Pioneer Wealth: Economic Commentary

In 2009, numerous new and expanded deductions and credits came into being for a broad cross-section of taxpayers: College tax benefits for parents and students; energy credits for homeowners who are going green; and even tax breaks for home buyers and car buyers.

Following is a summary of these and other key changes taxpayers will find when they start preparing their 2009 federal income tax returns.

Note: See Fact Sheet 2010-6 for more information on the first-time homebuyer credit and Fact Sheet 2010-7 for details on the making work pay credit.

American Opportunity Credit Helps Pay for First Four Years of College

More parents and students can use a federal education credit to offset part of the cost of college under the new American Opportunity Credit. This credit modifies the existing Hope credit for tax years 2009 and 2010, making it available to a broader range of taxpayers. Income guidelines are expanded and required course materials are added to the list of qualified expenses. Many of those eligible will qualify for the maximum annual credit of $2,500 per student.

In many cases, the American Opportunity Credit offers greater tax savings than existing education tax breaks. Here are some of its key features:

• Tuition, related fees and required course materials, such as books, generally qualify. In the past, books usually were not eligible for education-related credits and deductions.
• The credit is equal to 100 percent of the first $2,000 spent and 25 percent of the next $2,000. That means the full $2,500 credit may be available to a taxpayer who pays $4,000 or more in qualified expenses for an eligible student.
• The full credit is available for taxpayers whose modified adjusted gross income (MAGI) is $80,000 or less ($160,000 or less for filers of a joint return). The credit is reduced or eliminated for taxpayers with incomes above these levels. These income limits are higher than under the existing Hope and lifetime learning credits.
• Forty percent of the American opportunity credit is refundable. This means that even people who owe no tax can get an annual payment of the credit of up to $1,000 for each eligible student. Existing education-related credits and deductions do not provide a benefit to people who owe no tax. The refundable portion of the credit is not available to any student whose investment income is taxed, or may be taxed, at the parent’s rate, commonly referred to as the kiddie tax. See Publication 929, Tax Rules for Children and Dependents, for details.

Though most taxpayers who pay for post-secondary education qualify for the American Opportunity Credit, some do not. The limitations include a married person filing a separate return, regardless of income, joint filers whose MAGI is $180,000 or more and, finally, single taxpayers, heads of household and some widows and widowers whose MAGI is $90,000 or more.

There are some post-secondary education expenses that do not qualify for the American Opportunity Credit. They include expenses paid for a student who, as of the beginning of the tax year, has already completed the first four years of college. That’s because the credit is only allowed for the first four years of a post-secondary education.

Students with more than four years of post-secondary education still qualify for the lifetime learning credit and the tuition and fees deduction.

For details on these and other education-related tax benefits, see Publication 970, Tax Benefits for Education.

Many Energy Improvements Qualify for Expanded Tax Credits

People who weatherize their homes or purchase alternative energy equipment may qualify for either of two expanded home energy tax credits: the non-business energy property credit and the residential energy efficient property credit.

Non-business Energy Property Credit: This credit equals 30 percent of what a homeowner spends on eligible energy-saving improvements, up to a maximum tax credit of $1,500 for the combined 2009 and 2010 tax years. This means that a homeowner can get the maximum credit by spending at least $5,000 on qualifying improvements. Homeowners must make the improvements to an existing principal residence; this tax credit is not available for new construction. Due to limits based on tax liability, other credits claimed by a particular taxpayer and other factors, actual tax savings will vary. The cost of certain high-efficiency heating and air conditioning systems, water heaters and stoves that burn biomass all qualify, along with labor costs for installing these items. In addition, the cost of energy-efficient windows and skylights, energy-efficient doors, qualifying insulation and certain roofs are also eligible for the credit, though the cost of installing these items does not count.

Residential Energy Efficient Property Credit: Homeowners going green should also check out a second tax credit designed to spur investment in alternative energy equipment. The residential energy efficient property credit, equals 30 percent of what a homeowner spends on qualifying property such as solar electric systems, solar hot water heaters, geothermal heat pumps, wind turbines, and fuel cell property. Qualifying property purchased for new construction or an existing home is eligible for the credit. Generally, labor costs are included when calculating this credit. Also, no cap exists on the amount of credit available except in the case of fuel cell property.

Not all energy-efficient improvements qualify for these tax credits. For that reason, homeowners should check the manufacturer’s tax credit certification statement before purchasing or installing any of these improvements. The certification statement can usually be found on the manufacturer’s Web site or the product packaging. Normally, a homeowner can rely on this certification. The IRS cautions that the manufacturer’s certification is different from the Department of Energy’s Energy Star label, and not all Energy Star labeled products qualify for the tax credits. Use Form 5695, Residential Energy Credits, to figure and claim these credits.

(NOTE: The 2009 Form 5695 is expected to be available by Jan. 15, 2010.)

New Vehicle Purchase Incentive

New car buyers can deduct the state or local sales or excise taxes paid on the purchase of new cars, light trucks, motor homes and motorcycles. There is no limit on the number of vehicles that may be purchased, and eligible taxpayers may claim the deduction for taxes paid on multiple purchases. However, the deduction is limited to the tax on up to $49,500 of the purchase price of each qualifying new vehicle. Qualifying new vehicles must be purchased, not leased, after Feb. 16, 2009, and before Jan. 1, 2010.

Taxpayers who buy a new vehicle may deduct state or local fees or taxes that are similar to a sales tax whether or not their state imposes a sales tax. To qualify, the fees or taxes must be assessed on the purchase of the vehicle and must be based on the vehicle’s sales price or as a per-unit fee.

The amount of the deduction is reduced for taxpayers whose modified adjusted gross income is between $125,000 and $135,000 for individual filers and between $250,000 and $260,000 for joint filers. This deduction is available regardless of whether a taxpayer itemizes deductions on Schedule A. Itemizers claim the deduction on either Line 5 or Line 7 of Schedule A. See the Schedule A instructions for details. Non-itemizers claim the deduction on new Schedule L, Standard Deduction for Certain Filers.

Tax Credits Increased for Low and Moderate Income Workers

More workers and working families are eligible for the Earned Income Tax Credit. In particular, expanded benefits are now available for those with three or more qualifying children and married couples. The EITC helps taxpayers whose incomes are below certain income thresholds, which in 2009 rise to:

• $48,279 for families with three or more qualifying children
• $45,295 for those with two or more children
• $40,463 for people with one child
• $18,440 for those with no children

One in six taxpayers can claim the EITC, which, unlike most tax breaks, is refundable, meaning that individuals can get it even if they owe no tax and even if no tax is withheld from their paychecks.

In addition, the earned income formula for the additional child tax credit is revised for tax years 2009 and 2010. As a result, more low and moderate income families qualify for the full $1,000 child tax credit. See Form 8812 for more information.

Standard Deduction Increases for Most Taxpayers

Nearly two out of three taxpayers choose to take the standard deduction rather than itemizing deductions such as mortgage interest and charitable contributions. The basic standard deduction is:

• $11,400 for married couples filing a joint return and qualifying widows and widowers, a $500 increase compared with 2008
• $5,700 for singles and married individuals filing separate returns, up $250
• $8,350 for heads of household, up $350.

Higher amounts apply to blind people and senior citizens. The standard deduction is often reduced for a taxpayer who qualifies as someone else’s dependent.

In addition, eligible taxpayers can further increase their standard deduction by any of the following three deductions:

• State or local real estate taxes paid in 2009
• A net disaster loss reported on Form 4684 and
• State or local sales or excise taxes on the purchase of a qualifying new motor vehicle.

Use new Schedule L, Standard Deduction for Certain Filers, to claim these additional deductions.

AMT Exemption Increased for One Year

For tax-year 2009, Congress raised the alternative minimum tax exemption to the following levels:

• $70,950 for a married couple filing a joint return and qualifying widows and widowers, up from $69,950 in 2008
• $35,475 for a married person filing separately, up from $34,975
• $46,700 for singles and heads of household, up from $46,200

Under current law, these exemption amounts will drop to $45,000, $22,500 and $33,750, respectively, in 2010. Form 6251 and the AMT calculator provide more information.

Other Changes

The standard mileage rate for business use of a car, van, pick-up or panel truck is 55 cents for each mile driven. The standard mileage rate for the cost of operating a vehicle for medical reasons or as part of a deductible move is 24 cents per mile. The rate for using a car to provide services to charitable organizations is set by law and remains at 14 cents a mile.

The value of each personal and dependency exemption is $3,650, up $150 from 2008. Most taxpayers can take personal exemptions for themselves and an additional exemption for each eligible dependent. This is one of more than three dozen individual and business tax provisions that are adjusted each year to keep pace with inflation. A complete rundown of these changes can be found in 2009 Inflation Adjustments Widen Tax Brackets, Change Tax Benefits.

The amount of taxable investment income a child can have without it being taxed at the parent’s rate is $1,900, up $100 from 2008. For details, see Form 8615.

There are several modifications to the definition of a qualifying child. For example, the child must be younger than the taxpayer, unless the child is totally and permanently disabled. These changes affect who can claim various tax benefits including the dependency exemption, child tax credit, credit for child and dependent care expenses, head of household filing status and the EITC. See the instructions for Forms 1040 or 1040a for more information.

A new rule applies to the noncustodial parent in situations where a couple is divorced or legally separated after 2008. To claim a child as a dependent, the noncustodial parent must attach Form 8332 or a similar statement to his or her tax return. For pre-2009 divorces and separations, the noncustodial spouse still has the option of attaching certain pages from the divorce decree or separation agreement, instead of Form 8332. See Form 8332 for further details.

A $3,500 or $4,500 voucher or payment made for such a voucher under the CARS “cash for clunkers” program is not taxable to the consumer buying or leasing a new car.

Unemployment benefits up to $2,400 received in 2009 are tax free for unemployed workers. Every person who receives unemployment benefits can exclude the first $2,400 of these benefits on their return. Unemployment benefit amounts over $2,400 are taxed.

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Some of our most successful clients have always been entrepreneurs. The passion for the businesses they are involved in, a strong work ethic, and the ability to deal with huge ups and downs and changes in their business environments gives these folks a strong ability to succeed in various ventures. However, we have found that many of our entrepreneur clients usually lack a few key attributes of a sound financial plan.

1) What happens to the businesses and business assets when they are gone?

Few entrepreneurs prepare for the eventuality that they may not be around to manage their businesses. Without their passion and overall knowledge of the business they are in, it is often difficult for the business to continue to survive after the founder has left the business. This makes building the business as an asset for future employees and future family members a difficult goal. Without careful structuring of the business and careful succession planning, this goal often fails to be accomplished.

2) Do you have anything besides the business?

Most entrepreneurs are used to throwing everything they have into their businesses including time, energy, and money.  While this can be one of the primary reasons for their success, it can also lead to their eventual demise.  Once the business is a success they rarely turn away from this process. This can lead to having no assets other than the business, which as we mentioned in #1 can be a problem for your family if something happens to you.

It is extremely important that as an entrepreneur’s business is succeeding, there is an active effort made to diversify assets and investments outside of the core business. It is too often that due to a change in the business climate, a departure of a key employee, or a change in other economic factors a business that was once tremendously successful fails to continue to be a success. Few entrepreneurs prepare themselves for this possibility and eventually find themselves with very little in the term of financial assets.

3) Do it yourself?

Many entrepreneurs start their business lives as the only employee in their businesses. This grooms them to be a master of many trades. As the business grows good entrepreneurs need to understand the value that other experts can provide to their businesses. Hiring a payroll manager, IT manager, human resources professional, etc can be a key to making sure the business is continuously growing the most efficient way possible. Do not let ego get in the way of continued growth and success.

Here are some great articles on the topic of business owners and investing.

http://www.inc.com/magazine/20070201/finance-wealth-management.html

http://www.inc.com/magazine/20071001/street-smarts-proof-that-good-entrepreneurs-can-make-bad.html

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Over the last couple years we have witnessed a large drop in interest rates because of the economic conditions. Interest rates move in regular cycles these days. Generally in reaction to whats going on in the macroeconomic environment. The basics are when the economy is growing very quickly the Fed raises interest rates to slow that growth not wanting the economic growth to lead to inflation. When the economy is dropping very quickly, the Fed decreases interest rates in the hope that people will borrow money at a low cost to invest in businesses or just spend as the case may be.

We are now at a very low point in interest rates as some of you may recognize based on what your savings accounts are earning now compared to 2 years ago. The chart below illustrates the changes in interest rates based on the fed funds rate since 1971. As you can see we are currently at almost a 40 year low. So what does this mean for our investments?

Fed Funds Rate 1971-2009

A couple things that are very important to consider. 1) Mortgages and 2) Bonds.

1. Mortgages

• As interest rates have gone down to these record lows we have seen a huge uptick in the amount of mortgage refinances. The truth is that borrowing money to purchase a home is cheaper now than it has been in the last 40 years, and these loans cant get much cheaper in the future. This may be a once in a lifetime opportunity to get this type of loan.
• The danger here is because interest rates have been so low in the last decade and continue at low rates today, we have built a basket of houses and real estate in general that has a value much different than the value was over the last 40 years. The value of real estate is based on what the demand for it looks like. When we are making borrowing money this cheap and over the last decade incredibly easy to do, we have artificially inflated the value of real estate. There is a huge question about what the real value of real estate should be. No one knows the answer to this. Economists are working on various formulas but the basics are the current value was based on cheap and easy loans. If cheap and easy loans dont continue the demand will go down and the prices should follow. How far down the real value lies is still undetermined
• So while interest rates are low, I would not recommend just buying any house at its asking price because borrowing money is cheap. What I would recommend is buying real estate that is selling at 50% of what it was selling for 1 or 2 years ago. This may seem like a ridiculous statement, but we have seen many clients doing this in the last 1.5 years. It just takes a little homework.

1. Bonds

• A bond is simply a company or government borrowing money from people. They promise to pay you, the investor or bond holder, a certain interest rate for a period of time. The period of time is called the maturity date. Lets look at an example.
• Example 1:  Lets say the state of California wants to borrow money to build a bridge. They know that they can pay back the money over the next 10 years. They also know that their finances dont look so good these days so investors will probably demand a higher interest rates than some other states. The issue a bond that has a 10 year maturity and pays 5% annual interest.

Well, in todays market where our savings accounts earn 1% if we’re luck and most state bonds pay around 3.5%, a 5% interest rate is pretty   attractive. Lets say we buy this bond. Lets also say that by 2012 interest rates have gone up and savings accounts now earn 5% interest like they did 2 years ago. What happens to our bond? Our bond is now less attractive than when we bought it. So the value of our bond goes down. If we wanted to sell it we would probably get less than what we paid for it.

So what do we do to try to prevent a loss in value of our bonds. The only solution if we still want bonds in our portfolio is to buy shorter term bonds. The idea here is that if those interest rates are indeed going up, a bond that matures in 6 months can be liquidated and used to buy a new bond at a higher interest rate. We can continuously do this until interest rates get to a level that we are comfortable with, and then lock in some longer term bonds/cd’s/ or anything that has a fixed interest rate.

So the conclusion here is we know interest rates are at all time lows. We know that they cant go anywhere but up. We could take advantage of this situation buy getting low cost mortgages on great deals in investment properties, but have to watch out for artificially inflated values. We could protect ourselves against the risk of losing value in our bonds by switching to shorter term bonds until interest rates rise to a more normal level.

As always, it is recommended to talk to your financial professionals for more details and to see what makes the most sense in your particular situation.

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There is a great Saturday Night Live skit from a few years back called “Dont Buy Stuff You Cannot Afford.” .

The general premise for those of you who dont have time to watch the video is a guy selling a great new financial book to help people get out of debt. The name of the book shares the name of the skit mentioned above.

The reason I mention this skit is it is something that is regarding a subject matter that permeates many facets of our lives today. Over the last 20 years or so, our culture and financial system has promoted the 0% down no payment for 36 month plans, the no interest for 5 year-no documentation required mortgages, the $10,000 credit card limits for 18 year old college students with less than 10k a year in income, etc. For the most part, our government has adopted the same mindset since around 1950. My aim today is to highlight the problem, point out the solution, and more importantly evaluate our options as investors.

Throughout our history as a country we have gone through many ups and downs politically and economically. Along with these ups and downs we have gone through periods where the government has had to borrow money to make some things happen, and we have experienced periods where the government did not have to borrow money and we were able to pay down our debts. Currently we owe more than 300% of our annual earnings. While we spend more and more money that we don’t have, we are also increasing the money supply to unprecedented rates. The Money supply has increased at least 100% in the last year. The chart below shows us our history with debt since 1920.

You will notice from this chart that we have been able to pay off debts in the past. For example going into WWII our countrie’s Total Debt was near 300% of what it earned annually. Starting at the end of WWII our income as a country skyrocketted as most of the world depended on us for goods, and we were slowly able to reduce our debt.

Our history also includes periods of tough economic decisions because of debt. When Paul Volker took the helm at the Federal Reserve in 1979, we were facing an enormous National Debt. The only solution to the debt problem was determined to be to earn more or spend less. In this particular case both options were determined to be necessary. Taxes (while first decreased by Reagan) where quickly increased to increase the national revenue and government spending was quickly cut. The combination of these two things allowed us to begin reducing our annual deficit. However, the country was also experiencing significant inflation at this time.

You see, when we create money out of thin air by changing monetary policy we are putting ourselves at risk for inflation. If an orange costs $1 today and there are $100 for people to spend then the orange is priced relative to the $100 people have to spend. If there are now $200 for people to spend and nothing whatsoever has changed demand wise, then that orange should be priced at $2 because it is still priced relative to what people have available to spend. You may ask how did we go from having $100 available to having $200 available. Well, the answer may surprise you. We simply said there is now $200 available to spend. If this sounds illogical its probably because it doesnt make any sense. How can we simply say we now have $200 to spend? Well, the answer is simply because the Federal Reserve controls the printing of money in this country and are assigned the task of managing the flow of money.

We are now in the position of having very large annual deficits, an enormous national debt, and an ever-increasing money supply. So what do we do?

A. What can we anticipate until we do something about this?
1) The value of the dollar should start to go down.
2) Inflation should start to increase
3) We will have to start paying higher interest on our debt as we become less attractive because of our high debt.

–How does this affect us investment-wise?
We should anticipate increasing inflation over the next 3-5 years. Investment-wise we should move away from CD’s and Money Market accounts and look at Treasury Inflation Protected Securities. (TIP, VIPSX, www.TreasuryDirect.gov)

We should anticipate increased taxes on income, investments, and anything else possible over the next 3-5 years. While this will hurt in the short run, it is a definite need in the long run. We can not continue to reduce taxes while spending more. What we have effectively done in the last decade is equivalent to a business owner who is making 200k a year and has expenses of 215k a year increasing his expenses from 215k to 230k and reducing his income from 200k to 150k and assuming everything was going to work itself out. Its just not going to happen.

B. What is the solution?
1) We have to increase taxes to be able to pay our debt.
2) We have to reduce spending so that we have more money left to pay the debt.
3) We have to increase interest rates to be able to continue to borrow money in the short run.

So the conclusion of this blog for the time being is
1) expect all of the things in Item B to take place in the next 3-5 years. They have to. If they do not happen, we have a big debt problem that will be almost impossible to tackle.
2) being prepared for the above items allows us to make good investment decisions today to take advantage of those potential changes.

With all of that said, these are just the thoughts of one person. I do not claim to know everything there is to know about the topic. I would recommend you talk to your financial professionals before making any decisions.

Recommended Readings/Viewings:

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In the past we have given you all sorts of information that we found to be interesting, informative, and useful to you through emails and one on one conversations. Over the last few months as various situations have taken a good bit of our time, we have neglected these beneficial general commentaries.  Many of our clients have asked for us to return to providing our general thoughts on economic conditions and general personal finance topics. In the spirit of continuing to provide you with this commentary, we have started this blog.

Please feel free to comment and ask questions as they arise. We will do our best to field all questions and address all issues and concerns.

Milad Taghehchian, CFP(R)

Pioneer Wealth Management Group

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