Paul Ferraresi

The only money you will ever have to spend, lose or invest is what the government allows you to keep. Many taxpayers do not understand that they do have a choice as to whether they will pay a small or large amount of income tax. Why pay the IRS investable funds you are allowed to keep?

Tax-advantaged investments are not “loopholes” in the Tax Law that the IRS is out to plug up. They are not immoral, as some would have you believe. A common fallacy is to confuse tax evasion with tax avoidance. Tax evasion is illegal and punishable. Tax avoidance, on the other hand, is legal and is encouraged by the lawmakers. The United States Congress promotes the shifting of funds from the taxable sectors of the economy to areas of public need or good by passing laws which create tax-deferred, tax-sheltered and even tax-free investments.

Many, ignorant of the nature of the tax-advantaged investments, would have you believe that you are “robbing” the economy of tax dollars by not giving your taxes to the government to spend in their great wisdom. Such advocates are ignorant of the fact that tax-advantaged investments are put into housing, energy, food, strategic metals, research and development, medical needs and transportation.

Rather than being filtered through bureaucratic mazes to the economy, these otherwise diverted tax dollars are being applied directly to where the need lies – creating new jobs, expanding industry and adding to the growth of the country.

Understanding that tax-advantaged investments can be risky should be a prerequisite to becoming involved in them. Although there is the possibility of “hitting it rich” with such endeavors, many have and many will continue to chance the loss of their investment. Yet when compared with the alternative, a 100% chance of loss when paying taxes, such investments can look quite attractive. After all, which investment will offer the greater possibility of providing you income in your golden years or at any other time?

The taxpayer also needs to remember that Congress has passed tax incentives because such investments are risky. Tax advantages are provided to encourage investing in high-risk areas that provide for the social good of the country.

Being involved with a taxadvantaged investment requires a proper frame of mind. It is your sleep that will be lost if you are uncomfortable with such an investment. Such investments are complex – particularly with the ever-changing tax laws. Working with a knowledgeable financial planner will help you avoid many of the pitfalls and help you keep more of your hard-earned dollars from taking a one-way trip to the IRS.

When the Alternative Minimum Tax (AMT) was instituted, it was designed to make sure the top American income earners paid their “fair share” of taxes. The tax rate was a flat 28% with very few deductions allowed. Over the years, Congress has made very few attempts to adjust the level at which Americans will be taxed at the AMT level. Consequently, as inflation has raised individual incomes over the years, many now cross the threshold level to pay AMT. Well, over one-third (33%) of Americans now pay the AMT due to increases in their pay. You see…you calculate the regular tax and the AMT – whichever is greater, you pay.

In trying to fund the new healthcare plan (that only 30% of Americans wanted), Congress set up another trap for everyone…not just the “rich.” Better plan now for future tax increases coming your way as your income rises in the future. The new program is a Medicare surtax.

Strategies for the tax involve creating effective tax deductions under new investment income rules, choosing the right investments, insurance products and business structures, and picking the right time to set up trusts. The idea is two-pronged but basic: Reduce overall taxable income, and reduce investment income.

The surtax adds a 0.9% Medicare Hospital Insurance Tax on earned income over $200,000 for single taxpayers and $250,000 for married couples, and an Unearned Income Medicare Contribution of 3.8% on investment income for taxpayers with adjusted gross incomes over $200,000 for single filers and $250,000 for married filers.

The 3.8% is assessed on the lesser of net investment income or the amount of modified adjusted gross income over the threshold. Net investment income is investment income minus certain expenses and includes interest, dividends, capital gains, annuities, rents, royalties and passive activity income. It does not include active trade or business income, distributions from IRAs or other qualified retirement plans, or income considered for self-employment taxes.

Keeping income below the threshold will be a key line of attack. Ways to do that include stashing money in tax-exempt investments, including municipal bonds. Non-qualified deferred compensation, life insurance policies, and oil and gas investments are other ideas.
Begin now, today, to take an aggressive move in shifting your investments to avoid these future taxes. Do not wait until the “crowd” starts to move their monies. Talk with your advisor now and systematically move your monies. The “crowd” will wait until after they pay the tax to think about making changes.

Ah, discipline or regret…

Every workshop I conduct often leads me to ask the participants: “In the future, do you think tax rates will be going lower, staying the same, or going higher?” Without question, 99% of the people vote higher.

One does not need to be a tax attorney to know what is ahead for all Americans. Here is why rates are going higher:

• Congress moves rates from high to low and back to high. You have been in a “low” period.

• Effective 12/31/2010, the Bush tax cuts will expire, so rates go back up to pre-Bush. This means an average of 3-5% higher for every bracket.

• The war on terrorism will continue for another generation and will require increasing amounts of money.

• Social Security and Medicare are broke. The Baby Boomers are just starting to lean on these programs, so both programs will need increasing amounts of money.

• We have a financial crisis not seen in two generations – a stimulus and mortgage bailout program were failures and thus, will require more monies to pay back these borrowed funds.

• The present administration is designing programs so that 45% of American taxpayers (the payers) will provide for 55% of American non-taxpayers (the takers). Thus, the payers (producers) will be required to ante up more for the takers (non-producers).

Now, all the hype has been…”tax the rich.” Be careful what you wish for…you will become part of the rich very soon, according to the present administration’s plan.

• A report from the IRS for the 2008 tax returns filed, only 256,000 returns out of 142 million returns filed, which is the top 2%, had an adjusted gross of over $250,000 (what some may think is rich). This top 2% paid 45% of all federal taxes collected even though they only earned 25% of all income. Hmmm…. I thought the system was to be fair…you know, top 10% pays 10%, top 50% pays 50%, and so forth. Right now, 50% of all those that earn income pays NO TAX!!

• Even if they confiscated 100% of the income of the top 2%, it would not touch the deficit. Do the math yourself.

• They asked Willy Sutton…“why do you rob banks?” He said…“cuz that is where the money is.” Look for Congressional Revenuers to come looking for more money… “where is the money” – the middle class.

To make my point, let’s look at a few new taxes that have come into effect due to the new health care law:

1) Medicare taxes will increase by 0.9% on joint household wages above $250,000 (on 1/1/2013). Thus, if a couple had $400,000 in wages, they would have a new tax of $1,350 ($150,000 x 0.9%). This amount is not indexed for inflation. So, in the future more people will creep into this area. Also, as with every tax they place on high income earners, it eventually goes down to the middle class.

2) The same upper-income couple above will be subject to a 3.8% new tax on unearned income (interest, dividends, royalties, rents, and capital gains). Say our couple earns $50,000 in interest from their bank accounts. This would produce a new $1,900 tax bill for them (sources: House of Representatives and CBO). This will have a dramatic negative effect on savings and the stock market. In all cases, see your tax advisor for details.

3) As you sell your home in the future, there will be a 4% tax on the gross sales proceeds for everyone. (Hmmm…I thought no new taxes on those earning less than $250,000 – then, they said only on those above $200,000, then they said on those above $150,000.)

You know Congress does all its tax planning based on the “static” approach. That is, they assume everything will stay static and no one will do anything to avoid taxes. In our example above, our couple will incur over $3,000 in taxes and they will do whatever it takes to lower or reduce the taxes. This avoidance will lead to less economic growth, fewer jobs, less tax revenue coming in, then they will have to raise taxes somewhere else and…well, you connect the dots. Just cut spending. Stop this madness!!

Now, I have just covered a few of the new taxes. Rather than waiting for the sword to cut you, I am demanding you take action now…or forever hold your peace.

I have been advocating for years to get your money into programs that will allow your money to grow tax-free. You can have access to the money tax-free at any time and when you die, it transfers income tax-free. This strategy is a layup with a ladder, or a stolen base on a wild pitch.

Please contact us at (713) 871-5919 or at conswella@fgmci.com to take action now. If you wait until the rates go up, it will be too late.

Ah yes….discipline or regret.

I have written many times in this blog about the special Roth conversions available in 2010. My summary of all the long-winded blogs was that a conversion will probably cost you more in taxes than you think, and you will still have strings attached with the Roth. There are far better alternatives for you.

An article in Baron’s magazine may have found other reasons why people are not converting. A Fidelity study found only 7% of investors will convert to a Roth IRA. Also, even with all the media hype, education, and bank/brokerage flyers, more than 88% are unaware of the opportunity. Another reason why people are holding back, the survey found, was government mistrust. A TD Ameritrade survey found that 36% of those who are most ideal for conversion suspect that Washington will change the rules later. Thus, rule changes will mean that the money coming out of Roth will be taxed to reduce the national debt. (This is exactly what happened to Social Security benefits…that is, up to 85% of your benefits can be taxable. Hmmm…taxed once when you earned the money and then taxed again when you receive it. Are you screaming yet?)

There are far better alternatives than IRAs, 401(k)s, and Roth IRAs. Contact us at 713-871-5919 and we will be glad to present them to you. If what you always thought to be true…turned out not to be true…when would you want to learn about it?

Popular wisdom tells you the best way to build a nest egg is to maximize your company’s 401(k) plan. Popular wisdom also held that the sun rotated around the earth, the Titanic could not sink, and the Berlin Wall would never crumble. That’s my way of saying that I think you can construct a stronger nest egg if you funnel money into a personal non qualified retirement plan versus a 401(k) program.

Many people feel that by placing the maximum amount into their 401(k) plan and IRAs they will have great benefits, but these qualified plans are also time bombs.

Assume a couple is making contributions of $4,000/year into their IRA or 401(k) for 30 years. Their total 30 year contributions would amount to $120,000. That is, their…

1) Annual IRA/401(k) Contribution = $4,000 x 30 yrs = $120K Total contributions

Assume they are 34% combined marginal tax bracket for state and federal taxes.

2) Tax Bracket (Income > $67,000) = 34% (Fed + State)

Then, their tax savings would be $1,360 per year, or, $40,800 over the 30 years.

3) Tax Savings = $1,360/yr x 30 years = $40,800 Total

Now, assume they invested the $4,000 per year and obtained a hypothetical 10% annual rate of return for 30 years. They would amass a nest egg of $727,773.

4) $4,000 @ 10% for 30 yrs = $727,773

Let’s assume in retirement they could still earn 10% annual return. Then, without touching the principal they could withdraw $72,700 of annual income per year.

$727,773 X 10% = $72,700 per year withdrawal

Since they are retired, the kids have moved on so they have lost those exemptions; they mistakenly paid their home off so they lost those deductions; They will also be receiving Social Security benefits, maybe they have a pension or are working part-time, which will now place them in as high or higher tax bracket as they were in prior to retirement. Let us assume they are in the original combined state and federal rate of 34%. Their tax bill on the $72,700 withdrawal from their IRA/401(k) would be:

$72,700 income from IRA/401(k) X 34% tax bracket = $24,700 Tax bill

So, in the first two (2) years of retirement they will pay $49,400 in taxes. This $49,400 is far in excess of the $40,800 they saved in taxes during the accumulation years (see Section 3 above). Additionally, they will pay the $49,400 in taxes every two years for the rest of their life. Also, they will have to pay income tax on the $727,773 nest egg when it is withdrawn, plus possible estate tax of 45%. Hmmm! Whose retirement were they planning? Theirs or Uncle Sam’s?

In the first 20 months of retirement, every dollar of taxes saved during 30 years of deductions will be paid back. In fact, a person living a normal life expectancy will pay back over 10 times in taxes, on a qualified retirement plan, during the retirement years than the taxes saved during the contribution years.

For an average couple, they will pay over $500,000 in taxes from their IRA/401(k) from age 65 to 85½ for the privilege of saving $40,800 in taxes while they were working.

Why didn’t someone tell me the rest of the story?