the presentations focused on safe retirement withdrawal rates (i.e., the percent of your portfolio you can safely withdraw during each year of retirement). We’ve read many articles published in past issues of the Journal of Financial Planning so we thought our readers might be interested in how much they can safely spend once they retire.

It turns out that when you retire can have a huge impact on whether your money will last through retirement. If you’re lucky enough to retire at the beginning of a bull market your chance of having your money last is significantly greater than if you retire just before a market crash such as we have just recently experienced.

Traditional financial planning techniques utilized a set of assumptions about portfolio returns, inflation and tax rates along with income and expense data to project what would be left at the end life expectancy. Portfolio returns, tax rates and inflation were typically the same for each year. Yet we all know that tax rates, rates of return and inflation vary significantly from year to year. Therefore such a projection would likely differ significantly from actual results. Even by using very conservative assumptions, there was significant risk of running out of money before life expectancy if you happened to retire at an inopportune time.

A number of studies have been conducted to determine a “safe” withdrawal rate that would ensure your funds would last through retirement. A classic study by Bengen in 1994 suggested a safe withdrawal for a 30-year retirement of about 4.1% with adjustments for inflation. Note this 4.1% is based on the portfolio value on the first withdrawal year and is not recalculated every year – only the inflation adjustment is added to the previous year’s withdrawal amount. Bengen’s safe withdrawal rate assumed a portfolio mix of approximately 60% equities and 40% bonds. The withdrawal rate varied as the portfolio mix varied.

Thus, if you have a portfolio worth $1,000,000 at the beginning of retirement you could withdraw $41,000 the first year. Each year thereafter, your next year’s withdrawal would equal to the previous year’s amount adjusted by the previous year’s rate of inflation. In the example above, if inflation was 3% in the first retirement year, the second year’s withdrawal would be $41,000 x 1.03 = $42,230. Assuming 3% in year three: $43,497…and so on.

Obviously, how much you will need in retirement depends not only what you need to spend but also on other sources of income such as Social Security and any pensions you may have. Our next post will discuss some more recent research on withdrawal rates.

Our last post discussed the importance of having a high credit score in order to minimize credit card, mortgage and car loan interest rates. We also noted how low credit ratings can lead to higher insurance premiums in some states.

This post focuses on some of the various factors that have an impact on your credit rating. A recent Wall Street Journal article titled “Credit Scores: What You Need to Know” (September 9, 2009) outlined some of the common myths about your credit score.

First, the article points out, your credit score has little to do with your overall financial situation. It doesn’t reflect your income, assets or whether you pay your utilities or rent on time.

Secondly, paying off your credit card every month, while a good financial trait has no impact on your credit score. Nor does carrying a balance have an impact. One of the most critical factors is how much of the available credit you’ve used. The article points out that you need to keep your balance under half of your limit in order to minimize the effect on your score.

One of the most important factors, the article points out, is paying your credit card, car lease, and mortgage payments on time. A late payment can impact your score for up to a year. If you miss a credit card payment, pay it as soon as possible. Credit card companies typically wait about a month before reporting late payments.

It’s also recommended that you don’t close accounts you’re not using. Let the issuing companies close them instead. A long credit history of both open and closed accounts can help you.

Finally, the article points out that inquiries into your credit report can lower your score, even if you weren’t applying for a loan. When making large purchases, merchants may check your credit, so it may pay to ask about merchant’s policies and shop around to avoid unnecessary inquiries.

Paying attention to your use of credit can have a huge impact on your financial future. Keep the above facts in mind to help minimize your credit score.

Most everyone understands that their credit rating is quite important when it comes to getting a car loan or mortgage. But are you aware that your credit score can have a huge impact on the cost of those loans and can affect other aspects of your finances as well?

Your credit report can be obtained free, annually, from each of the three major credit bureaus: TRW (Experian), Equifax and Trans-Union. Obtaining your credit score may or may not cost you a small fee. A number of services can be found online that will give you free reports from all three credit bureaus. Some of these services also typically offer a free credit report (including your credit score) that requires that you sign up for a credit-reporting service that must be cancelled within a specified number of days or you will be charged for the service. This is one way to obtain your credit score (also called a FICO score) for free. FICO stands for Fair Isaac & Company. Be aware that the credit scores you purchase may not be exactly the same as scores used in reporting your credit (FICO score). Be sure you are obtaining your FICO score and not some other proprietary credit score that may be calculated differently and possibly even on a different scale.

FICO scores generally range from 300 to 850. The three credit bureaus use different methods to calculate credit scores, so your scores will vary slightly from one bureau to the next.

A study was conducted of the relationship between credit scores and the likelihood of a delinquent account. For example, the odds of someone with a credit score of 595 having a delinquent account were 2.25 to one. The odds for someone with a credit score of 780 defaulting on an account are 576 to 1, according to the study. Therefore, it’s easy to understand that your credit score is a major factor in determining whether or not you can obtain a loan.

In addition to your credit score affecting your ability to obtain a loan, it is a major factor in determining the interest rate you will have to pay. The higher your credit score the lower your interest rate. Each lender has its own tiers with associated rates, so it pays to shop around for a mortgage.

The higher your credit score, the more you you’ll pay for mortgages, car loans, cell phones and credit cards. But that’s not all! Insurance companies use credit scores to determine the risk of losses from homeowner and auto policies. Premiums can be substantially higher for those with low credit scores. The insurance companies claim the studies have shown that losses are inversely proportional to individuals’ credit scores (i.e., the lower your credit score the higher the risk of a claim and vice versa.)
The Michigan Court of Appeals recently ruled that state regulators can prohibit insurers from using customers' credit scores to determine home and auto insurance rates. That 2-1 decision reversed a previous 2005 ruling by a lower judge who allowed companies to keep using credit scores.
Ken Ross, Michigan’s Office of Financial and Insurance Regulation commissioner, has stated that this method of assessing risk is discriminatory and against the law. Earlier this year, Ross had rejected rate hikes ranging from 2 to 10 percent proposed by seven insurers who were citing credit scores as a factor. An appeal to the State Supreme Court was still pending in May.
Regardless of whether or not insurers can continue using credit scores in determining premiums, a high credit score can save you plenty and ensure that financing is available should you need it. A little work at maintaining good credit will provide a good return on your effort.
In our next post we’ll discuss things you need to do in order to maximize your credit score.