Summer Jobs

For students, summertime is that wonderful time of year when they get to put down the books, stay up late, sleep in and spend time with their friends.  And for many older kids, it also means it’s time to find a job!  Encouraging your kids to work during their summer break can be a great way to teach them about their personal finances and give them a sense of financial responsibility.  It will also give you peace of mind to know where they are and what they are doing while you are at work.  So whether they get a part-time job at the local sub shop or an internship in their field of study, there are a number of things to keep in mind as they get started in the working world:

• If they did not owe any tax last year and don’t expect to owe any this year, they don’t need to have federal income tax withheld.  To claim this exemption, they need to write “EXEMPT” (NOT a zero) on line 7 of the W-4 form they will need to fill out with their employer.  They should leave boxes 5 & 6 blank.  No tax will be due for 2013 if their total income doesn’t exceed $6,100 and their unearned income (interest, dividends, and capital gains) is $350 or less.  If unearned income is more than $350, their total income can’t exceed $1,000.
• If a W-4 was filed for 2012 with an exemption from withholding, even if they work for the same employer, they will need to refile the form for 2013.
• State rules vary for withholding so they should check the rules for the state in which they will be working.  For Maryland, if their total income will be below $9,750 for 2013, they do not need to withhold Maryland taxes either. 
• Students will often work in a state other than their home state – either getting a job in their college town or moving to the beach for the summer.  Filing an exemption from withholding if their income is low enough will not only allow them to keep a few more dollars in their wallet, it will also save money on additional tax filings to claim any potential refund in a nonresident state!
• If you are looking for an incentive to encourage your children to work and save, you could offer a “matching contribution” to a Roth IRA.  You can contribute 100% of your dependent child’s earnings to a Roth IRA, up to a maximum of $5,500.  This is a great way to teach your kids to start saving for retirement early and also give them an incentive to work hard and save!
• If you are self-employed and your kids are under 18, hiring them to work for you can lower your tax bill.  No FICA (Social Security and Medicare) tax is due on their income and you can take a deduction for the payments on your Schedule C.  Federal unemployment tax is also not owed on their salaries until they hit age 21.  Of course if you do this you need to make sure the child has a legitimate job and is providing services as an employee.

While your kids might be reluctant to give up their summer freedom, getting a summer job will help set them on the path to financial independence.  It will be easier for them to enter the working world after college if they’ve already had some experience.  I always kept busy during my summers and it certainly helped me prepare for life after college.  Whether it was mowing lawns, laying tile or auditing benefit plans, all my summer jobs were valuable learning experiences that helped shape who I am today. 

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Check Your Credit Report

Unless you tried to qualify for a loan recently, you probably haven’t thought about your credit score in quite some time.  A study completed earlier this year by the Federal Trade Commission (FTC) might change that.  If you saw the report that aired on 60 Minutes in February, you were probably shocked to find that one in five Americans had at least one error on their credit reports.  While many of these errors are minor and don’t impact their overall credit score, more than one in ten consumers saw a change in their credit score after errors were modified.  They also found that 5.2% of participants had errors that were serious enough to negatively impact what they pay for products such as auto loans and insurance.

Even if you don’t plan to take out a loan in the near future, you should still check your credit report each year to make sure the information is accurate.  You now have the right to a free copy of your credit files once every 12 months at www.annualcreditreport.com.  Be sure to avoid the catchy TV commercials trying to drive you to some other site where they will no doubt attempt to sell you more than you need in addition to your “free” report.  This website is the only official site where you can get your free report. 

I just walked through the process myself and it is pretty simple.  You will need to enter some information about yourself, then you will be asked to pick among the 3 different credit reporting agencies.  They should each be similar in their reports.  Keep in mind you won’t find out your actual number score, but you will get the nuts and bolts behind your number in a detailed report that you can print out and keep in your files.  The report will show what bank accounts, credit cards and loans you have along with all recent balances and any late payments.  Be sure to carefully review each entry – you might even find an old account you thought you closed that is still sitting out there unused like I did!

If you find any information that you believe to be inaccurate, you should be able to dispute that item through the credit agency you selected online.  The FTC website has additional information on disputing errors in your credit reports along with other helpful hints for dealing with credit issues.

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President Obama's Proposed 2014 Budget

Earlier this year The American Taxpayer Relief Act of 2012 was passed and it “made permanent” a number of provisions, including the $5,250,000 (for 2013 and indexed for inflation) estate and gift tax exemption.  Apparently they have a loose interpretation of the word “permanent” down in Washington.  President Obama’s proposed 2014 budget was released a few weeks ago and it has us going back to the 2009 estate, gift and GST tax rules in 2018.  This would increase the top estate tax rate back to 45% from the current 40% and reduce the exclusion amount back to $3.5 million for estate and GST taxes and $1 million for gift taxes. 

While the budget will likely face a number of revisions before it reaches its final form and many of these proposals will never become law, it is still important to take a look at them to see what changes we might soon be seeing in the tax law.  The estate tax change is just one of many interesting proposals that include:

• A new “Buffett Rule” that would be called the “Fair Share Tax”.  This would make sure that higher income taxpayers (starting at $1 million of income) pay a minimum tax rate of 30%, less a credit for charitable contributions. 
• A limit on itemized deductions that would cap their value at 28% if your income is over $250k ($200k for singles).  That means if you are in the highest tax bracket you would no longer receive a full benefit of your itemized deductions.
• This 28% cap on deductions would also apply to tax-exempt bonds, making them partially taxable for those in the top tax brackets.
• A $3 million cap on the value of IRAs and other tax-deferred retirement accounts.  This rule wouldn’t penalize you if your account is over $3 million but would prevent you from making additional contributions once you reach this limit.
• A number of proposed rules would limit the effectiveness of many estate planning techniques, such as the use of grantor retained annuity trusts (GRATs) and intentionally defective grantor trusts (IDGTs).
• Elimination of the “stretch IRA” where non-spouse beneficiaries are allowed to take distributions over their life expectancy when they inherit an IRA.  Under the new rules the beneficiary would need to completely withdraw the full amount of the IRA within 5 years of the original owner’s death.

These are just a few of the more notable highlights from the proposed budget.  We will continue to monitor any developments on this front and let you know which, if any, of these proposals actually make it into law.

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The B Word

They are normally the forgotten part of your portfolio.  They provide steady returns with low volatility.  They aren’t as exciting as stocks, but lately they are on everyone’s minds.  I’m talking of course about bonds.  Bonds have historically offered lower long-term returns than stocks but provided protection against stock market declines and have been an integral part of any portfolio.  However over the past 30 years interest rates have fallen to near zero and seem to have nowhere to go but up in the future.  So what does that mean for bonds in your portfolio?

Let’s step back a minute to provide a quick summary of how bonds work.  When you buy a bond, you are buying a stream of future payments at a certain interest rate.  When market interest rates fall, that bond becomes more valuable because nobody else can buy a bond at that rate anymore.  When interest rates rise, the bond loses value because now investors can buy a different bond with a higher rate.  Rates have been steadily falling for a long time now and as a result, bond investors have not only been earning interest on their bonds, but also gains on the increase in the bonds’ value.

If you hold individual bonds, you can always hold the bond to maturity, collect the interest payments and receive the principal of the bond at maturity, assuming the entity who issues the bond doesn’t default (default risk).  Many of our clients use mutual funds to invest in bonds because it is too expensive to buy individual bonds and you need to invest a large amount of money to diversify the bond portfolio enough to reduce the default risk.  Bond fund managers don’t just hold bonds to maturity – they actively buy and sell bonds and therefore generate capital gains when bond rates decrease and will generate losses if rates rise.

We know bonds will lose value when rates rise and we know rates are near zero so should we sell all our bond holdings now before rates rise?  Of course not!  Here is a list of some reasons why you need to keep bonds in your portfolio:

1. We don’t know when rates will rise.  The Fed has said it expects to keep short-term rates low through mid-2015, but it’s anyone’s guess if they will stick to this and if they do, we don’t know how intermediate and long-term rates will react.
2. If you keep expectations in check, bonds will still do their job and provide ongoing income and stability to your portfolio. Don’t expect your bond portfolio to earn 6-8% annual returns like we’ve seen recently. If you expect more modest returns and keep a long-term focus, you won’t be disappointed. 
3. In the long run, higher rates will actually benefit bond investors, assuming inflation stays in check.  While the value of your bonds will face a short-term decline in value, new bonds will be issued at higher interest rates.  If you are invested in a bond fund or have a bond ladder, money from maturing bonds can be reinvested in bonds with higher yields that will eventually help you recover the short-term loss in value.
4. Keeping your duration short and your bond portfolio diversified will help protect against a spike in interest rates.  Long-term bonds will face a steeper drop in value when rates rise so try to stick to shorter-term bonds, even though that means lower rates right now.  Make sure you have some exposure to other bond categories like TIPs, international, high yield and emerging markets.  They will behave differently than high quality corporate and municipal bonds and provide some diversification to your portfolio.  Just be aware that some of these bond categories are much more volatile.
5. Remember that even when rates rise and values decline, we aren’t likely to see bonds fall 30-40% in value in a short period of time like we saw in the stock market in 2008.  A 5-10% loss on your bond portfolio might feel just as bad though, especially when it’s been so long since we’ve seen bonds lose value at all.  But keep things in perspective – a short-term loss can result in long-term gain.
6. Bonds are still the best complement to stocks in a portfolio.  They have a low historical correlation to stocks so if stocks take another plunge, bonds will help soften that blow.  Just look back to 2008 when high quality corporate and government bonds provided positive returns while stocks were in a free fall.  We don’t know when stocks might see another 2008 so having that protection from bonds is critical.
7. DIVERSIFICATION!  We say this over and over again but we really can’t stress it enough.  Bonds continue to be the best way to add diversification and reduce volatility in your portfolio.  

Remember it’s important to come up with an asset allocation that makes sense for you given your risk tolerance and return objectives, then sticking to this allocation for the long term.  We can’t predict what the markets will do in the short-term so having a long-term plan for your money is the best way to accomplish your goals.  Now is a great time to review your asset allocation and your bond portfolio to make sure they are in line with your goals.

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The American Taxpayer Relief Act of 2012

It took until the last minute and it certainly doesn’t solve all the problems facing our country, but Congress was finally able to reach a deal to avoid the fiscal cliff.  We are still sorting through all the details of the compromise but wanted to highlight a few pieces we thought might have the most impact for many of you:

Income Taxes:

• Ordinary income tax rates will stay the same if your income is under $400,000 for single filers or $450,000 for joint filers.  If your income is over these levels, the top ordinary rates increase from 35% to 39.6%.
• The top long-term capital gains and qualified dividend tax rate rises from 15% to 20%.  This rate applies for those in the new top bracket.  For those not in the top bracket, the prior 0% and 15% rates are made permanent.
• The phaseouts for personal exemptions and itemized deductions are reinstated at income levels of $250,000 (single) and $300,000 (joint).  Itemized deductions will be reduced by 3% of excess income over the threshold and personal exemptions will be reduced by 2% of the total exemptions for each $2,500 of excess income over the threshold.
• The AMT is permanently indexed for inflation and the exemption for 2012 will be $78,750 (joint) or $50,600 (single).

Estate Taxes:

• The $5,120,000 (for 2012) estate and gift tax exemption is made permanent and indexed for inflation.
• The tax rate is raised from 35% to 40%.
• Portability for the surviving spouse is made permanent.

Other Items:

• The 2% payroll tax cut was NOT extended.  This was already set to lapse but in effect will act as a tax increase as the rate had been reduced for the past 2 years.
• The new Medicare taxes set to go into effect in 2013 were NOT affected by this bill.  This means the additional 3.8% Medicare surtax on net investment income and the 0.9% tax on earned income (over the thresholds) will still be in place.  This means for many people the tax on long-term capital gains and dividends will actually be 23.8% in 2013.
• The American Opportunity Tax Credit for college expenses is extended 5 years.
• The exclusion from income for qualified charitable distributions from an IRA to a charity is extended through 2013
• Makes permanent many other Bush-era tax cuts in addition to the rate cuts, including but not limited to: $1,000 child tax credit, increased dependent care credit, above the line deduction for student loan interest, adoption credit.

There are many additional items included in the 157 page bill.  If you are feeling particularly motivated in this new year, you can read every page here.  If you’d prefer to read some well written summaries that go into more detail than what we have provided, here are a few of our favorites:

• Financial Planning Implications of HR8 – the Taxpayer Relief Act of 2012, by Michael Kitces
• It Passed: Five Things Everyone Should know about the Fiscal Cliff Tax Deal, by Robert Woods at Forbes
• What the New Law Means for Taxpayers, by Laura Saunders at the Wall Street Journal
• Congress Passes Fiscal Cliff Act, by Paul Bonner and Alistair Nevius at Journal of Accountancy
• House Passes Senate Budget Bill Convincingly: We Have a Tax Deal!, by Kelly Phillips at Forbes

If you have any questions related to the bill and how it might impact your tax situation, feel free to contact us at 410-494-6680 or send us a message here.  There are many personal financial planning implications so stay tuned for our thoughts later this month.

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