A Q&A About Our Market Confusion

Here's an amusing graphic that sums up, perhaps in exaggerated form, how some people view the mathematics behind the recent U.S. Treasury bond debt downgrade:



Normally, the very last thing we would want to do is call your attention to daily market movements, because all of the worst investment decisions are made with a short-term focus. But I want you to be aware that we are following, very closely, the market events and their impact on your investment portfolio and ability to fund future goals.

As you no doubt heard in the media echo chamber, the U.S. markets recovered in dramatic fashion on Tuesday after the Monday free-fall. By the end of the trading day, the S&P 500 index was up 4.74%, and the technology-heavy Nasdaq index was up 5.29%. This helps to offset the roughly 16% drop over the past 11 trading days.

What does this mean? Here are some good questions that you may be asking yourself, and the best answers we can provide at the moment.

What was different about Tuesday (when the market was dramatically up) from Monday (when the market was dramatically down)?

Very little from the standpoint of fundamentals. The economy is no stronger or weaker from one day to the next, corporate profits didn't make any radical adjustments, and the underlying worth of the business enterprises and debt obligations that you own have been pretty much the same throughout these Summer doldrums.

The main difference can be found in investor emotion, which is not predictable by any measure that we've been able to find. The Federal Reserve Board gave the optimists something to cheer about when it announced that it would maintain low rates--which tend to stimulate the economy by encouraging banks to lend and companies to borrow (and build factories, and hire workers)--through mid-2013. That means that even though the federal government's expenditures won't be stimulating the economy during this time of highly-partisan belt-tightening negotiations, at least higher interest rates won't slam the economy into recession.

What about the ratings downgrade? Won't that hurt the economy and the markets?

Over the last couple of days, economists and veteran market watchers have been mocking the Standard & Poors rating agency. The kindest things they are saying is that the other rating agencies--Moodys and Fitch--have continued to give U.S. Treasury debt their highest safety ratings. Warren Buffet recently came out with a statement that U.S. government debt is the safest on the planet, and should be given a AAAA rating (which doesn't exist), rather than a downgrade.

Those who are less kind are pointing out that the downgrade came from the same Standard & Poors that rated boatloads of subprime debt as 'AAA', fueling the fire that resulted in the 2008 financial crisis. During that same period, it raised the credit rating of Bear Stearns an astounding 5 notches to AA- in March of 2008--the same month that the brokerage firm declared bankruptcy. Lehman Brothers, as a company, held an S&P rating of 'A' the week they went under, and the rating agency reaffirmed its 'AAA' rating on some of the company's securities just three days before it filed for bankruptcy and basically defaulted on everything. It made similar mistakes with Merrill Lynch and Morgan Stanley (rated A and A+ respectively the week they had to be bailed out), and completely missed the problems with the Republic of Iceland.

Meanwhile, despite the downgrade, the prices of Treasury securities surged for the second straight day, sending the 10-year yield to an all-time low of 2.03% before it settled at 2.19%. Sophisticated investors around the world seem not to be worried that the U.S. will default on its debts.

Is this a good time to sell? Or to buy?

Some economists are saying that the market was oversold on Monday--which means that stocks, in general, were selling at a discount to their true value. But we aren't as confident that we know the true value of stocks in an uncertain economy, and it seems clear that emotions are ruling the recent market moves. It is possible that the emotions will take the markets further down, and it seems equally possible that the optimism we saw on Tuesday will continue.

It is worth remembering that in the first half of last year the market experienced a 17% decline (which was greater than the current downturn), and yet finished the year ahead by double-digits.

What should I do about these uncertain markets?

For now, we recommend that you not make any dramatic moves. Your account statements are reflecting the recent drop in market value, but this is a "paper loss" only. If you were to sell right now, you would be locking in a real loss. As we have discussed in the past, investing is a long-term process, and generally full of unpredictability and surprises. If you look back three years ago, the Dow had dropped to around 6,000. At the end of the day Monday, it was still around 11,000--almost double the low of a few years ago. Think back to all the scary headlines about double-dip recessions, sovereign debt crises in Europe, unemployment and all the rest, and you realize that the headlines were telling you to sell when it was much more profitable to hang on.

Is this time different?

Probably not. 　The world will come to its senses and hopefully we will be in a better place. 　However, we never know what is really going to happen, and I have found by planning for the things I can control - sharing time and love with friends and family, and living life fully from a place of love and joy, makes my world a better place while waiting for the rest of the world to get it together.

　
Sources:

Market rise and Treasury surge:
http://finance.yahoo.com/blogs/daily-ticker/dow-jumps-430-points-stealth-fed-ease-202736590.html

The Debt Ceiling

THE DEBT CEILING

Many Americans don’t want it to be raised.
Could our economy hold up if it isn’t?

Congress must think (and act) fast. In the middle of May, the national debt limit of $14.3 trillion will be reached. This means the federal government must increase the debt ceiling sufficiently to cover U.S. obligations through the end of 2012. It will undoubtedly happen, but not before a loud round of partisan politics is finished.1

What does the public think? In April, a CBS News poll showed that 63% of Americans opposed raising the debt ceiling. Polls often ask simple yes-or-no questions, and the respondents may not have understood the consequences here. If the debt ceiling isn’t raised, America will end up defaulting.2

What would default mean? Picture something like the Wall Street downturn of 2008-2009 happening again … but in a broader context.

As Treasury Secretary Timothy Geithner explained succinctly in a letter to Senate Majority Leader Harry Reid (D-NV), a default would mean that “the Treasury would be prevented by law from borrowing in order to pay obligations the Nation is legally required to pay, an event that has no precedent in American history.” A default would limit, halt or impact Social Security and unemployment benefits, veterans’ benefits, federal worker salaries and payments to members of the armed forces.3

These aren’t the only calamities that would happen. America sells Treasuries to finance its federal government operations, and other nations and investors have bought them with absolute confidence – we haven’t defaulted since 1933. A default would elevate borrowing costs across the board. It would act like a tax. You would see higher interest rates, with implicit damage to equity prices and home values. The ripple from this could hurt retirement savings, consumer spending and investment.4

Moreover, a default would shatter the conviction other nations have in our political framework. It might be decades before we could count on cheap debt again.

GOP’s memo to Obama: no higher debt limit unless we cut trillions. The President is adamant about raising the debt ceiling. On May 9, Speaker of the House John Boehner (R-OH) said it could only happen if “significant” cuts to the federal budget could be made: “We’re not talking about billions here. We should be talking about cuts in trillions if we’re serious about addressing America’s fiscal problems.”1

The GOP leadership does not want to see emergency tax increases. Addressing the Economic Club of New York, Boehner said that “raising taxes is off the table” because “it will have a devastating impact on our economy.” On May 7, Senate Minority Leader John Kyl (R-AZ) requested that revisions to the tax code to address the deficit be kept “totally off the table” as such moves would only amount to backhanded tax hikes.5

“We do not have a revenue problem; we have a spending problem,” Boehner noted. “Let’s address the spending problem.”5

How would privatizing Medicare help? House Budget Committee Chairman Paul D. Ryan (R-WI) claims that his controversial plan to privatize Medicare by 2022 would save the federal government $5.8 trillion over the next ten years. Ryan’s proposed voucher system would assign $8,000 annually to a typical 65-year-old for purposes of buying a private health plan. (The voucher amount would vary per person, with richer and/or healthier seniors getting less.)6

The non-partisan Congressional Budget Office disagrees and says out-of-pocket medical costs would double for seniors through Ryan’s plan. The CBO estimates that with this voucher system, the typical 65-year-old would pay about $12,510 out-of-pocket each year for medical care above the $8,000 of “premium support” provided. In contrast, it says that under the current Medicare structure, the same 65-year-old would pay $6,150 out-of-pocket in 2022 (providing Medicare payments to doctors are not greatly reduced).6

How long before this impasse gives way to agreement? It could take days, it could take weeks. “I am guarded in my optimism,” House Majority Leader Eric Cantor (R-VA) remarked on Bloomberg Television this week. Secretary Geithner claims that the federal government could use “extraordinary measures” to keep borrowing money into the beginning of August. Noting that there was “no hard date” to hike the debt limit, Boehner said that “allowing America to default would be irresponsible. But it would be more irresponsible to raise the debt ceiling without simultaneously taking dramatic steps to reduce spending and reform the budget process.”

This material was prepared by MarketingLibrary.Net Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty.

Citations.
1 - advisorone.com/article/boehner-demands-obama-cut-spending-get-debt-limit-deal [5/10/11]
2 - mercurynews.com/breaking-news/ci_18041062 [5/11/11]
3 - economix.blogs.nytimes.com/2011/01/04/fearing-another-u-s-debt-default/ [4/1/11]
4 - treasury.gov/connect/blog/Pages/letter.aspx [1/6/11]
5 - businessweek.com/news/2011-05-10/republicans-rule-out-tax-increases-in-debate-over-debt-cap.html [5/10/11]
5 - businessweek.com/news/2011-05-10/republicans-rule-out-tax-increases-in-debate-over-debt-cap.html [5/10/11]
6 - articles.latimes.com/print/2011/apr/07/nation/la-na-gop-budget-20110408 [4/7/11]
7 - montoyaregistry.com/Financial-Market.aspx?financial-market=common-financial-mistakes-and-how-to-avoid-them&category=29 [5/12/11]

The Unexpected Recovery

Did you know that the Internet can now read minds? Here's the proof: Reading Your Mind.

Last week, the world celebrated an unusual two-year anniversary: 24 months from the low point in the global markets, the point of maximum pain and panic following the 2008 economic meltdown and so-called Great Recession.

On March 9, 2009, the S&P 500 had fallen to its low of 676, which is about where it had been in October of 1996--13 years before. Since then, the S&P index has gone up about 95%, bringing it within 15% of its record high in 2007. The Russell 2000 index, which tracks small cap stocks, has gone up 140% in the same period, and the MSCI Emerging Markets Index is up 122%.

If you look back at the economic forecasts and market reports in March two years ago, you don't find, anywhere, a prediction that the markets would recover as they have. There was even some doubt whether the U.S. economy would survive intact, and the most common prediction was deflation, continued recession and more downside in the stock markets.

In retrospect, this most frightening time was the ideal time to shove all the chips on the table and bet everything on a stock market recover--but who had the intestinal fortitude for that? After the losses that virtually all investors had sustained, no matter where they had deployed their assets, few had the stomach, or the heart, to bet on a robust recovery. This is a terrific lesson in the value of disciplined investing; the consensus and our own gut feelings are often wrong and inevitably point us in the opposite direction from where the returns are going to come from next. In the past, every long-term upturn has been greater than the losses sustained in the prior bear market. We don't know how this one will end, but it seems to be following the same seemingly unlikely, but not unusual, course.

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The Tsunami's Global Impact

We're all hearing about the tragedy in Japan, with horrific photos and video footage of the aftermath of the earthquake and 10-meter Tsunami. The humanitarian disaster, with thousands dead and tens of thousand homeless, will continue to capture the world's attention. If you can bear to look, here's some remarkable Japanese TV footage of the tsunami roaring into the Japanese coastline: Tsunami Footage

But what impact will the disaster have on the global economy and investment portfolios? Japanese stocks fell 6.2% on Monday after a 1.72% drop on Friday. While significant, this decline is actually less than the 7.5% decline that followed the 1995 Kobe earthquake. London's Guardian newspaper reported that the Bank of Japan injected 21.8 trillion yen ($266.9 billion) into the Japanese economy, as a measure to limit the financial devastation wreaked by the crisis.

The hardest-hit Japanese stock is likely to be Tokyo Electric Power Company, which has had to close power plants and is fighting core meltdowns in three nuclear facilities. Toyota, which is now the world's largest car maker, has announced that it will close 12 assembly plants across the country until at least Wednesday night, causing $72 million a day in losses.

The disaster also had a counterintuitive impact on global oil prices, crude prices actually fell 3% on Friday and slid further on Monday as analysts expected lower demand in the short-term from the world's third-largest oil consumer. Longer-term, prices could be pushed up. Japan typically receives about a third of its energy from nuclear power, but its power capacity fell by more than one-fifth as 11 reactors went off-line. Japan may be bidding against the world for oil supplies, since oil and gas are the most plausible energy replacements to its nuclear generators. Of course the additional demand comes as Libyan oil fields have come off-line.

How the disaster will affect other countries is uncertain. U.S. shares fell 1%, and European shares dropped 1.5% on Monday, but the U.S. News & World Report web site quoted several international economists who believe that the damage is unlikely to spread, and who expect the high-savings Japanese to rebuild quickly and efficiently. The Japanese do hold about 10% of U.S. government debt, so if the Japanese decide to repatriate funds to pay for a massive cleanup and rebuilding effort, it could raise government bond rates.

The U.S. News & World Report analysis further speculated that the Japanese auto industry may have to temporarily curtail shipments of the Toyota Yaris, Scion xD and xB, Honda CR-V, Accord and Fit and Acura TSX and RL. Dealer networks normally carry a 30-day supply of autos, so the shortage won't become immediately apparent; a bigger issue is whether Japanese auto makers will be able to find replacements for the parts suppliers whose factories were destroyed, and whether U.S.-made models will suffer from a shortage of parts shipped from Japan.


Sources:

Guardian articles: Article 1

Article 2

U.S. News & World Report: US News

SHOULD YOU PAY OFF YOUR HOME BEFORE YOU RETIRE?

Before you make any extra mortgage payments, consider some factors.

Should you own your home free and clear before you retire? At first glance, the answer would seem to be “absolutely, if at all possible.” Retiring with less debt … isn’t that a good thing? Why not make a few extra mortgage payments to get the job done?

In reality, things are not so cut and dried. There is a fundamental opportunity cost to consider. If you decide to put more money toward your mortgage, what could that money potentially do for you if you were to direct it elsewhere?

In a nutshell, the question is: should you pay down low-interest debt, or should you invest the money into a tax-advantaged account that could potentially bring you a strong return?

Relatively speaking, home loans are cheap debt. Compare the interest rate on your mortgage to the one on your credit card. Should you focus your attention on a debt with 6% interest or a debt with 15% interest?

You can usually deduct mortgage interest, so if your home loan carries a 6% interest rate, your after-tax borrowing rate could end up being 5% or lower.

If history is any barometer, your home’s value may increase over time and inflation will effectively reduce the real amount of your mortgage over time.

A Chicago Fed study called mortgage prepayments “the wrong choice”. In 2006, the Federal Reserve Bank of Chicago presented a white paper from three of its economists titled “The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings”. The study observed that 16% of American households with conventional 30-year home loans were making “discretionary prepayments” on their mortgages each year – that is, payments beyond their regular mortgage obligations. The authors concluded that almost 40% of these borrowers were "making the wrong choice." The white paper argued that the same households could get a mean benefit of 11-17¢ more per dollar by reallocating the money used for those extra mortgage payments into a tax-deferred retirement account.1

Other possibilities for the money. Let’s talk taxes. You save taxes on each dollar you direct into IRAs, 401(k)s and other tax-deferred investment vehicles. Those invested dollars have the chance for tax-free growth. If you are like a lot of people, you may enter a lower tax bracket in retirement, so your taxable income and federal tax rate could be lower when you withdraw the money out of that account.

Another potential benefit of directing more funds toward your 401(k): If the company you work for provides an employer match, then you may be able to collect more of what is often dubbed “free money”.

Let’s turn from tax-deferred retirement investing altogether and consider insurance and college planning. Many families are underinsured and the money for extra mortgage payments could optionally be directed toward long term care insurance or disability coverage. If you’ve only recently started to build a college fund, putting the assets into that fund may be preferable.

Let’s also remember that money you keep outside the mortgage is money that is easier to access.

What if you owe more than your house is worth? Prepaying an underwater mortgage may seem like folly to you – or maybe you really love the house and are in it for the long run. Even so, you could reallocate money that could be used for the home loan toward an emergency fund, or insurance, or some account with the potential for tax-deferred growth – when all the factors are weighed, it might look like the better move.

Think it over. It really comes down to what you believe. If you are bearish, then you may lean toward paying off your mortgage before you retire. There is no doubt about it - when you pay off debt you owe, you effectively get an instant return on your money for every dollar. If you are tantalizingly close to paying off your house, then you may just want to go ahead and do it because you love being free and clear.

On the other hand, model scenarios may tell you another story. After the numbers are run, you may want to direct the money to other financial priorities and opportunities, especially if you tend to be bullish and think the market will perform along the lines of its long-term historical averages.

No one path is right for everyone. If you’re unsure which direction may be most beneficial to you, speak with a qualified Financial Professional.

William Morrissey may be reached at 360-336-6527 or wtmorrissey@soundfinancialplanning.net

This material was prepared by Peter Montoya Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information should not be construed as investment, tax or legal advice. The publisher is not engaged in rendering legal, accounting or other professional services. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. If assistance or further information is needed, the reader is advised to engage the services of a competent professional.

Citations.
1 chicagofed.org/digital_assets/publications/working_papers/2006/wp2006_05.pdf [8/06]
2 montoyaregistry.com/Financial-Market.aspx?financial-market=will-you-have-an-adequate-retirement-cash-flow&category=3 [2/27/11]

White House Plans to Wind Down Fannie and Freddie

WHITE HOUSE PLANS TO WIND DOWN FANNIE AND FREDDIE

Congress will consider three suggestions.

A fundamental reform for the housing market. For two-and-a-half years, economists and housing industry analysts have wondered what would happen with Fannie Mae and Freddie Mac. On February 11, they got an answer: the Obama administration announced plans to shut down both of the troubled mortgage giants by 2018 or sooner. 1

As he met with the press, Treasury Secretary Timothy Geithner cited the “very broad consensus” that the government should play “a much smaller role” in the housing market. Capitol Hill Republicans would agree, pointing to the $154 billion price tag for the 2008 bailout of both firms. (That is the Treasury’s estimate.) 2,3

The choices on the table. The Obama administration’s white paper offers three proposals to Congress, with the hope of legislation emerging by 2014. 1,2,4,5

• Option 1. The government walks away from the mortgage market except for the FHA, VHA and a few other programs designed to help low-income and moderate-income homebuyers.
• Option 2. The government offers a kind of downside protection. In addition to backing home loans via the entities mentioned in Option 1, it would also provide “reinsurance” to guarantee private mortgages in the event of a real estate downturn and/or recession. But the guarantee would only apply in a crisis.
• Option 3. A variation of Option 2 that would provide a “reinsurance” backstop for a range of mortgage investments already guaranteed by private insurers. The “reinsurance” would take effect if a private insurer couldn't pay (i.e., if its shareholders were wiped out).

The timeline. The Obama administration may be long gone by the time all this plays out, but here is the three-stage conception of how it will wind down both agencies. 2,6

• Stage 1. Between now and 2014, the government gradually reduces its subsidy for the housing market. The conforming loan limit for Fannie and Freddie – now $729,000 in some metro areas – is scheduled to shrink to $625,000 in October. In addition, Fannie and Freddie would start to require 10% down for all loans and fees would rise for the government guarantee.
• Stage 2. Starting around 2013-2014, the federal government will “accelerate the pace of transition” (in Geithner’s words) to a mortgage market based in private capital with government intervention occurring only as needed.
• Stage 3. This stage depends on Congress. The idea is that by the middle of this decade, legislation emerges spelling out Option 1, Option 2 or Option 3 above in detail and a new law is passed.

The big picture. By the end of this decade, it could be considerably harder to buy a home. If the government gets out of the mortgage market (or at least drastically reduces its role), a major influx of private capital needs to flow into the housing system to replace the federal subsidy, with the following possible effects:

• A 30-year fixed rate mortgage could become significantly more expensive. How much more expensive? In early February, Credit Suisse projected that interest rates on a basic 30-year FRM could rise by up to 2% if Fannie and Freddie disappeared.7
• If the Option 1 scenario occurs, you could see considerably fewer FRMs and more ARMs. In fact, you would likely see fewer fixed-rate mortgages if Options 2 or 3 were chosen by Congress.
• Big banks could grab a bigger chunk of the mortgage market.
• Higher mortgage rates could negatively impact home sales - and in turn, home prices.

We’ll have to wait and see how this all plays out, all while hoping it won’t lead to a decline in home ownership.




This material was prepared by Peter Montoya Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information should not be construed as investment, tax or legal advice. The publisher is not engaged in rendering legal, accounting or other professional services. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. If assistance or further information is needed, the reader is advised to engage the services of a competent professional.

Citations
1 – money.cnn.com/2011/02/11/news/companies/fannie_mae_freddie_mac_white_house_proposal/ [2/11/11]
2 – usatoday.com/money/economy/housing/2010-10-21-fannie-mae-freddie-mac-bailout_N.htm [10/22/10]
3 - cnbc.com/id/41529671 [2/11/11]
4 –blogs.abcnews.com/george/2011/02/the-end-of-fannie-mae-and-freddie-mac.html [2/11/11]
5 –nytimes.com/2011/02/12/business/12housing.html [2/11/11]
6 –finance.fortune.cnn.com/2011/02/11/fannie-mae-the-long-goodbye/ [2/11/11]
7 – cnbc.com/id/41533702 [2/11/11]
8 – http://montoyaregistry.com/Financial-Market.aspx?financial-market=the-financial-security-rulebook-5-crucial-steps&category=3 [2/13/11]

27 Things You Should Know About the 2011 Tax Laws

2011 is here and there is much to report. Congress has restored the estate tax, cut the payroll tax and retained and/or restored a variety of tax breaks.

Here’s a look at some recent developments in federal tax law – not just the changes for 2011-2012, but also the decisions (some quite recent) that may impact your 2010 return. This is by no means a tax planning guide, just an update on what has changed and what hasn’t.

Before we get started, some news about filing your 2010 federal return:

• Due to a lag in IRS processing systems, you will need to wait until at least mid-February to file your return if you are going to claim …

o itemized deductions on Schedule A
o the Higher Education Tuition & Fees deduction
o the Educator Expense deduction

• This year, the federal income tax deadline is April 18. That’s because April 15 is a holiday in the District of Columbia (Emancipation Day).
• Correspondingly, all taxpayers who file for an extension this year will have until October 17 to file their 2010 returns. 1

Here’s a look at the numerous revisions, alterations and restorations to federal tax law affecting tax years 2010, 2011 and 2012.

1 The federal income tax brackets remain at 10%, 15%, 25%, 28%, 33% and 35% for 2011-2012.

The ordinary taxable income brackets for TY 2011 are set as follows, reflecting minor COLAs:

• Single Taxpayers:
o 10% bracket has a ceiling of $8,500
o 15% bracket starts @ $8,501
o 25% bracket starts @ $34,501
o 28% bracket starts @ $83,601
o 33% bracket starts @ $174,401
o 35% bracket starts @ $379,151

• Married Filing Separately:
o 10% bracket has a ceiling of $8,500
o 15% bracket starts @ $8,501
o 25% bracket starts @ $34,501
o 28% bracket starts @ $69,676
o 33% bracket starts @ $106,151
o 35% bracket starts @ $189,576

• Head of Household:
o 10% bracket has a ceiling of $12,150
o 15% bracket starts @ $12,151
o 25% bracket starts @ $46,251
o 28% bracket starts @ $119,401
o 33% bracket starts @ $193,351
o 35% bracket starts @ $379,151

• Married Filing Jointly or Qualifying Widow/Widower:
o 10% bracket has a ceiling of $17,000
o 15% bracket starts @ $17,001
o 25% bracket starts @ $69,001
o 28% bracket starts @ $139,351
o 33% bracket starts @ $212,301
o 35% bracket starts @ $379,1512

2 The payroll tax paid by employees and the self-employed has been reduced by 2.0% in 2011.

This means many Americans will effectively get a 2% raise this year. The reduced withholding could mean as much as $2,136 in savings, as earnings up to $106,800 are subject to payroll tax. No phase-outs apply, and if taxpayers are married, both spouses can get the individual deduction. 3,4

Two related notes:
• The partial credit for payroll taxes paid by employers is gone this year.5
• As a result of this payroll tax holiday, the Making Work Pay credit is gone for 2011. However, many taxpayers can still claim the Making Work Pay credit for 2010 ($400 for individual taxpayers, up to $800 for taxpayers married filing jointly, income phase-outs applicable). 6

3 The estate tax is back for 2011- 2012.

For this year and next, the federal estate tax is set at 35% with a $5 million individual exemption.4 Please note that:
• The $5 million individual exemption is portable. This means that an executor may elect to transfer an unused $5 million individual estate tax exemption (upon the death of one spouse) to the surviving spouse. So with this new portability, a married couple could potentially transfer up to $10 million of assets without incurring federal estate tax.7
• In 2011, an executor of an estate for a decedent who died in 2010 may choose between two options in administering said estate. That executor can elect to
o Subject the estate to the 2011 federal rules (35% estate tax, $5 million estate exemption, stepped-up basis for appreciated assets per IRC rule 1014).
o Subject the estate to the 2010 federal rules (0% estate tax and the $1.3 million modified carryover basis for appreciated assets in the estate, which becomes $3 million for assets passing to a surviving spouse). 8

4 The estate tax, the gift tax and the generation-skipping tax (GST) have all been reunified for 2011-2012.

They all have top rates of 35% with $5 million individual exemptions. The individual estate and gift tax exemptions are portable between married couples; the GST exemption is not. The GST has been restored for 2011; it was 0% in 2010. 4,8

The annual gift tax exclusion remains at $13,000 per donor in 2011. A single taxpayer may gift up to $13,000 to an unlimited number of individuals. The lifetime exclusion (see above) is $5 million. 4

In addition to the annual exclusion, an unlimited gift tax exclusion is allowed for amounts paid on behalf of a donee directly to an educational organization for tuition. Likewise, amounts paid directly to health care providers also qualify for the unlimited gift tax exclusion. 9

5 Tax rates on capital gains and dividends haven’t been hiked.
In 2011 and 2012, the long-term capital gains rate is

• 0% for taxpayers in the 10% and 15% brackets.
• 15% for everyone else.4

6 Traditional IRA owners who go Roth this year can’t defer income resulting from the conversion into subsequent tax years.

In 2010, you had that option; this year, you don’t. If you went Roth in 2010, you have until October 17, 2011 to choose whether you wish to divide the income from the conversion between your 2011 and 2012 federal returns. 4

7 High earners won’t be bitten by “stealth income taxes” during 2011-2012.

The Pease and PEP limitations – repealed for 2010 – are now on holiday through 2012. A quick explanation if you’ve never heard of them: the Pease provision cancels out up to 80% of the amount of a taxpayer's itemized deductions if his or her AGI exceeds a certain level. In other words, you can deduct the full amount of your itemized deductions in 2011. The PEP (personal exemption phase-out) whittles away at the personal exemption benefit for taxpayers who reach certain AGI levels. 4,10

8 The charitable IRA rollover is back – at least for 2011.

In federal tax law, this is known as a Qualified Charitable Distribution – a tax-free donation of IRA proceeds to a qualifying charity or nonprofit. Given the generous $5 million individual estate tax exemption now in place, there may be less impetus to make such gifts – but nonprofits are just glad the opportunity is back.

To be tax-free, the donor must be 70½ or older and the donation has to take the form of a direct transfer (a rollover) from your IRA trustee to the qualifying charity, nonprofit foundation or nonprofit organization. (You can also make a tax-free donation of IRA proceeds to a fund held by a community foundation, but not a donor-advised fund.) You cannot claim a charitable tax deduction from this move. 11

Will this opportunity stick around after 2011? We don’t know. It is set to sunset at the end of the year.

• The Tax Relief Act of 2010 gives donors who make such Qualified Charitable Distributions before through January 31, 2011 the option to have them treated as QCDs on their 2010 federal tax returns. 11

9 The Small Business Jobs Act of 2010 extended some tax breaks and put some tax changes into play for small companies in 2011.

The SBJA was passed into law during September 2010, and its recently enacted laws will affect both 2011 and 2010 federal returns.

• Full business expensing is permitted for 2011, just as it was in 2010. The IRC Section 179 expense deduction limits of 2010 remain in effect this year. A small business can write off 100% of the expense of qualifying equipment or computer software made in 2011 with a $500,000 limit. The capital expenditures can be on new or used equipment. Your company has to be profitable in order for you to take full advantage of the write-off, and you can’t take complete advantage of it if you have spent more than $2 million on qualifying capital in the given tax year. 12,13

• 100% exclusion possible on gains from small business stock. If you bought such stock after September 27, 2010, any gain may qualify for a 100% exclusion under IRC § 1202.). 13

• The bonus first-year depreciation has been extended. If your company purchases new tangible or intangible property in 2011 (which includes buildings, machinery and equipment, vehicles, furniture, software and even patents and copyrights), your company can claim 100% of its cost as long as your business uses the property before 2012. This 100% depreciation also applies for tangible or intangible property bought after September 8, 2010. You can also claim 50% depreciation on purchases of this kind made from January 1 - September 7, 2010 as long as the tangible or intangible property is put into service prior to 2013. (Real property is not eligible for this tax break.) 12,13

• The deduction for start-up expenses has doubled. The Small Business Jobs Act of 2010 raised it to $10,000 for 2010 and subsequent tax years. Phase-outs on this deduction now kick in at $60,000 worth of startup expenditures (previously, it was $50,000). 13

• Some businesses may be able to claim a major health care tax credit. Does your business have 25 or fewer full-time employees? Are you paying most of them less than $50,000 annually? Do you pick up the tab for 50% or more of their health insurance premiums? If so, you may be able to deduct up to 35% of the money you spend on those premiums in tax years 2010-2013. To get the full 35% credit, you must have 10 or fewer full-time employees with annual wages averaging $25,000 or less. Above that, phase-outs apply. The tax break is unavailable if you have more than 25 full-time employees or if you pay your full-time employees average wages of more than $50,000. 12,13

• The carryback period for eligible small business credits under IRC § 38 was extended from 1 year to 5 years. This was put into effect for the 2010 tax year. Such credits may be used to offset both regular tax liability and AMT liability. 13

• The depreciation deduction has increased for business-owned vehicles. The SBJA increased the maximum deduction for a passenger automobile first placed in service in 2010 to $3,060. The maximum deduction for a truck or van first placed in service in 2010 increased to $3,160. Remember that the car or truck has to be totally used for business purposes to take full advantage of the deduction. 14

• In 2011, the holding period for S corporations is reduced by 2 years. The SBJA cut the holding period from 7 years to 5 years for 2011. So if your C corp elected to convert to an S corp as recently as 2006, it can sell appreciated assets this year without paying the built-in corporate level tax. This provision only applies in TY 2011. 15

10 Employers must begin reporting employee health care benefits on Form W-2 in either 2011 or 2012.

This is an effect of the Affordable Care Act. For informational purposes, employers are now required to report the value of the health insurance coverage they offer to employees on W-2s. The IRS is offering employers a one-year grace period, however: it has deferred the reporting requirement for TY 2011, so this year it is optional. Reporting the value of the health care coverage to the IRS will not affect the taxable income of your employees. 16

11 Landlords must abide by new IRS reporting requirements.

Prior to 2011, only full-time property managers and some lessors had to file 1099 forms with the IRS as a consequence of doing business. The Small Business Jobs Act of 2010 changed that.

Anyone who receives rental income in 2011 has to file a Form 1099 for all payments of $600 or more made to service providers – handymen, plumbers, carpenters, landscapers, electricians, any individual or company providing a service linked to your residential or commercial rental property. You don’t need to file 1099 forms for purchases of goods for your rental property, only services. Only aggregate annual payments of $600 or more for services have to be reported.

Unless Congress intervenes, such reporting will be demanded of all businesses, self-employed individuals and independent contractors come 2012. 17

12 The first-time homebuyer credit is gone.

It expired at the end of September 2010. You can take advantage of the credit on your 2010 federal return if you closed escrow on a home before October 1, 2010 and had a binding contract in place prior to May 1, 2010. 13

13 The personal exemption and standard deduction amounts have (barely) increased.

For 2011, the personal exemption amount increases by $50 to an even $3,700. Standard deductions are as follows for 2011:

• Single Taxpayers: $5,800
• Married Filing Separately: $5,800
• Head of Household: $8,500
• Married Filing Jointly or Qualifying Widow/Widower: $11,6002

14 The AMT has again been patched.

As part of the Tax Relief Act of 2010, the Alternative Minimum Tax exemptions were increased to these levels for 2011:

• Single Taxpayers and Heads of Household: $47,450
• Married Filing Separately: $36,225
• Married Filing Jointly or Qualifying Widow/Widower: $72,45018

15 The self-employed may be able to use the self-employed health insurance deduction to reduce their SECA taxes in 2010.

This was a mid-year tax law change that happened as a result of the SBJA. For TY 2010, self-employed business owners may deduct the cost of health insurance for themselves and their family members as a business expense when calculating self-employment tax. (You can do this on Schedule SE, Line 3.) Prior to 2010, the self-employed could only deduct health insurance costs for income tax purposes (on Form 1040, Line 29). A worksheet on all this accompanies IRS Form 1040. The health coverage must be arranged under the umbrella of your business, and you must not be eligible to participate in an employer-sponsored health plan. 18

16 If you have a Flexible Spending Account, you can no longer use your FSA funds to pay for most over-the-counter medicines.

Insulin is a notable exception to this new rule. You can still use your FSA money for non-prescription medical or medically related items like crutches, wigs, contact lens solution and other items detailed within IRS Publication 502. 4

17 Investment brokers have to provide the IRS with cost-basis reporting in 2011 when it comes to the sale of certain assets.

They must report the original purchase price of stocks, REIT shares and foreign securities to the IRS in 2011 when these assets are sold. In 2012, they will have to follow new rules for cost-basis reporting for mutual funds, bonds, options and many ETFs. 4

18 If you own more than $50,000 in foreign financial assets, you may be subject to a new IRS reporting requirement.

You may have to meet additional reporting and disclosure requirements in 2011 in addition to filing an FBAR (Report of Foreign Bank and Financial Accounts). This new reporting requirement may impact hedge fund investors who previously didn’t have to file FBARs. Consult your tax advisor. 4

19 The state and local sales tax deduction option is back for 2011 (and you can also claim it on your 2010 return).

Do you live where there are no local or state income taxes? Once again, you have the choice of taking a deduction for state sales taxes instead of the state income tax deduction for 2011 (and 2010). 18

20 The $250 classroom supplies deduction for teachers is back for 2011 (and may be claimed for 2010).

Are you a K-12 educator who pays for classroom expenses out-of-pocket? Then you are able to take an above-the-line deduction to offset up to $250 of such costs. 18

21 The higher education tuition and fees deduction is back for 2011 (and may be claimed for 2010).

The limit on this deduction is $4,000. (And if you’re reading this item, don’t forget about the American Opportunity Credit, a credit of up to $2,500 that can be used for the first four years of college and applied to the tuition costs and other higher education expenses.) 18,19

22 The adoption credit is larger – and it has been made refundable.

As you file your 2010 return, note that it is now $13,170 per child as opposed to $12,150 in 2009. As it is refundable, an eligible taxpayer can qualify for the credit even if he or she doesn’t owe any federal income tax. The adoption must be documented, so that means you can’t claim this credit via eFile. 18

23 The Earned Income Tax Credit eligibility limit has increased to $48,362 and the Child Tax Credit has been expanded.

The result: more middle class and working class families may qualify for these credits. The CTC is a credit of up to $1,000. Under the new laws, you can claim the CTC if a child was no older than 16 in 2010 lived at home for more than half of 2010, and is claimed as a dependent on your 2010 federal return. 19

24 If you bought a home in 2008 or 2009, you may have to repay up to 100% of any federal homebuyer credits related to the purchase on your 2010 Form 1040.

This is more likely if you bought your home during 2008. Most taxpayers will merely have to repay 1/15 of their credit in 2010. Consult your tax advisor. 20

25 Most unemployed individuals will have to report 100% of their 2010 federal jobless benefits as taxable income.

Not everyone who is unemployed realizes this. In 2009, the first $2,400 of federal unemployment insurance came to you tax-free. There was no such tax break offered for 2010. 20

26 No more real estate tax deduction for those that don’t itemize.

This is just a reminder that you can’t claim this deduction on your 2010 federal return. The additional standard deduction for property taxes went away at the close of 2009. 20
27 No more sales tax deductions for buying a new car or truck.

You won’t be able to claim these tax breaks for 2010, as they faded away at the end of 2009. 20



This Special Report is an update of 2010 and 2011 tax law changes, and is not intended as a guide for the preparation of tax returns. The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by William Morrissey and Peter Montoya Inc. to recipients. No information herein was intended or written to be used by readers for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Readers are cautioned that this material may not be applicable to, or suitable for, their specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. Readers are encouraged to consult with professional advisors for advice concerning specific matters before making any decision, and William Morrissey and Peter Montoya Inc. disclaim any responsibility for positions taken by taxpayers in their individual cases or for any misunderstanding on the part of readers. William Morrissey and Peter Montoya Inc. assume no obligation to inform readers of any changes in tax laws or other factors that could affect the information contained herein.


Citations.
1 irs.gov/newsroom/article/0,,id=233910,00.html [1/4/11]
2 irs.gov/pub/irs-drop/rp-11-12.pdf [12/10]
3 bloomberg.com/news/2011-01-18/it-s-not-too-early-to-think-about-2011-taxes.html [1/18/10]
4 online.wsj.com/article/SB10001424052748703675904576063903166546250.html [1/8/11]
5 turbotax.intuit.com/tax-tools/tax-tips/IRS-Tax-Return/Summary-of-Federal-Tax-Law-Changes-for-2010-2017/INF12041.html#2011 [1/19/11]
6 walletpop.com/2011/01/19/dont-forget-about-the-making-work-pay-credit/ [1/19/11]
7 naepc.org/journal/issue07a.web [12/20/10]
8 blogs.forbes.com/hanisarji/2011/01/02/new-year-different-rules-2011-estate-tax-gift-tax-gst-tax-rules/ [1/2/11]
9 turbotax.intuit.com/tax-tools/tax-tips/Tax-Planning-and-Checklists/The-Gift-Tax/INF12036.html [1/27/11]
10 taxpolicycenter.org/press/press-resources-pease.cfm [1/18/11]
11 ctphilanthropy.org/s_ccp/bin.asp?CID=14889&DID=45124&DOC=FILE.PDF [12/17/10]
12 money.cnn.com/2011/01/17/smallbusiness/small_business_new_tax_credits/ [1/17/11]
13 journalofaccountancy.com/Web/20113750.htm [1/14/11]
14 irs.gov/formspubs/article/0,,id=177054,00.html [10/14/10]
15 s-corp.org/2010/09/28/president-signs-big-relief/ [9/28/10]
16 irs.gov/newsroom/article/0,,id=220809,00.html [1/14/11]
17 realtor.org/wps/wcm/connect/f9c47a804427e7068bf5eb34cafa6d66/government_affairs_issue_brief_rep_rules_1099rev.pdf [1/18/11]
18 irs.gov/newsroom/article/0,,id=233927,00.html [1/4/11]
19 bloomberg.com/news/2011-01-18/children-can-mean-extra-tax-deductions-and-credits.html [1/18/11]
20 smartmoney.com/personal-finance/taxes/whats-new-on-the-2010-form-1040-1295384880669/ [1/20/11]
21 montoyaregistry.com/Financial-Market.aspx?financial-market=finding-a-tax-preparer&category=31 [1/28/11]

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