October 11, 2011

All the talk of a Recession: 

We are now into the last quarter of 2011 and uncertainty has reared its head with issues that just won’t go away. Questions regarding our economy, tax policy and Europe are weighing heavily on us all. There is a plethora of negative commentary in the news which is clearly over shadowing any good news. Quite frankly people are more interested in issues that scare them, than in issues that might make them feel good. That’s human nature. I remember a speaker once telling the story of an entrepreneur that started a print newspaper that only reported good news stories, it failed after a few issues. When was the last time you did a Google search for a good news publication? I just did. I found Happynews.com in Austin, Texas. I also went to twitter and found they had 101 followers as of September 9, 2011 and 14,161 "Likes" on Facebook . Not exactly a large following. I also found the goodnewsnetwork.org webpage, apparently they don’t tweet, the mission is to provide a "Daily Dose of News to Enthuse". The Facebook page has 16,242 likes, that’s encouraging but considering the size of the Facebook community, not really that large. Fox News has 2,270,359 and CNN has 3,029,010 "Likes".

Now let’s get to the facts. We are definitely in a period of time when discernment and acting prudent is extremely important. Cut through the "noise" and focus on the facts at hand. A good rule of thumb is to ask why something is true, economic data can be impacted by factors that can spike the numbers to the good, as well as to the bad. A look at history can tell us a lot, as long as we also consider what is different.

Since when is a recession a new thing? Our economy has troughs, expansions, peaks and contractions, we always have. Contractions come at us with varying degrees of magnitude. I am not predicting the magnitude of the next recession, but I am pretty sure we will have another one. That is the American business cycle, Econ 101. It has been widely quoted that more millionaires were made in the "Great Depression" than in any time period of American History. I haven’t done a study on "when" in the depression most of the millionaires started, but my guess is that the majority started their endeavors late in the 1930s in the trough or early into an expansion. Colonel Sanders of KFC fame started serving fried chicken at his gas station in the 1930s. He probably started serving chicken just to increase traffic for gasoline sales. Bill Hewlett and Dave Packard became business partners in 1939, resulting in Hewlett Packard. Had these depression era millionaires started their endeavors at the peak before the great depression the outcome could have been significantly different. Contractions create opportunities by bringing down valuations that have been inflated during the peak of the cycle, exposing weaknesses in business models and management, providing opportunities at lower costs to entry for entrepreneurs and well managed companies to innovate and build better mousetraps. That’s good news.

Our economy is coming off a "credit high". Basically, the credit bubble burst and we are in a period of "deleveraging" that could continue for some time. The "Baby Boomers," those of us born between 1946 and 1964 are not the same consumer today that drove the credit build up with help from accommodating tax policies ( look to May, 1997, for the first time you could sell your home and exclude $500,000 of gain if you were married, every two years and not have to wait until you were age 55 and pay taxes on any gain over $125,000) and credit availability (that one was obvious), consumer spending was in vogue, now it is consumer frugality, except for things we want. According to the US Census Bureau there are about 78 million in the Baby Boomer age group. Quite simply spending and saving trends are changing for this large segment that represents a little more than 25% of our population. This is a fact that we can not change with monetary and fiscal policy. While reports on consumer spending may show improvement, it is important to look at where the spending is occurring. A rising tide in this environment may not raise all ships. But some ships will be raised, so look into the horizon for those masts. That is good news.

What is working for our economy now? Recent prices at the gasoline pump are lower, interest rates are at extreme lows due to an accommodating Federal Reserve, there is liquidity, the dollar is weak (helps with the exporting of our goods), assets prices (especially real estate) have been lowered and Corporate profit margins are good.

What is not working for our economy? Risks of Geopolitical events and terrorism, the appearance of protectionism in our legislative process, uncertainty of inflation, Congress and the administration, our country’s fiscal issues, our demographics, slow economic growth, uncertain tax policy, slow moving implementation of newly enacted and proposed regulations creating extreme uncertainty for businesses and the consumer, consumer and business negative sentiment resulting in caution, causing a lack of demand for many of the usual goods and services.

Yes, there are more on the "not working lists" than on the "working lists". But these lists are fluid and can change before you wake up tomorrow or just stay on the page until the paper yellows. Its usually when the paper yellows that significant changes begin to happen. What worked yesterday may not work tomorrow, but opportunities exists in all environments. That’s good news.
Martin James, CPA/PFS
October 11, 2011

June 9, 2011

Indiana to Tax Out of State Municipal Bonds Beginning in 2012

On May 10th, 2011, Indiana Governor, Mitch Daniels signed two tax bills, one bill includes a provision to tax municipal bond interest from bonds issued from states other than Indiana.

Ind. Code § 6-3-1-3.5(a)(33) as added by L. 2011, P.L. 172, §53, eff. 01/01/2012. "Adjusted gross income" defined adds back to your Indiana income the amount excluded from federal gross income under Section 103 of the Internal Revenue Code interest received on an obligation of a state other than Indiana, or a political subdivision of such a state, that is acquired by the taxpayer after December 31, 2011.

Certain municipal bond interest is generally not taxable for federal income tax purposes and as the law now stands will continue to be tax free for federal purposes. Under prior Indiana law, Indiana considered all municipal bond interest (whether an out of state bond or not) tax free for federal purposes to be tax free on your Indiana income tax return. Many states have always taxed out of state bonds, now Indiana joins that list. An example would be if an Indiana resident owns an Illinois municipal bond and an Indiana municipal bond, the interest from both bonds would have been free from Indiana income taxes. Now, if an Indiana resident buys an Illinois municipal bond after December 31, 2011 the interest received will be taxable on the Indiana income tax return. Your existing out of state municipal bonds are grandfathered.

The current Indiana adjusted gross income tax rate is 3.4% plus a county tax rate that depends on your county of residence as of January 1st each year. The county rate can be in excess of 2%. For a Morgan County, Indiana resident the total state and county rate would be 6.12%. $10,000 of out of state municipal bond interest that was previously tax free would have a state tax burden of $612.

What does this potentially mean to the Indiana municipal bond investor? First, we should see an increase in the demand for Indiana municipal bonds from Indiana residents. The impact all things being equal (i.e., credit quality, etc.) should be to drive yields on Indiana bonds down, resulting in appreciation of existing Indiana Bonds. However, given Indiana’s low income tax rates as compared to states with much higher rates the impact of this additional demand may not be significant. So don’t throw your out of state bond purchase decisions out with the bath water, without some careful analysis. Non-Indiana municipal bonds provide geographical diversification, it’s not only how much of your income you keep on after-tax basis, return of principal matters for the municipal bond investor.

From a tax return preparation perspective, your Indiana return will now be a little more complicated due to the add back of municipal bond interest, municipal bond interest will be separated between Indiana and non-Indiana interest. Municipal bond mutual fund investors will have to dig into the details of the tax reporting to determine how much of any of the income is attributable to Indiana bonds.

This is probably a good time to review your municipal bond portfolios. Not only as a result of this law change, but due to other risks and opportunities associated with municipal bonds in general.

Call risk, credit risk and interest rate risk in your portfolio should be strongly considered in this analysis. With potentially rising tax rates looking into 2012 and 2013 ( as part of the healthcare bill there will be an additional 3.8% surtax on investment income for some taxpayers beginning in 2013) and our country’s aging demographics, more households will be looking to invest more for income, resulting in more demand for income producing investments such as bonds. Being pro-active by actively managing your bond holdings for income and total return, much like you manage your stock portfolio makes a lot of sense in this tax and economic environment. The days of buying bonds, putting them away in safe keeping and clipping the coupons until your bonds mature or are called, are in the past.

Give us a call to schedule a portfolio review.

Martin James, CPA/PFS

May 25, 2011

Ed Slotts IRA Advisor - April 2011 Edition

Ed Slott’s IRA Advisor
April 2011

Guest IRA Expert

Martin James, CPA
Mooresville, Indiana

Dig Deeper for True Marginal Tax Rates

Should your client convert a traditional IRA to a Roth IRA? Contribute to a traditional 401(k) or a Roth 401(k)?

Most advisors have clients weighing such questions, year after year. Often, the decision turns on marginal tax rates. The lower a client’s tax rate, the more attractive a Roth IRA conversion will be, with the promise of future tax-free income. Similarly, lower current tax rates make contributions to a Roth 401(k) more appealing because there’s less benefit to deferring tax now by contributing to a traditional 401(k).

However, marginal tax rates can’t be accurately gauged merely by looking at tax tables. There are many moving parts to consider, including phaseouts, "cliff" tax benefits, and the role of the alternative minimum tax (AMT). Sometimes the results can be surprising. A client with low or even no taxable income might have a higher marginal tax rate than someone earning six figures.

Factors that Impact the Marginal Rate

A simplified example may illustrate this. Suppose Michael Johnson is 52 years old with children aged 10 and 13. Michael has a full-time job while his wife Kim is a homemaker. If Michael contributes $22,000 to a traditional 401(k) this year, the family’s adjusted gross income (AGI) will be $100,000. The Johnsons own rental property that they actively manage. In 2011, the anticipated loss from that property is $25,000.

After taking the standard deduction and four personal exemptions, plus a $25,000 deduction from the rental property loss, the Johnsons’ taxable income would fall to $48,600. Their federal income tax for the year, taking the child tax credits into account, would be $4,444.

Now suppose that Michael calls his financial advisor to ask about a 401(k) contribution. The advisor looks at the federal income tax table for 2011 and sees that the 15% rate goes up to $69,000 on a joint return.
The Johnsons, with a projected $48,600 of taxable income, are solidly in that 15% bracket. Michael’s advisor might tell him that it makes little sense to defer tax in a traditional 401(k) in a 15% tax bracket, so he’s better off putting $22,000 into the Roth 401(k).

The reality, though, is that Michael’s marginal tax rate is much higher than 15%. That’s because of his rental property loss deduction. With AGI of $100,000 or less, up to $25,000 of passive losses from such property can be deducted, assuming other conditions are met. That deduction phases out, $1 for every $2 over $100,000, until disappearing at $150,000 of AGI.

Therefore, by funding the Roth 401(k) instead of the traditional 401(k), Michael effectively increases his family’s AGI by $33,000. That’s from $22,000 going into the Roth 401(k) plus an $11,000 reduction in the deductible loss from the rental property. Crunching the numbers, the Johnsons would have taxable income of $81,600 and a tax bill of $10,656. That’s a $6,212 increase, from switching a $22,000 contribution from the traditional 401(k) to the Roth 401(k): a 28% marginal tax rate.

Just to make matters even more complicated, the "lost" deduction is not actually lost but suspended until it can be used, perhaps when the property is sold. Therefore, the Johnsons’ intention to hold onto or sell the property also would affect the traditional 401(k) vs. Roth 401(k) decision.

Planning for Clients in Low Brackets

As mentioned, even low-bracket taxpayers can have high marginal tax rates. Advisors might not have many low-income clients but there are situations when this can arise.

Suppose, for example, that a valued client asks you to help his son Matt who is married with two young children. Matt has scant earned income while he finishes up his education. Assume that Matt has some money in a traditional IRA. He and his wife are effectively in a 10% income tax bracket, which covers taxable income up to $17,000 on a joint return this year. Therefore, you might advise Matt to convert his traditional IRA to a Roth IRA this year, at least to the extent a conversion would fill up the 10% bracket.

However, a low-income taxpayer can benefit from refundable tax credits, such as the earned income tax credit. Increasing income via a Roth IRA conversion can reduce those credits. If Matt has earned income of $30,000, in this example, his family might be entitled to a $5,000 refund. Increasing his income by $10,000 with a Roth IRA conversion would drop that refund below $2,000.

So Matt’s family stands to lose over $3,000 from a $10,000 Roth IRA conversion. That’s a marginal tax rate over 30%–a higher marginal rate than the 28% rate of a couple with $200,000 of taxable income!

Planning for Seniors

Roth IRA conversions often take place after clients are retired. At that point, tax brackets may have dropped. However, clients 65 and older typically are on Medicare. They often pay monthly premiums for Medicare Part B (doctors’ visits) and Part D (prescription drugs). High-income Medicare enrollees pay more for Parts B and D. The payments increase with income, which go up in steps rather than phase out.

For example, a new single enrollee with modified AGI (MAGI), including tax-exempt income, of $85,000 or less typically would pay $115.40 a month for Part B, or $1,385 a year. If that enrollee earns even $1 over $85,000, he’d pay $161.50 a month, or $1,938 a year.

Falling over the $85,000 cliff costs $553 a year. The same cutoff adds $144 a year to Part D costs, for a total of $697 a year. If a $10,000 Roth IRA conversion moves a client’s MAGI from, say, $85,000 to $95,000, the one-year extra $697 in premiums would add 6.97% to the tax rate on the conversion.

For married couples, the first break point is $170,000 in MAGI. If both spouses are on Medicare, a $10,000 Roth IRA conversion that takes them over the break point adds $1,394 to premiums, effectively a 13.9% surtax.

The maximum Part B premium is $369.10 a month; taxpayers who pay that much also will pay an extra $69.10 a month for Part D, for a total of $438.20 a month: $5,258 a year, or $3,873 over the standard premium cost of $1,385 per year. For married couples, the maximum excess premiums would be around $7,746 a year.

Planning for Part B and D premiums can be difficult because of the time lag. A Roth IRA conversion in 2011, for example, will result in extra MAGI on a client’s 2011 tax return, which won’t be filed until 2012. That MAGI, in turn, will be used to determine Part B and Part D premiums in 2013. Therefore, there is always a two-year delay between a MAGI-boosting action, such as a Roth IRA conversion, and its impact on Medicare costs.

These Medicare issues suggest several strategies. For instance, plan around the Medicare break points. For couples, suggest Roth IRA conversions that result in MAGI just shy of $170,000 or $214,000, for instance. Exceeding the MAGI breakpoints by even a small amount can trigger substantially higher Medicare costs.

If clients want to convert a large traditional IRA to a Roth IRA, warn them of the Parts B and D consequences. A client who converts a $500,000 IRA in 2011 may wonder why he’s paying steep Medicare premiums in 2013, unless there have been some conversations along the way.

At the same time, it may be advisable to avoid small Roth IRA conversions for Medicare enrollees. Triggering $1,850 in extra premiums might be annoying on a $50,000 conversion but that same premium increase would represent a huge chunk of a $10,000 conversion.

Required Distributions

Once clients reach age 70½, they must take required minimum distributions (RMDs) from traditional IRAs. Those RMDs will boost a client’s MAGI and may trigger extra premiums for Medicare Parts B and D. Therefore, it might make sense for clients to do some Roth IRA conversions before age 70½. If the conversions are calculated to avoid triggering higher Medicare premiums, the immediate impact can be modest and those conversions might reduce a client’s traditional IRA, reduce RMDs, and thus reduce the potential impact of RMDs on Medicare premiums.

Once clients reach age 70½ and must take RMDs, another strategy is possible, at least in 2011. Those clients can make donations directly to charity, partially or completely fulfilling RMD obligations without raising MAGI. Thus, such IRA charitable rollovers might be a valuable way to offset the impact of Roth IRA conversions on Medicare Parts B and D this year. These rollovers also may help reduce the tax on Social Security benefits for some seniors.

Alternative Minimum Tax

All the tax deductions and phaseouts and other tax wrinkles discussed above may mean little or nothing to some clients–the ones who are subject to the alternative minimum tax (AMT). Many taxpayers with AGI between $100,000 and $500,000 will owe the AMT, especially if they have multiple dependents and pay hefty amounts of state and local tax.

Taxpayers who owe the AMT must calculate AMT income (AMTI), which allows few deductions. They also have two official tax rates: 26% and 28%. An AMT exemption provides some shelter from this tax. In 2011, the exemption amounts are $48,450 (single taxpayers) and $74,450 (married couples filing joint returns). The AMT exemption phases out as AMTI increases. The phaseout begins at $112,500 of AMTI for singles and at $150,000 of AMTI for joint returns.

Therefore, single clients who are subject to the AMT will have a marginal tax rate of 26% if their AMTI is $112,500 or less. Couples in the AMT have a 26% marginal rate as long as their AMTI is $150,000 or less.

The phaseout of the AMT exemption ends with AMTI over $306,300 (singles) or $447,800 (couples) in 2011. Clients with such incomes have a 28% marginal rate. In between those thresholds, AMT payers are phasing out the AMT exemption. Their marginal tax rates are higher because they’re losing the exemption; their marginal rates are 32.5% or 35%.

Thus, clients likely to owe the AMT will be in one of four marginal tax rates–26%, 28% 32.5%, or 35%. Once you know which of those four marginal rates applies to a particular client, you’ll be able to help make knowledgeable decisions on Roth IRA conversions and 401(k) contributions.

Again, low marginal tax rates can create an ideal climate for Roth IRA conversions and Roth 401(k) contributions. The higher a client’s true marginal tax rate, the more it makes sense to defer tax via a traditional 401(k) and the less appealing a Roth IRA conversion will be.

Martin E. James, CPA/PFS, Certified Public Accountant/ Personal Financial Specialist has been assisting individuals and businesses for over 29 years with their tax, accounting and financial planning needs. A native Hoosier, Marty is a 1981 graduate of Indiana University, School of Business majoring in accounting. Marty is President of Martin James, CPA, PC, founded in 1986 and Managing Member of Martin James Investment and Tax Management, LLC, located in Mooresville, IN. Marty is a Charter Member of Ed Slott’s Master Elite IRA Advisor Group. He is listed on the IRAhelp.com website. Marty can be reached at 317-834-2276 or by email at mjames@mjamescpa.com.
Copyright © 2011
Reprinted with permission of Ed Slott’s IRA Advisor
All rights reserved to Ed Slott and Company, LLC
Excerpted from Ed Slott’s IRA Advisor Newsletter

January 5, 2011

Families with the Highest Tax Rates. Not what you think.

The highest tax rates in the land are not what you think.  Many families are taxed more heavily on the next dollar earned than are most professional athletes and corporate executives.

Before I get into my discussion, it is important to understand the difference between a marginal tax rate and an effective tax rate.  Your marginal tax rate is the rate at which the next dollar of taxable income is taxed; this is what we commonly refer to as your “tax bracket.” Not all of your income is taxed at your marginal tax rate.  Before you get to the higher marginal rates, your  income will progress through the lower brackets: 10, 15, 25, 28, 33, and 35%.  Your effective tax rate is the percentage of tax you pay on all of your income.  Your effective tax rate typically is lower than your marginal rate.  For example, a family in the 35% marginal tax bracket may have an effective tax rate of only 30% on all of their income. Now here is the rub:  At the lower income levels and with certain family dynamics, refundable tax credits (credits you get even if you owe no income tax), which phase out as your income increases, have a significant impact on the family’s tax burden as they earn more income.

Take, for example, a family of four: dad and mom (both under age 65) and two qualifying children.  Assume they are not itemizing their deductions and have a gross earned income (W-2 income) of $25,000.  With standard deductions and personal exemptions totaling $26,000 (based on 2010 tax law), the family’s taxable income is a negative $1,000.  The result is that they owe no federal income tax.  In fact,  because of refundable credits such as the Earned Income Credit (EIC), the Additional Child Tax Credit, and the Making Work Pay Credit, the family would be “entitled”  to a refund of 100% of their withholding, plus an additional $7,085 of refundable credits.  The  refund is tax free, from income and payroll taxes (the purpose of the EIC originally was  to compensate certain wage earners for the amount of payroll taxes withheld from their pay checks).  In this situation, the payroll taxes withheld on the $25,000 of wages would have been $1,913, and the EIC is $4,285, a  difference of $2,372.  The remainder of the refundable credits is $2,000 for the Additional Child Tax Credit and Making Work Pay Credit in the amount of $800, making a total of $7,085 of additional refundable credits.

I would argue that this family is in one of the highest tax brackets possible (see chart below).  If  wages were increased by $2,000, to $27,000, the refund would fall to $6,563, or by $522. Add in the additional payroll tax of $153, and the total tax increase is $675, or approximately 34% of the $2,000 increase in wages.  A $5,000 increase in wages would be taxed at  approximately 37%.  The increase in tax burden from the family’s current position (earning $25,000) continues to increase until wages reach approximately $46,000, at which point the percentage is approximately 39% .  This is occurring while, according to the tax rates published, including the payroll tax, the marginal dollars should be taxed as follows:
  • $25,000 W-2 wages taxed at 7.65% (0% federal and 7.65% payroll)
  • $27,000 and $30,000 W-2 wages taxed at 17.65% (10% federal and 7.65% payroll)
  • $46,000 W-2 wages taxed at 22.65% (15% federal and 7.65% payroll)

Earned Income

Refundable Credits

Income & Payroll Taxes

Cash Flow after Taxes
Increase in Cash Flow
as Earned Income Increases

Percentage of Tax Paid on Increase in Tax Flow































Now assume a family with the same dynamics, except with gross wages of $1,000,000 and receiving an increase in gross wages of $25,000.  They will pay the same marginal rate, 35%, for income taxes and 1.45% for payroll taxes on that increase in wages, all other items on their tax return being equal. The family will keep almost 64% of the increase in pay. The lower-income family has to almost double their earned income before their tax paid as a percentage of increase in cash flow decreases.

In 2011 families lose the Making Work Pay Credit; it was not extended in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.  They will receive a 2% reduction in payroll taxes in their paychecks.  With the loss of the expired credit, the 2% reduction in payroll taxes actually does not increase the household income by 2% for many families.  A family earning $50,000 receives $1,000 but loses $800, for a net increase of $200.  A family earning $106,800 receives $2,136 but loses $800, for an increase of  $1,336 in cash flow.

The point of this discussion is to drive home the point that accross all income levels income tax planning is important to families looking to maximize household cash flow.
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