Financial Planning Stuff You Need to Know

No, this is not about crops. It’s time to harvest your tax losses after the big declines in the stock market. Tax loss harvesting is a silver lining in a terrible year for stocks.

Here’s how it works:

On January 1, 2008 you had mutual funds worth $400,000.

Now they are worth $250,000 for a paper loss of $150,000

To harvest this loss you do the following:

• Sell your mutual funds – now you have a loss for tax purposes of $150,000
• Buy very similar mutual funds with the $150,000 proceeds – your investment strategy is still essentially the same
• After 31 days, sell the new mutual funds and buy back your original funds

With your loss of $150,000 you can do the following:

• Offset any gains you have (one client had substantial from earlier this year from selling individual stock holdings. This strategy will save her over $20,000 in capital gains tax.)
• Offset up to $3,000 per year in income each year until your losses are used up.
• Offset future gains you may have in the future.

Obama will inherit twin economic crises. The immediate financial crisis and recession and a longer-term crisis (Medicare, Social Security, Infrastructure)

What should you expect?

In the next year:

• Obama’s tax plan will likely be passed by congress meaning a tax cut for most Americans earning less than $200,000/year and a tax increase for those earning more than $250,000. There will possibly be a capital gains tax rate increase for these taxpayers as well.

• Some sort of fiscal stimulus plan although more focused on infrastructure rebuilding vs. checking sent directly to taxpayers.

• A re-evaluation of the current economic rescue plan and an expansion of the plan to other industries and to some homeowners facing foreclosure.

Over the next few years:

• Some type of health care plan that would be similar to the one in Massachusetts which requires everyone to buy health insurance if their employer doesn’t provide it. It will likely offer a Medicare-type like option for people who could not afford to purchase private insurance.

• Possible changes in Medicare and Social Security, more likely Medicare which is in more trouble. Expect Medicare to be allowed to negotiate prices for prescription drugs (which it cannot do by law now) and higher premiums. The very complicated Medicare+Choice options are likely to stay.

• A tougher economic climate (not due to Obama) but due to our country’s desire to live on borrowed money. Eventually living off newly borrowed money becomes unsustainable, especially if we use that money for current consumption (flat screen TVs, cars, etc.) vs. investments that increase our long-term wealth (education, bridges, etc.)

What should you do?

• Save more. Long-term returns on stocks will average in the single digits as they did from 1966-1982. Although you cannot control what returns you get in the market you can control how much money you save. Plus if I am wrong, you can retire that much earlier.

• If you earn more than $250,000 and can shift your income into 2008 from 2009, or possibly 2010 into 2009, then doing so will reduce your tax bill.

• If you earn more than $250,000 and have capital gains that you are thinking about realizing, do it now. Capital gains tax rates will be higher for you in the future.

Major economic transformations are always difficult, and usually lead to major political transformations (as happened yesterday). If Obama can navigate the political and economic waters he could set the nation on the course to a much better future.

In the past I have recommended that you keep three months of living expenses in cash on hand in case of an emergency. Now I am increasing that to six months.

We may be on the cusp on the most severe recession since 1980-1982 when unemployment hit 10%. Although most of you will keep your jobs during a recession it is important to be prepared for the worst. If you do lose your job finding a new one will take longer, and other sources of credit (Home Equity, Credit Cards) are reduced due to the financial crisis.

How do you get there? If you already have three months stashed away then start cutting back on some of your extras (entertainment, vacations, dining out) with the goal of saving an additional one week’s worth of living expenses each month. Over the course of a year you will have six months of living expenses saved. If your living expenses are $6,000 per month then you would need to save an additional $1,400 per month.

If this seems to daunting to you, you could save ½ that amount each month and then add any “extra” money you receive to your cash stash. (e.g. tax refunds, bonuses, etc.)

This exercise will also prepare you for living on less should you lose your job. (See “Could you live on less”).

The stock market has had some crazy gyrations of the past month, sometimes swinging wildly up and down during the course of a single day. These gyrations are normal during times of economic transitions. During the period after the great crash of 1929, the stock market did not go straight down but swung wildly with big rallies and big drops. Some of the biggest up days were in late 1929 and again in 1931. However, the overall trend was down. Our recent experience has been similar although the timeframe has been greatly compressed.

Until we understand the full extent of our economic situation expect the market to overreact to any news whether good or bad.

We are facing some difficult economic times. I’m challenging you to figure out how to live on 30% less income than you have if you had to.

What are your top priorities and what would you cut? What is really necessary? Should you have a decline in your income due to a job loss, reduced business income, or for a medical reason it’s much easier to cope with the change if you have already figured out how you would adjust your spending.

Check out the November, 2008 issue of Kiplinger’s to see how people have dealt with a reduction in income.

The world economy is having its worst financial crisis in decades. The stock market has dropped by over 30% from its peak. Several major banks have failed. Many people are worried.

At times like this having a long-term plan is more important than ever. If you don’t you are likely to be swept up by the emotions of the moment and make decisions that will hurt you in the long-run. Making decisions under stress causes us to go into “fight or flight mode.” When we are in this mode, all of our higher reasoning ability is shut down in order to make sure we can escape from the imminent danger. Unfortunately for our brains a financial crisis is not the same as being chased by a tiger and responding to it instinctively vs. using our higher reasoning ability often leads to a poor long-term outcome.

Below is a logically true statement that goes against emotional sentiment:

• What ever happens in the future now is a better time to buy stocks than in Oct 2007.

The statement is true because on average stocks are more than 30% cheaper than they were in Oct 2007. Even if the market declines more someone who buys today will be better off than someone who bought in Oct 2007.

However, stocks were selling like the proverbial hotcakes in 2007 and now it’s hard to give them away. Why?

Our emotions tell us that the recent past always predicts the future, even though intellectually we know that is incorrect. In 2007 with the market reaching new highs we felt that it could only go up, and now with the financial crisis we feel it can only go down.

Having a long-term plan allows you to weather the financial and emotional storms and make better decisions for your future. Not having a plan could allow you succumb to emotions and make investment decisions on the “Sell-Low, Buy-High” philosophy which never works.

Changes are coming that will affect most Americans who will seek to borrow money in the future. Here are some of my predictions: (Note some of these changes have already occurred).

1. You will need a substantial down payment to purchase a home. Yup, we essentially back to the 20% down payment requirement of the past.
2. It will be harder to qualify for a mortgage. To get the best rates a FICO score of over 760 will likely be necessary.
3. It will be harder to get a home equity line of credit and the loan-to-value ratio of the credit line will be lower than in the past
4. It will be harder to get an auto loan unless you have great credit.
5. Fewer auto lease deals will be available (We’re already seeing that with domestic makes).
6. It will be harder to get credit cards and credit lines will be lower.You will see fewer credit card offers in the mail.

In essence the days of living on borrowed money are over. For those of you who are working with me, most of you have already made that transition and are ahead of the game. For the rest of you it’s coming if it hasn’t already.

Lehman Brothers an investment bank files for Chapter 11 Bankruptcy, Bank of America buys Merrill Lynch at a fire sale price, and insurance giant AIG needs a huge loan from the Fed to avoid bankruptcy. All of these problems are the result of the mortgage excess with its roots in greed that have now spread across the financial sector. Banks no longer want to lend to each other because they don’t trust that the bank they are lending to is actually solvent or ready to implode.

The Fed and the Treasury Dept. have now developed a plan to address the financial sector meltdown and the stock market shot up yesterday and today, but there is likely more bad news ahead.

Despite the bad not all is not lost. You should not move all of your retirement money to cash. The S&P 500 (the best measurement of “the market”) is still over 50% higher than it was 6 years ago. If you are having trouble sleeping or you are worrying a lot about your investments, I recommend you do the following:

1. Check your retirement account balances and calculate how much your portfolio has declined.It may have declined less than you thought because most investors are invested more broadly then the Dow or S&P 500 indices which are often used to represent the stock market.
2. Review your results with the downside risk inherent in your asset allocation.Your financial advisor should have reviewed this with you when he or she wrote your investment policy statement and reviewed it with you.If your advisor did not do this or if you need an advisor who can develop a good investment strategy for you go to www.napfa.org
3. If your losses are within the range the advisor projected as possible but you still are uncomfortable then you may want to review your overall risk tolerance.You may be less risk tolerant than your thought.
4. If your risk tolerance has changed, you may want to consider changing your asset allocation strategy.Understand that moving to a more conservative allocation may mean that you need to save more or be prepared to work longer.
5. Understand that investing is for the long-term and that almost no long-term strategy that provides a reasonable long-term rate of return can protect you completely from short-term losses
6. Also understand as humans we are wired to respond to short-term changes (positive or negative) and discount long-term changes that are more significant

For example, only a short-term increase in gas prices got us to reduce our gas consumption, not the possible larger but longer term effects of global warming.

Next blog, what to expect in the future.

With the record rainfall and flooding we have had recently, the topic of flood insurance comes to mind. Your homeowners insurance does not cover damage from flooding. In order to be protected in case of a flood you need to purchase flood insurance through the Federal Flood Insurance Program.

You can find out more information about flood insurance at www.floodsmart.gov . At this website you can find out the flood risk in your area, review what coverage is available, and the cost, and find out which agents sell federal flood insurance in your area. The cost of flood insurance is the same no matter which agent you purchase it from.

One of the biggest challenges some of my clients have is tracking how they spend their money. I have been experimenting with an online service called Mint www.mint.com which claims to do just that.

Mint is a kind of online aggregator. It pulls together information from your online bank accounts, credit cards, investment accounts, and loans. It then analyzes and categorizes the information for you. It can also send you weekly tracking updates. It also allows you to create a budget or it will attempt to create one for you based on its analysis of your prior spending habits.

Setting it up was very easy. I just entered my login information for each of my accounts. I did spend some time reading Mint’s privacy and security information. You can check them out on Mint’s website.

Mint makes its money by offering you “better deals” on loans, credit cards etc. from it’s sponsors. For me none of these was really a better deal, but Mint has been excellent about not letting its partners bombard my inbox with spam.

Over time the Mint has been doing a better job categorizing my spending. You can correct any classification errors pretty easily and Mint will remember the change going forward.

I also like that Mint provides me with a net worth calculation (excluding real estate). I wouldn’t recommend looking at this too often if the stock market gyrations make you too nervous.

There are other services that provide similar benefits to Mint but after trying about four of them, Mint is the one that provided the best information, and appeared to have the strongest, privacy and security policies.