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Mechanics Of The 0% Long-Term Capital Gains Tax Rate And Harvesting Capital Gains For A Free Step-Up In Basis!

November 26, 2014 07:01 am 48 Comments CATEGORY: Taxes

Social Template Series of Income Deductions

For “lower income” individuals whose income falls within the bottom two ordinary income tax brackets, the Internal Revenue Code applies a 0% long-term capital gains rate to the extent their gains also fall within the lower two brackets. However, the 0% rate only applies as long as the income actually does fall within those lower brackets – which means “too much” in capital gains will eventually cross out of the 0% rate and into the higher tax brackets.

Nonetheless, the potential for 0% long-term capital gains rates means that for those who are eligible, the best thing they can do every year is not harvest capital losses – the “typical” capital gains strategy – but instead to harvest gains! By selling investments that are up, and buying them back again immediately (without any wash sale rules to navigate!), the taxpayer can effectively get a step-up in basis on current investments without any (Federal) tax liability!

Of course, the caveat to this strategy is that while long-term capital gains may be eligible for 0% rates for lower income individuals, it is still income itself, potentially impacting certain deductions and tax credits, and the taxation of Social Security. In addition, harvesting capital gains must be coordinated with other strategies, like partial Roth conversions, which can potentially drive up long-term capital gains rates and make capital gains harvesting less effective. Still, though, the potential to claim a free step-up in basis is not one to be missed, for any years where income is low enough to take advantage of the rules, whether due to just having income low enough to qualify, having a “temporarily” low income year due to a job loss or change, or simply looking to harvest capital gains once retired when wage income is gone and required minimum distributions have not yet begun!

Will Financial Planners Be Forced To Reduce Or Unbundle AUM Fees As The Price Of Beta Goes To Zero?

November 24, 2014 07:01 am 5 Comments CATEGORY: Practice Management

As ETFs and indexing makes the raw cost of “owning the market” cheaper and cheaper, the question arises of whether or how advisors can continue to justify an ongoing AUM fee for an investment portfolio. For some, the cost is justified by the alpha or portfolio-related “advisor gamma” value-adds that are provided; for others, the benefit is the inclusion of financial planning services; and for the rest, the benefit may just be to help protect clients from themselves and their self-imposed “behavior gap” on returns.

Yet the reality is that AUM fees are far more relevant for some of these services – like portfolio-related alpha – than others, and in some cases while some AUM fee is justified there is significant pricing pressure (e.g., providing portfolio-related gamma like automated rebalancing, tax-loss harvesting, and asset location). In some cases, the advisor provides so little actual portfolio-related value that the financial planning fee may become unbundled altogether.

Notwithstanding the potential pressure to unbundle, though, a look at the landscape of the financial services industry suggests that, if anything, the trend remains towards AUM fees. The shift towards fee-based revenue has been increasingly adopted by even the largest firms, from wirehouses to Schwab Private Client to Vanguard Personal Advisor Services – often bundled together with comprehensive financial planning services that are either very low cost, or entirely free because their impact on retention rates and increased lifetime client value alone justifies their cost to deliver. Which means in the end, even the declining cost of beta may not be enough to end the AUM fee… though the fact that a huge swath of Americans cannot be served by AUM fees – because they don’t have the assets in the first place – means a wider range of financial-planning-fee-for-service models may be inevitable anyway!

Weekend Reading for Financial Planners (Nov 22-23)

November 21, 2014 03:02 pm 3 Comments CATEGORY: Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with coverage of the newly shortened computer-based CFP exam that was administered for the first time this week, and also an announcement by the CFP Board in its recent business webinar that the public awareness campaign, and the additional $145/year fee that funds it, is expected to continue "indefinitely" (as long as the campaign results continue to be positive). In addition, the FPA also released this week a new study about advisors and growth, finding that advisory firms are struggling to achieved their growth goals, with only 9% of all firms reporting that their business development efforts are "very effective" in achieving their goals.

From there, we have a number of technical articles this week, including: a discussion of the current status on Social Security benefits for same-sex married couples; how early retirees can maximize premium assistance tax credits for getting health insurance during the "gap" years from retirement until Medicare eligibility; some key details to know about how non-transparent "active" ETFs will work; a discussion of what kinds of assumptions are (and are not) reasonable when clients are pitched on equity-indexed universal life strategies; a new court case in Pennsylvania on "filial support" that raises the question of whether long-term care facilities may become more aggressive in pursuing adult children for the unpaid expenses of their indigent elderly parents; and a summary of the current state of dependent care accounts, and the opportunities they provide, even though they are not often utilized.

We wrap up with three interesting articles: the first provides a good overview of some of the latest research on whether money really can buy happiness or not (hint: it's not just about having wealth, but about how it is spent); the second explores some new research on the behavioral biases that impact not only investors, but also advisors and even fund managers; and the last is a (not entirely positive) review of the recent Tony Robbins book that finds the book may not have as clear of a fiduciary message in practice as it purports in theory.

And be certain to check out Bill Winterberg's "Bits & Bytes" video on the latest in advisor tech news at the end, including the launch of a new financial planning software solution called Advizr, a new "robo-planning" solution iQuantifi, and more! Enjoy the reading!

Allocating A Portfolio In The Context Of Human Capital And The Rest Of A Household’s Total Balance Sheet

November 19, 2014 07:01 am 7 Comments CATEGORY: Human Capital

While portfolio management understandably focuses on how best to allocate a portfolio, the reality for many (or even most) investors is that their financial assets may not even be the majority of their total net worth, compared to other assets like real estate, the (illiquid) value of their pensions and Social Security, and for those who haven’t retired yet, their human capital. In fact, for younger workers, their human capital – or the present value of their future earnings from employment – may actually be the largest asset they own!

Yet the reality is that assets like human capital, illiquid pensions and Social Security, and even real estate (especially if in the form of a primary residence) are not easily traded or altered; in other words, whatever you’ve got, and the risk it entails, is largely what you’re stuck with. In turn, this suggests that if the individual is going to try to optimize the risk and return of their total net worth – across all these different “asset classes” – that the portfolio is the one that should change to accommodate the rest, because it is the most malleable.

And in fact, recent research from Morningstar suggests that, when viewed on this basis, the optimal portfolio allocations for many investors really do shift, potentially quite significantly! Human capital, in particular, plays a significant role, given that both the growth rate potential and the volatility risk can vary quite a bit from one industry to the next, and different industries themselves have varying correlations to different segments of the market and (financial) asset classes. Which means, in the end, that advisors who are not considering these other balance sheet risks – especially for the human capital of their working clients – may be significantly over- or under-risking the client’s total household balance sheet over time!

A Birthday Celebration, An FPA NexGen Graduation, And A Moment Of Rebirth

November 18, 2014 11:15 am 53 Comments CATEGORY: Nerd's Eye View

It is with mixed feelings that today I face my 37^th birthday – a unique milestone for me, as it marks the maximum age threshold for NexGen, a group I helped to co-found 10 years ago (with the original inauspicious name of "Mouseketeers"!), and for which I was perhaps the most ardent advocate for having a maximum age as a requirement for membership. Now, a decade later and with no small amount of irony, I find myself being “forced out” – or as I like to put it, “graduating” – under the very age-based rule I fought so hard to keep in place early on. For me, today is a day of change, of transition, and of rebirth as I close the book on one decade of my life, and open to the next.

Are Profit Margins For Financial Advisors Too Generous, Or Are AUM Firms Actually Not Profitable Enough To Survive The Next Bear Market?

November 17, 2014 07:01 am 14 Comments CATEGORY: Practice Management

While early adopters of the assets-under-management (AUM) model got started in the late 1980s or early 1990s, the model only really began to become widely adopted in the early 2000s. Yet as the AUM model has become increasingly popular, and firms have had time to build, the “typical” advisory firm has grown significantly, from an average of only $25M of AUM in 2002 to more than $200M of AUM in 2013. And with an average profit margin of about 22%, the typical advisory firm owner with an AUM practice is enjoying record take-home pay.

Yet the caveat is that as advisory firms on the AUM model have grown, their growth rates seem to be slowing, a combination of both the ongoing crisis of differentiation for advisory firms, and the simple fact that as the firm gets bigger the denominator of the growth rate fraction is difficult to overcome; after all, adding “just” $4M of new assets a decade ago would have been double-digit organic growth, yet the same new asset flows yielded barely a 4% growth rate for a typical firm in 2009 and would be less than a 2% growth rate for the average firm today!

The significant danger of this situation is that advisory firms with now-low growth rates will not be able to grow through the next bear market as they have in the past. And in fact, at an average profit margin of “just” 22% and the risk that the next bear market could lop off 25% or more from a firm’s assets and revenue, the reality is that not all advisory firms may even survive the next downturn! Or at least, not without laying off significant staff or forcing owners to stop taking any profits and actually plow money back into the firm just to ensure its survival. To say the least, the next bear market may be the worst one ever for advisors and their firms!

These risks – which seem somewhat inevitable, given that a market downturn will eventually happen, and so many advisory firms are too large to just grow their way through it – mean advisory firms should be focusing, now, on whether they have sufficient flexibility to their overhead costs, other means to stabilize revenues, or enough profit margins to absorb the next market decline when it comes. While many have been critical that advisory firms are “too profitable” and due for some competition in today’s environment, the reality is that judging profit margins after a 5-year bull market may not be the best measure, and in fact the greatest risk for most firms may be that their profit margins are still too small to withstand the next bear market when it comes along!