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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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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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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Just to give a quick refresher, the Homestead Credit was passed to help homeowners deal with large assessment increases on their principal residence.  As home values soared in the 2000’s, many people faced big increases in their real estate tax bills due to the increased assessment values.   The Homestead Credit was put in place to cap the annual increase in assessment value at 10% per year.  This helped ease the burden of increased real estate taxes on many individuals.

In 2007, legislation was passed that required homeowners to submit a one-time application in order to continue eligibility for the Homestead Credit.  Prior to that the credit was automatically available and as a result many people were taking the credit on their primary home along with vacation and rental homes.  Property owners were mailed a notice sometime between 2007 and 2011 to alert them that an application needed to be filed. 

Odds are you don’t remember if you ever filled out the application.  That’s ok – it’s easy to find out online!  Just go to the State Department website and enter your county and street address.  Once you find your property, at the very bottom of the screen you should see a section that shows “Homestead Application Information”.  If you’ve filed an application you should see the details here, and it will look like this:

What if it doesn’t show that you’ve applied for the credit?  You can easily fill out an application online here or you can print out a PDF of the application and mail it or fax it in.  More details about the credit and how to file an application can be found here.

 Be sure to check for yourself and remind others to check as well.  With the recent decline in home values, this credit isn’t at the top of most people’s minds right now.  But if home values rebound or even start to increase again, you want to make sure you have filed your application so that your real estate tax rates don’t jump up unexpectedly!

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They are both similar in many ways.  Being healthy physically and financially will lead to less stress and a better quality of life.  Both take long-term commitment and sacrifice.  You can’t expect to lose all your weight in a week and you won’t solve all your financial issues overnight either.  If you want to lose weight you need to eat healthier and stay active.  If you want to reach your retirement goals you need to save more, spend less and invest wisely.  Just as I always advise you not to jump on the hot new investment; you also shouldn’t try every new fad diet that comes along.  Sure it might help you lose some weight in the short term, just as you might hit a couple home runs on “hot” investments.  But in the long run you are bound to revert back to your old ways and gain back that weight, just as you will eventually pick some losing investments that will hurt your retirement goals.

The best way to reach your long-term goals is to change your lifestyle, not try for the quick fix every year.  It’s not easy and it’s certainly not the most fun way to reach your goals, but it’s the best way.  This doesn’t mean you can’t enjoy yourself from time to time.  Just as most diets allow you one “cheat” day where you can eat something bad, if you are trying to save and cut costs, allow yourself to “cheat” every once in a while and buy something you really want.  It will make that purchase all the more rewarding and enjoyable.  Just make sure that purchase isn’t so big it will do damage to your long-term goals.

Many people are self-starters who will try to reach their financial and physical fitness goals on their own.  However others need a little guidance.  These people might hire a personal trainer to help them get in shape.  Fee-only financial planners can offer the same benefit to your financial health.  Whether you just need to come in for a one time review of your finances to see if you are on the right path, or if you need ongoing advice to make sure you stay on track, we can help.

These next couple weeks are a great time to sit back and come up with your personal goals for 2013.  Maybe this year, in addition to getting in better physical shape, you should make a resolution to improve your financial health too!  Take the time to sit down and review your portfolio to make sure your asset allocation still makes sense given your risk tolerance and goals.  Look at what your expenses were for 2012 and see if there are areas you can cut back.  What did you save last year?  Can you save more?  Even bumping up your 401(k) by just 1% can make a huge difference!  These are just a few of the things you should be looking at.  We’re happy to help so contact us if you want to schedule a time to talk.

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We understand not many people will be impacted by this change but it also provides a good reminder to review the FDIC Insurance rules.  If you have any bank deposits over $250,000 at one institution, you might be exposing yourself to more risk than you realize.  If something were to happen to that bank, all the cash you hold there might not be covered by FDIC insurance.  We have a good article on our website summarizing the FDIC Insurance rules or you can go directly to the FDIC website.  If you have any questions feel free to contact us.

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President Obama won reelection with wins in both the Electoral College as well as the popular vote.  The Democrats retained control of the Senate while Republicans held onto the House.  So the government will have a very familiar look, but does that mean we will be in for the same old gridlock of the past four years?  Maybe, but maybe not. 

As we have discussed at length here on this blog and in person with many of you, our government has a lot of issues to deal with and they need to deal with them soon.  Before the election there was your typical posturing about what each party would do to avoid the “fiscal cliff” and to set the country on the right course.  Now they need to get down to it and come to some type of agreement.  There have already been some good signs that each side is willing to bend a little.  The Republicans are reeling after failing to capture the Presidency or to pick up seats in the Senate and now seem more willing to negotiate. 

So what will happen next?  There are two more likely scenarios.  The first is a short-term extension during the lame duck session for many of the tax increases and budget cuts set to go in effect at the beginning of 2013.  This would give Congress time to come up with comprehensive tax reform in 2013.  The other scenario is they don’t come up with any agreement during the lame duck and instead it takes until early 2013 to agree to extensions of the tax increases/spending cuts.  This is clearly the riskier scenario and many think the President will fear the reaction of the markets to this scenario and that will help hasten a deal before the end of the year. 

No matter what happens it looks like major tax reform could occur sometime in 2013 or 2014.  It’s too early to tell what exactly this would look like but many experts are already comparing it to the 1986 reform.  The impact on the markets is also yet to be seen.

Despite the uncertainty this is not the time to panic with your investments.  Trying to time the markets and predict what will happen with our government is nearly impossible.  We have already seen a sell off in equities since the election but we don’t know when they will recover.  Trying to get out of equities now could leave you on the sidelines for any recovery.  As always, you should stick to your asset allocation targets and maintain a diversified portfolio that is appropriate for you.  If you’d like help assessing your portfolio and coming up with a financial plan, feel free to contact us.

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I just went through a refinance myself and was able to get an incredibly low rate that will save us thousands of dollars over the length of our loan.  We have seen many clients do the same.  Refinancing to a lower rate can free up additional cash flow in the short term and it also lowers the cost of the loan in the long-term.  If your cash flow is fine you might even want to consider a shorter loan term.  This lowers the cost of the loan even further and allows you to pay down the principal of the loan much quicker.

It is important to run a cost benefit analysis before deciding on a refinance to make sure the settlement costs don’t negate any savings from the new lower rate.  You will need to factor in your current and potential loan rates along with estimated closing costs on the refinance.  You should also consider how long you plan to stay in your current house.  If you want to move in the next couple years you might not have enough time to recover the costs of the new loan.

If you are currently paying anywhere over 3.5-4% on your mortgage it would be worthwhile to at least consider a refinance, even if you refinanced not that long ago.  We would be happy to help you run the numbers and decide if it makes sense for you.  Contact us to find out more.

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