Moment on Money

A Reader Asks #19: Personal Record Retention

A client recently emailed that she was cleaning out old files and wondered how long she should keep certain records. As a result of answering her questions, I have put together some basic guidelines of what to keep and how long to keep it.

	Retention Requirement	Recommendation
Tax Records	3 years min.	7 – 10 years
Bank/Credit Card Statements	None	File with tax records
Deposit Slips/ATM receipts Credit Card Transactions	None	Reconcile with statement then destroy
Pay Stubs	Most recent	File year end with tax records
Medical Records	None	Current physicians, treatments, and mediations. File medical expenses with tax records
Insurance Policies	None	Inforce polices. Maintain list of insurance policies and servicing agent.
Retirement Investment Accounts	None	Year end statement
Non-Retirement Investment Accounts	Cost basis	Year end statements for 7 – 10 years after investment is sold.

Tax Records – Generally the IRS has three years (from the date you filed) to audit your taxes. However, substantial omission of items (generally defined as over/under reporting income by 25%) extends the audit window to six years and there are situations such as filing a false return, willful attempt to avoid taxes, or failure to file a return which may be examined by the IRS at any time without limitation. If you are audited, the IRS can provide a copy of the return(s) you filed, but you need to provide the documentation and information that was used to prepare the return. Many sources recommend destroying tax information after seven years. That is plenty of time to defend yourself in an extended six year audit window. Frankly, you know if you should be concerned about an indefinite tax examination or not. I tend to hold tax documents longer that the standard seven year recommendation. I keep all tax records for ten years. For example, when I filed my 2010 taxes I destroyed my records from the 2000 tax year.

Bank/Credit Card Statements –These are essentially tax records. File them, by tax year, with tax records. Like all tax documents, keep them for ten years and then destroy them.

Deposit Slips/ATM Receipts/Credit Card Transactions – Save these only until the appropriate statement is received and reconciled. Once you know the statement is correct, it is okay to destroy these.

Pay Stubs – As long as your pay stub contains year-to-date information, you only need to retain your most recent pay stub. Keep the last pay stub of the year with your tax records.

Medical Records – It is a very good idea to keep records with the names and addresses of your family's personal physicians, medical history, and current prescriptions/treatments. Having this information at your fingertips will save you time and energy when you need to see a new doctor or have some other reason to summarize your health such as when purchasing insurance or, in some cases, getting a new job. Receipts and records for expenses related to healthcare should be retained with your tax records if you itemize and deduct your medical expenses.

Insurance Policies – Insurance policies are important, but replaceable. More important that keeping the actual policies is to keep the names and contact information for the agent who services your insurance. If need be, the agent can always get a replacement policy for you. But in a time of crisis, your agent should also be the first person you contact to initiate a claim.

Investment Accounts – what you need to keep really depends on the type of investment account

Retirement Accounts (including IRA's, Roth's, 401(k)'s, Pensions etc) – In general, these accounts are tax deferred so they are fully taxable when money is distributed. Throughout the year, you should retain all confirmations and statements. The final statement of the year will usually summarize all of the activity in the account for the year. You should keep this year end summary with your tax records. Roth accounts have a little greater need for recordkeeping. For Roth's, make sure you keep all your year end statements.

Non-Retirement Accounts – In order to calculate the taxes due when an investment is sold, you need to be able to document your cost basis (that is, how much you have paid in to the investment). If you purchased an investment in one "buy order" that can be pretty simple. But if you are making periodic investments over a long period of time, calculating cost basis may be a bit more difficult. Especially since the IRS allows for a couple different methods of keeping and tracking cost basis and there are special rules which apply to some investments like zero coupon bonds. The good news is, you don't really need to worry about it. Worrying about cost basis is your accountants' job. But you do need to provide your account the information they need. Just like retirement accounts, you need to keep a year end of summary of all your activity in your investment accounts. The difference is that you need to keep this information for as long as you own the investment… even if you own the same investment for decades. You should not consider destroying investment year end summaries for at least seven to ten years AFTER YOU SELL the investment. (By the way, new rules for investment companies will make this easier for investors. Soon investment companies will be required to track cost basis on your behalf).

When cleaning out files (especially after the years end), there can be a lot of documents which no longer need to be kept. Remember that DV Financial has a document shredding procedure which is compliant to military standards. As a service to you, you may bring in your documents and put them in our secure and confidential destruction bin. Your documents will be destroyed at no charge.

Have I missed anything? Let me know!

Is there a financial topic you have a question about? Or is there something you have always wanted to know but were afraid to ask? This is your opportunity! Send me an email and ask your question. I will publish the answer here at the blog and promise to keep your identity confidential. No cost. No obligation. No strings attached.

mail by chona kasinger

Economic Update: August 2011

This morning I awoke to the news that a compromise has been reached in regards to the debt ceiling. I have been holding off posting my quarterly economic update since very little of it mattered with a potential default looming. With that axe no longer over our necks, it seems appropriate to see where the economy stands.

Looking at four key components of the economy - light vehicle sales, inventories, housing starts, and capital goods orders – all appears stable.

Capital goods orders are above average and on the rise. Housing starts are below average, but steady. Given the large surplus of real estate available in the market right now, this is about the best we can hope for. Manufacturing and trade inventories are down which means goods must be produced to meet demand; that is good. The biggest blemish we see is in auto sales and that is explainable. The auto industry is closely linked to manufacturing in Japan. The slowdowns and shutdowns of U.S. automobile plants as a result of the Japanese earthquake and tsunami were well covered by the media. With a shrinking supply, auto dealers felt less compelled to sell cars at bargain prices and as a result, car sales have slowed. Automobile prices have been on the rise, both in the new car and the used car markets.

The biggest factor affecting the economy right now is the consumer. Let us not forget that consumer spending makes up over 70% of our economy.

So perhaps a better measure of our economy is to look at the consumer. As a result of the economic meltdown, the average consumer has responded by increasing savings, and reducing their debt.

But holding the consumer back is a general lack of confidence. Consumers are not as pessimistic as they were before the recession, but they have not regained pre-recession confidence levels.

Unemployment is below its recent peak, but not by much. We lost nearly 9 million jobs in the economic meltdown, but not quite 25% of the loss has been recovered.

But breaking down the unemployment finds that the real problems are geographically concentrated. Perhaps not coincidentally the same regions with the worst unemployment are the same regions which are still feeling the worst of the housing bubble.

This is where, as investors, we must be disciplined. Turn off the news. Quit reading the papers. The media will rarely report good news. But the economic foundation for growth is in place. Corporate earnings per share today are nearly as high as they were before the recession.

Yet the market was 12% lower at the end of the second quarter (S&P500 closed at 1320.64 on June 30, 2011) than it was at the end of the second quarter 2007 (S&P500 closed at 1503.35 on June 29, 2007). That means stocks are cheaper today than they were before the recession but the earning power of each share is about the same. This is not a time to be selling and it may be a great time to be buying.

CFP® Board’s “Let’s Make a Plan” Campaign

Have you seen the new public awareness campaign launched by the Certified Financial Planner Board of Standards, Inc? Here is the first TV spot:

The campaign is designed to help educate Americans about the importance of sound financial planning and raise awareness about the significance of the CFP® certification and the need for competent and ethical financial planning. "The CFP® mark truly serves as the gold standard for personal financial planning," said CFP Board CEO Kevin R. Keller, CAE. "Just about anyone can use the term 'financial planner.' But only those individuals who have passed a rigorous set of criteria and meet our strict ethical qualifications can call themselves a CFP® professional."

In addition to the advertising there is also a website with additional resources, LetsMakeAPlan.org.

Letter to Clients: 2nd Quarter 2011

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so" -Mark Twain

 

April 2011

 

Dear Clients & Friends,

My quarterly letters typically contain an overview of what has happened in the market over the past quarter and an outlook to where I think we may be heading. This quarter, I am going to bypass the market review and instead take a closer look into how recent world events have made a financial impact.

In his Market Commentary on April 12, 2011, Scott Marcouiller, Chief Technical Market Strategist for Wells Fargo Advisors wrote "Event risk came back into the spotlight in Asia as aftershocks hit Japan. This was followed by a rise on the nuclear accident rating to the highest severity level. The effect of the quakes on stocks was progressively less but still a threat. Meanwhile, Portugal became the third Eurozone country to be granted a bailout. Speculation is that Spain could be next. In North Africa and the Middle East, there were more clashes and deaths in hot-spot countries. Not to be outdone, oil prices climbed above $112 per barrel and served to drag out stocks' current sideways action."

Everything in his commentary is absolutely true, but entirely meaningless to investors who plan to be in invested for years.

In investing, Black Swans are low-probability, high-impact events. The Black Swan theory was chronicled by Nassim Nicholas Taleb in his popular 2007 (revised 2010) book, "The Black Swan." Taleb writes about extremely rare or highly improbable events that have a major market impact, positive or negative, which surprise even the experts.

The enormity of the tragedy in Japan has saddened the world. We have never seen a triple disaster such as this with an earthquake, a tsunami and a nuclear disaster all hitting one country at the same time. Like many others, we are hoping and praying the Japanese people will receive the support and resources they need for a speedy recovery. As humans, we are keenly aware of the pain and suffering these tragic world events inflict upon our collective community.

Earthquakes, tsunamis and energy disasters are high-probability, high-impact events, especially these days. While the human devastation is horrendous, the economic cost is negligible over time and quickly priced into the stock markets. Unfortunately, disasters happen more often than we think (and are apt to remember). Here are just a few from the past decade alone:  

• September 11, 2001, attacks on the World Trade Center and Pentagon
• 2003 European heat wave (40,000 deaths)
• 2004 Tsunami in Sumatra, Indonesia (230,000 deaths)
• 2005 Kashmir, Pakistan earthquake (80,000 deaths)
• 2008 Myanmar cyclone (140,000 deaths)
• 2008 Sichuan China earthquake (68,000 deaths)
• 2008 Derivatives roil the world's banking system and financial markets
• 2008 Failure of Lehman brothers and the sale/liquidation of Bear Sterns
• 2009 30% drop in US home prices
• 2010 Port-Au-Prince Haiti, earthquake (315,000 deaths)
• 2010 Volcanic eruptions in Iceland shut down 100,000 transatlantic flights
• 2010 Russian heat wave (56,000 deaths)
• 2010 BP Gulf of Mexico oil spill
• 2010 Market flash crash (1000 point drop in the Dow Jones)
• 2011 Surge of unrest in the Middle East
• 2011 Earthquake, tsunami and nuclear disasters in Japan

So what do we learn? Time and time again, for investors anyway, we know that Black Swan events do not matter much when it comes to the economy, and even nuclear disasters (thankfully we've only had a few) aren't material to the markets. Panic selling has been the downfall of many investors with numerous studies illustrating the losses when the panicked seller bails out of the market. Perhaps this explains why the average investor has underperformed every asset class over the past 20 years while barely beating inflation. In other words, the average investor's portfolio has made only negligible gains in purchasing power over the past 20 years.  

Barry Ritholtz expresses a valid point about investor reactions to Black Swans. When asked what investors should do now, his answer is always the same: "The time to look for the emergency aisles and where the exits are located is before takeoff, not after the wings fall off the plane. You must have a plan in place to deal with unanticipated events, a just-in-case things head south scenario."

It's that very reason why regular reviews of your financial and investing plans are so vital. Does your plan take into account the random events that happen all the time? You should be aware of your risk tolerance level and financial situations at all times. And that brings us right back to the importance of regular reviews.

And how do we make sure that you don't panic? A recent New York Times article, When to Buy or Sell? Don't Trust Your Instincts, starts off wonderfully: "Anyone watching television commercials could easily conclude that trading stocks is something a baby can do from a crib." It goes on to explain that the baby in us usually buys or sells at the worst possible time. Part of my job, as your advisor, is to make sure that you do not overreact to irrational tendencies.

I am your resource; here to discuss your situation and explain your options. James Montier of GMO LLC Mutual Funds, author of several books on behavioral finance, has put forward seven immutable laws of investing:

1. Always insist on a margin of safety
2. This time is never different
3. Be patient and wait for the fat pitch
4. Be contrarian
5. Risk is the permanent loss of capital, never a number
6. Be leery of leverage
7. Never invest in something you don't understand

Together, we use these seven laws to build a financial plan which best fits you and your needs. We have always experienced unanticipated events and always will. Investors with a long-term view of investing understand this. The risk-controlled approach to investing may not be "fun" in the short-term; but all the evidence at hand suggests that over time it will serve you well, getting you to your goals with the least amount of stress and distress along the way.

Are you on Facebook? As of recently so is DV Financial! Be sure to stop by and "like" our Facebook page. Following DV Financial is a quick and efficient way to keep up with pertinent financial information without being overwhelming.

Last quarter I closed by saying there was no reason to believe the markets will not continue to gyrate, and they certainly have. Yet my confidence in my tools and abilities to guide you through these turbulent times remains extremely high. Let Sue or I know anytime you have questions. We are here to serve you and appreciate your trust. It is a responsibility we take seriously with great pride. Thank you.

Sincerely,

Art Dinkin, CFP®

Financial Self-Defense

Years ago I was approached by an attorney about a financial program he had developed which had a lot of potential for owners of some closely-held businesses. The strategy was not new, I had seen it before. But the manner in which the attorney approached this complex planning was well done and particularly appealing. The attorney wanted me to introduce his program to some of my clients.

As I did my due diligence, on two separate occasions the attorney said something which struck me as odd. The first time, I just let it pass. The second time I heard it I decided to look into it a bit more.

I approached some other people who I respect and who knew this attorney well. I explained that he had approached me with a concept which I was considering introducing to my clients, but that a couple of the statements the attorney made were bothering me. I asked them all, "How well do you trust him?" and everyone told me I had nothing to worry about. They assured me he was as reputable as he was brilliant.

After one of those meetings I came into the office the next morning and discovered a voicemail from the attorney and he was quite upset. He had discovered that I had been checking up on him, and he did not appreciate it. His voicemail was clear. He considered our relationship to be over and refused to work with someone who did not trust him unconditionally. Frankly, I was okay with that. My intuition and experience has taught me that only people with something to hide get upset when you check up on them. We never spoke professionally again.

This is not a fairy tale. I can't wrap this up in a bow and tell you that soon after that I was grateful that I never worked with him or that he committed some egregious act. The fact remains that he is a successful business person and a respected attorney with a fine reputation. He has close connections with some of my close connections. Yet I have never regretted our mutual decision not to work together. We all need self-defense mechanisms in place to protect ourselves. It is prudent to err on the side of caution.

Occasionally a potential client will question me about my credentials and background. I can sometimes tell that they feel uncomfortable asking and I try to assure them that their questions are legitimate and not offensive. I encourage their inquiries because there is nothing to hide.

Recently, the Certified Financial Planner Board of Standards Inc., the body that governs the CFP^® certification, published a Consumer Guide to Financial Self-Defense. In the post-Madoff era, these 10 tips are a primer for what you must know and do to protect yourself from financial abuse.

Tip 1 is Do Your Homework: "Ask your prospective advisor to identify the organizations that license or supervise him. Brokers are regulated by FINRA; investment advisors by either the SEC or a state securities regulator; insurance agents by the state insurance commission in states in which they do business; CFP^® professionals by CFP Board. Use these organizations' Web sites to check the advisor's background and disciplinary history, if any."

To make it easier on anyone, here are the places you can do a background check on me:

• FINRA Broker Check – it's free and you can search by name. I am listed both by my given name (Arthur) as well as my common nickname (Art).
• SEC Investment Adviser Public Disclosure – is also free. Search by name or CRD number (Central Registration Depository). I am CRD number 2096185.
• Licensee Lookup via the Iowa Insurance Division website – Search by name or NPN number (National Producer Number). My NPN is 1433330.
• Certified Financial Planner Board of Standards Inc. – Search by name and state for CFP® credentials

My mission is to make you comfortable with your financial decisions. I hope that making this information readily available makes you even more comfortable with your choice of financial planner.

Photo DSC_0055 by ichibankarate

Letter to Clients – 2nd Quarter 2010

Dear Clients and Friends,

It is difficult to believe 2010 is already 25% (and by the time you receive this probably closer to a third) behind us. It was a record setting winter here in Iowa, and fortunately the markets have thawed along with the snow! The market's low point of the recent recession was March 9, 2009. Now that a full year has passed it is useful to look at the first quarter of 2010 in light of the market's progress in the last twelve months.

For the quarter, the major indices logged solid gains, with the S&P 500 up 5.4% and the Nasdaq Composite up 5.9%. The quarter continued to add to what was already one of the strongest cyclical bull markets in history, with the S&P 500 75% higher and the Nasdaq 84% higher than their lows of a year ago. Despite this run, however, the markets remain well off their secular highs achieved in the last decade, with the Nasdaq still 54% off its 2000 high.

There are many indications that the recovery, which began in the latter part of 2009, continues. According to the Financial Times, "economists are predicting the U.S. economy will see a surge of new jobs [in March], with some 300,000 positions being created after a loss of about 8.4 million jobs during the recession." The Federal Reserve statement that business spending on equipment and software had "risen significantly" and its reiteration that interest rates would be kept low for an "extended period" were also encouraging.

But there are several economic factors that may weigh on the recovery. Even with the modest job growth predicted for March, unemployment remains very high. Household spending continues to be constrained by flat income growth and tight credit, and this will likely affect retail sales as consumers remain cautious. Meanwhile the housing market still sits at record lows. Sales of new single-family homes in the U.S. declined a seasonally adjusted 11.2% in January, which represents the lowest sales pace since these records began in 1963.

There are also two larger trends, one historical and the other demographic, that may affect market returns going forward.

Cyclical Bull Market Trends. According to Ned Davis Research, the median gain of the S&P 500 in the first year of a cyclical bull market is 29% but the second year sees only 9% growth. Small cap and lower quality stocks, which tend to lead the broader market during periods of recovery, tend to give ground as recoveries mature into their second year. With the first year of the current cyclical bull market experiencing torrid gains, which is in line with this historical trend, many analysts are expecting to see this year's returns also follow the trend and come in below last year's while still remaining positive. Ned Davis Research believes there is still a good chance the markets could experience a drawn out correction in the second and third quarter, bringing the overall gain for the two years to be more in line with historical averages.

Inflows to Bond Funds. As mentioned in The Wall Street Journal, The Investment Company Institute reported that long-term mutual funds had net inflows for 52 weeks in a row as of March 18, a shift in assets totaling some $506.6 billion. Certainly some of this inflow represents money returning to the market in the wake of recent gains. But the bulk of investment in 2009 was in bonds, which accounted for $409 billion of the net inflows.

This reveals an interesting demographic trend that may also have implications for market growth in the coming months and years. As baby-boomers enter retirement, they tend to allocate a greater share of their portfolios to fixed-income securities. As the Journal goes on to report, another factor at work in this trend, "is a dip in risk tolerance. Investors, who have seen steep losses in two bear markets, have lost some of their appetite for risky investments. Additionally, the rising use of automatic asset allocation, which moves investments toward bonds as investors age, is driving inflows to bonds."

This suggests that older investors may be less likely to invest in equities even if the broader recovery proves strong. With so much money remaining on the sidelines, the massive inflows to equities that some predict may not materialize. Lower-than-expected inflows would likely have a dampening effect on equity prices. However, the broader inflow trend is definitely positive.

Predicting which of the above factors will most influence the market is difficult. The market may present opportunities, but it also contains risk. Investors may want to proceed with caution and diligence.

There is an old saying, "Good, fast, or cheap. Pick any two". We could almost rephrase it to the world of investing with, "Safe, liquid, or the potential for high returns. Pick any two." Managing investments in this environment requires balancing multiple objectives which are often in conflict with each other. Fortunately, there are new products and tools in the marketplace which have been developed specifically to address common concerns.

The first step in the process is to identify what your goals and concerns are and I am here to help you. Please contact me anytime you want to discuss your financial plans, dreams, and concerns. We can review what you have done so far and discuss any options you might want to consider.

As always, I thank you for the continued opportunity to work together.

¹ All returns sourced from Morningstar.com and Bloomberg Finance L.P.

² "Outlook for US economy upgraded," Financial Times, March 17, 2010

³ ibid

⁴ ibid

⁵ Chart of the Day, March 9, 2010, Ned Davis Research, Inc.

⁶ "Fund-Inflow Streak Makes It a Full Year," The Wall Street Journal, March 18, 2010

⁷ ibid

And the times, they are a-changing

I knew it would happen sooner or later.

I was at a social function and someone came up to me and asked why I had not been writing very much. I wish I had a good excuse, but I don't.

It is simply a fact that we are in a time of change and transition. The old perspectives can no longer just be assumed. Clients and planners alike must question everything and reassess their portfolios, goals, and risks. It is a time of uncertainty but also a time of great opportunity. As of the beginning of this year I have been in practice for over twenty years, and never before have I experienced such a strong demand for my time.

Last year, in Managing the Road to Retirement from the TransAmerica Center for Retirement Studies, survey respondents were asked how much money they believe they will need to have saved by retirement to feel secure. Here are the survey results:

Ages 20 - 29	$750,000
Ages 30 - 39	$1,000,000
Ages 40 - 49	$800,000
Ages 50 – 59	$500,000
Ages 60 +	$500,000

With the exception of the youngest group, it makes sense that younger respondents felt like they would need to have more money saved to feel secure in retirement. Over time, inflation demands retirees have more available savings to pay for the same retirement.

The real eye-opener for me was the follow up question where the same respondents were asked to admit if they had just guessed at that amount. The percentages who admitted to guessing were:

Ages 20 – 29	63%
Ages 30 – 39	50%
Ages 40 – 49	49%
Ages 50 – 59	45%
Ages 60 +	37%

Again, those closest to retirement seemed more certain of their responses but still… more than 1/3 of pre-retirees have no idea how much money they will need for a successful retirement. Add to that an uncertain stock market, talk of potential tax increases, and fears of inflation. Is it any wonder many people are seeking professional advice?

Monte Carlo Simulations are Not Perfect

Monte Carlo simulation is a complex statistical modeling method which can be useful in financial planning. The goal of Monte Carlo analysis is to apply statistical realities over multiple simulations and conclude how many of those iterations had a successful result. As I have said many times, financial planning is as much an art as is it a science. Unfortunately there are no absolutes or guarantees even with proper planning. Past performance is not an indicator of future results, so relying on historical averages can be misleading. Analysis is a tool, but only the proper use of the tool combined with skilled interpretation provides any value.

The May 2nd article, "Odds-On Imperfection: Monte Carlo Simulation" in the Wall Street Journal explores using Monte Carlo analysis as a planning tool. Specifically, it points out that a dramatic downturn in the market like the one we have been living for the past year or so, would generally be ignored in a Monte Carlo simulation since it is statistically unlikely to occur. The article argues that once-in-a-lifetime market events are occurring with greater frequency and therefore the best analysis tools should give catastrophic episodes greater importance.

One solution to the problem is to continue using Monte Carlo analysis with "fat-tailed" distributions. Ordinarily, extreme events occur on the outer edges of a bell shaped curve. The more extreme, the less likely it is to occur. A fat-tailed curve allows for a greater probability of an extreme downtown than an extreme period of growth. Another solution is to use a large number of simulations in a Monte Carlo analysis. The article suggests using 10,000 simulations or more.

Some critics think these limitations of Monte Carlo analysis prove that it is an invalid tool. I disagree. Monte Carlo analysis has never been perfect, and it never will be. As we grow in our experiences it is only natural that we discover limitations that we had previously not considered. The wisdom is in learning and adapting to make the tool better.

As for my clients, the Monte Carlo simulations I use already employ 10,000 iterations. According to the manufacturer of the software I use, they will be making "fat-tailed" distributions available in a few weeks. This has the potential to make the tool better, but still imperfect. No one can predict the future financial markets with certainty, but we can use the best tools available to plan for potential scenarios.

Roulette Wheel by John Wardell (Netinho)

Dissecting a Capital Transfer Plan

Every regulatory authority, designation grantor, and of course the State of Iowa have different continuing education requirements which I must comply with. Long ago, one of my early role models told me "if you are going to be a real professional in this field, you will constantly need to be taking continuing education courses. Forget about the minimums. Just go out there and learn." I have followed his wise advice ever since and absorb as much CE as I can fit into my schedule.

Recently I was at a CE program titled capital transfer planning. The presenter examined various methods of conservatively passing money from one generation to the next (ignoring the impact of estate taxes – that is another subject entirely). As an example, the presenter assumed a 65 year old male client with $100,000 of "idle assets" and an assumed 25% marginal tax rate. First, let's define an "idle asset" as money which is not planned for consumption during the client's lifetime. Many people have assets which they never intend to spend and leave to their heirs.

The course examined three options:

1. A CD @ 2% (interest from CD's is generally taxable)
2. A Fixed Annuity @ 4% (annuities offer tax deferral on interest)
3. A modified endowment contract (MEC). Modified endowments are life insurance policies which are heavily funded early on. Since this comparison assumes a single premium of $100,000 and no additional premiums, this life insurance policy would definitely be a modified endowment. Having a modified endowment has no impact on the death benefit but does have implications on withdrawing any cash value while the insured is still alive.

We were provided a worksheet which shows what the heirs would receive, net after tax, from each option in 5, 10, 15, and 20 years. For simplicity, the presenter called this amount the death benefit and it is labeled DB on the chart. The Yield is the average annualized return. For example, since the CD provides the heirs with $110,408 (after tax in 5 years) the chart indicates that would have been equivalent to earning 2.08% each year on the money. The formula for this calculation is to take the average gain per year divided by the initial deposit; (($110,408 - $100,000)/5)/$100,000.

DB = Death Benefit AY = Annualized Yield	Taxable CD @ 2.0%	Tax Deferred Fixed Annuity @ 4%	Modified Endowment Life Insurance Policy
After 5 Years	DB: $110,408 AY: 2.08%	DB: $112,999 AY: 2.6%	DB: $396,244 AY: 59.2%
After 10 Years	DB: $121,899 AY: 2.19%	DB: $128,814 AY: 2.88%	DB: $396,244 AY: 29.6%
After 15 Years	DB: $134,587 AY: 2.3%	DB: $148,056 AY: 3.2%	DB: $396,244 AY: 19.74%
After 20 Years	DB: $148,595 AY: 2.43%	DB: $171,467 AY: 3.57%	DB: $396,244 AY: 14.81%

The conclusion is obvious – even though the yields of the CD and the annuity are rising and the yield of the MEC is falling, this person cannot live long enough for the modified endowment to be surpassed by either the CD or the fixed annuity. The case for a MEC is further supported because the yield on the MEC is known in advance while the interest rates on the CD and fixed annuity will fluctuate with economic conditions. But does that mean a modified endowment life insurance policy is the best option for all idle assets?

The presenter of the CE program obviously thinks so, but I think there are two key factors which must be considered. First, is the person insurable? If the person has health issues the effectiveness of life insurance may be reduced (or not even available). Probably more important is determining the certainty that this asset will never be touched.

Aldous Huxley said "Hell isn't merely paved with good intentions; it's walled and roofed with them. Yes, and furnished too." While a capital transfer plan employing a MEC can be attractive, one has to consider the certainty that they will never need liquidity from those funds again. With surrender charges applicable to most life insurance contracts, chances are the CD or even the fixed annuity would win if we compared accessing the cash values across the same timeframe. With this in mind, I would only support this type of capital transfer plan if there were other sources of liquidity and the client had adequate protection in place for unforeseen financial stresses such as the need for long term care.

Definition of Marginal and Effective Tax Rates

In January someone told me that most people have broken their New Year's resolutions by the end of February. Armed with that trivia and the knowledge that my resolution to post to this blog once a week wasn't broken until April provides no solace. I "owe" you guys a couple of posts and will be posting some extra ones soon.

Everyone knows tax day was yesterday, April 15^th, so it seems appropriate that we discuss an often misunderstood element of taxes and financial planning – tax brackets.

Our tax system is a progressive tax. That means that you pay an increasing percentage of your income as taxes as your income increases. But moving up to a new tax bracket only affects the additional dollars you have earned. It does not increase your tax liability on all your income¹. For example, let's study the 2008 Married Filing Jointly tax brackets.

Taxable Income Over…	But Less Than…	The Tax Is…	Of the Amount Over…
$0	$16,500	$0 + 10%	$0
$16,050	$65,100	$1,605 + 15%	$16,050
$65,100	$131,450	$8,962.50 + 25%	$65,100
$131,450	$200,300	$25,550 + 33%	$131,450
$200,300	$357,700	$44,828 + 33%	$200,300
$357,700	And Over	$96,770 + 35%	$357,700

So how do you read this chart?

Start with your taxable income or the amount of income you are actually taxed on after taking all your legal deductions and exemptions. Chances are you earn much more than your taxable income. For example, let us examine a married couple. He is self employed and has gross earnings of $105,604 and his wife is a W-2 employee with gross earnings (after pre-tax deductions like 401(k) and health insurance) of $49,228. Their banker saw $154,832 flow through their checking account but after business expenses and self employed retirement savings they are able to reduce their adjusted gross income (AGI) down to $112,705. Their taxable income is even lower at $70,241 which is found by starting with their AGI and subtracting itemized deductions and personal exemption amounts.

Now we can look at the chart. The taxable income is over $65,100 and less than $131,450 so we use the third line. The total tax due is $10,247.75 which and this it is calculated $8,962.50 + 25% of ($70,241 - $65,100). In other words, they are pay 25% only on the amount over $65,100.

What tax bracket is this couple in? The third line down is the 25% bracket, but they paid nothing close to $38,708 which is 25% of $154,832 which is why we must distinguish between marginal and effective tax rates.

Marginal tax rate is the amount of tax you would pay on the next dollar you earn. For this couple that is 25%.

Effective tax rate is the percentage of taxable income actually paid in taxes. This couple has an effective tax rate of 14.6%.

In financial planning, we most often use marginal tax rates. Financial planners think "if my client had an opportunity to increase their income by $1000, they would owe $250 in additional taxes and would net $750", but when you file your tax return, effective tax rates are the most accurate measurement of your tax liability.

AIC does not give legal or tax advice. For specific information applying a strategy consult your attorney or tax professional.

¹ An increase in adjusted gross income can increase your tax liability by disqualifying various deductions and credits.