11) Short Primer on Estate, Gift & Generation-Skipping Taxes
The Stamp Tax of 1797, The Revenue Act of 1862, and The War Revenue Act of 1898 were all precursors to the modern estate tax. These laws allowed taxes on probating wills, gross estates, and legacies.
In 1916 the modern estate tax was enacted with the gift tax enacted in 1924. There have been many changes over the years.
Gross estates above $12.92 million are now taxed at 40%. In 2026, the exemption amount will fall back to $5-$7 million based upon inflation. Gross estates include all assets such as real estate, stocks, bonds, personal property etc. Debts and charitable bequests are deductions from a decedent's estate. An estate tax return is due nine months from date of death.
The Estate tax and gift tax are unified. This means that the rates for estate and gift taxes are the same and when an estate tax return is filed, all previous lifetime gifts are reported. You can either give up to $12.92 million gift tax-free during your life or you can leave it to your heirs’ estate tax -free at your death.
There is an unlimited marital deduction for amounts left to a surviving spouse.
In addition to $12.92 million (indexed to inflation) gift-tax free gifts made during one’s lifetime, each person can give $17,000 a year (indexed to inflation) to any other person gift-tax free. This is called the annual exclusion amount. You can also give unlimited amounts to education institutions or healthcare facilities for education and health care expenses on behalf of others.
The Generation-Skipping Tax (GST) tax was added in 1976. This closed a loophole where a grandparent could leave money in trust for a child and at the child’s death the money would go to the grandchild without being taxed in the child’s estate–a generation skipping event. The GST tax applies when the trust is initially funded along with the gift tax. It effectively places two taxes on amounts left to grandchildren.
There is currently a $12.92 million exemption amount per individual (indexed to inflation) for generation-skipping transfers (gifts from grandparents to grandchildren). Generation-skipping transfers above this amount are taxed at the highest gift and estate tax rate of 40%.
Always seek professional advice regarding these taxes and strategies to minimize them.
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10) Income Tax Planning
Effective income tax planning results in the lowest legal income tax liability for an individual, trust, foundation, corporation, or other tax-paying entity.
One longstanding planning principle is to defer/delay income as long as possible and accelerate deductions. Individuals report income and expenses on the “cash basis.” This means you report income when it is received and report deductions when paid.
Good tax planning (always exceptions) is to delay receiving income, if possible, and pushing it into the next year. Likewise, taking deductions now rather than later tax year makes sense.
It is important to monitor capital gains and losses during the year. If there are net capital gains before year-end, consider selling stocks with unrealized losses to offset the gains.
If there are net capital losses, consider selling stocks with unrealized capital gains. You will then receive sales proceeds without capital gains tax. Be aware of the “wash sales” rules that can prohibit the ability of taking a loss when selling a stock for a loss and then with-in 30 days of the sale repurchasing it.
Other ways to reduce income tax liability (if you itemize-your individual deductions are greater than the standard deduction) is making charitable donations. Donating appreciated stock (stock with an unrealized capital gain) avoids a capital gains tax and results in a deduction for the market value of the stock.
Take advantage of company sponsored 401-K plans and consider funding an individual retirement account (IRA) or Roth IRA.
Tax-deferred savings plans (401-K, IRA, Roth IRA) allow savings to grow tax deferred until age 73. Withdrawals are taxed as ordinary income except Roth IRA withdrawals are tax-free.
There are several unique situations such as selling a business or investment property that require professional tax advice. Again, seek the advice of trusted professionals if you have specific tax questions.
9) Short Primer on Income Taxes
Have you ever been confused with taxes and tax terms such as: dividend tax, capital gains tax, social security tax, wage tax, gift tax, estate tax, generation skipping tax, and many more? Taxes are complicated and convoluted. There are tax books and tax degrees. Professionals spend their careers working on taxes.
Many decisions we make can be impacted by taxes so it’s important to have a basic understanding. Let’s start with income taxes.
We file an annual tax return to report income and claim deductions. It is due on April 15th following the close of the calendar year. You can file a six (6) month automatic extension up until April 15; however, you need to pay what you believe you owe with the extension.
Income that is taxed usually falls into the following types or categories-
1) Wages and Salaries- highest Federal rate Federal of 37% along with various state and local taxes. These taxes are typically automatically withheld by your employer on each paycheck. In addition to income tax, we pay along with our employer a Social Security tax and Medicare tax (7.65% by each party) on wages and salaries.
2) Dividends (payments from companies) –highest Federal rate of 20% along with various state and local taxes. High income taxpayers pay an additional Medicare sur-tax of 3.8% on dividends (Affordable Care Act).
3) Capital gains (a gain is the difference between what you paid for an asset such as stock versus what you sell it for). Short-term gains (assets held less than a year) are taxed at the same rate as wages and salaries. Long-term gains (assets held for longer than a year)- highest Federal rate of 20% along with various state and local taxes. Capital gains and capital losses can be combined with the net result either a net gain or net loss. High income taxpayers pay an additional Medicare sur-tax of 3.8% on net capital gains (Affordable Care Act).
4) Interest Income
5) Rental Income
6) Self-Employment- earnings from businesses/ventures
7) Other- gambling winnings, lottery winnings other income such as retirement payments and Social Security payments.
Note items 4 through 7 taxed at highest Federal rate of 37% along with various state and local taxes.
Taxpayers can claim various deductions from their income listed above - adjusted gross income (AGI) by either claiming the higher of a standard deduction ($27,700 for married filing jointly) or by itemizing (claiming several individual deductions). Below is a sampling of various itemized deductions. Please note that there are various rules and limitations associated with them.
1) Health costs
2) Payments for mortgage and investment interest on loans
3) Payments for real estate taxes and state income taxes
4) Payments to charities
There is a perverse tax known as “the alternative minimum tax.” This is a separate way of calculating your tax liability that was implemented many years ago to prevent people from paying zero income taxes because of very high deductions. It is a complicated system but still in existence. Thankfully its impact has been reduced in recent years.
The Internal Revenue Service wants taxpayers to pay taxes as they earn income. Taxpayers are not allowed to wait until the end of the year to pay their taxes–if this happens there can be interest and penalties. Taxpayers earning wages and salaries normally have taxes automatically deducted from their paychecks. Taxpayers who do not have wages and salaries but earn income through dividends and interest income must pay estimated quarterly tax payments.
For those curious, below is a link to an article on the history of the income tax (Abraham Lincoln implemented the first income tax) :
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8) Stay the Course
John Bogle, founder of The Vanguard Group, stressed “stay the course” when it comes to investing. What does that mean? In the most basic sense, it means to have an investment plan/strategy and to stick with it through thick and thin.
It can be difficult to “stay the course” with twenty-four-hour news cycles and universal internet access. Warren Buffet, one of the most successful investors, is famous for saying that once he buys a stock, he intends is to hold it “forever.” He is unfazed by short term stock prices. Buffet paraphrased the great Ben Graham saying, “In the short run the market is a voting machine but in the long run a weighing machine.”
Successful investing can be counterintuitive. In many professions, the harder one works (more sales calls/more product launches/more legal briefs -the greater the success. In many instances, limiting trading and avoiding taxes and high fees provides better investment results.
Remember, “motion doesn’t necessarily mean progress” when it comes to investment performance.
Keep your eye on the real investing prize-maximizing long-term returns.
I hope you’ve found the above essay and previous ones interesting and thought provoking.
Please feel free to pass any or all my essays on to those who you think may find them worthwhile.
If you have specific investment questions, I encourage you to seek advice from trusted investment professionals.
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7) What Does Risk Mean?
A common question in the investment world is, “how much risk are you comfortable with?”
Risk is a very complex and nuanced subject. A standard definition of risk is variation/volatility of investment returns as presented in modern portfolio theory. The riskier the investment the more its returns will fluctuate versus a risk-free return of an investment such as a United States Treasury Bill.
Modern portfolio theory also assumes the riskier an investment, the greater the potential returns. This seems logical if we look at long-term returns for equities (stocks) whose returns can be variable from year-to-year and average around 8- 10% per year versus fixed income/bonds whose returns are less variable from year-to-year and average around 4% per year return over long holding periods.
Relying on variation/volatility of returns as a definition of risk can be problematic. The safest and least risky form of investment, based upon the notion of lowest variation/volatility, could be stacks of money stored under your bed. Every day, every year, every decade, there would be no change in the face value of the money- no variation/volatility. But this could be very risky. Yes, there is the risk of thief, but a more insidious risk is the risk of loss of purchasing power.
Over a long period of time, the face value of money will have much less purchasing power because of inflation. Think of what things cost 50 years ago such as homes, automobiles, and other goods.
In my view, a more useful definition of risk is “permanent loss of capital or purchasing power.” Using this definition, fixed income -savings accounts and bonds can be risky investments especially in an inflationary (rising price) environment.
Some may say, “look what happened in the Great Crash/ Depression of 1929 when it took 25 years (10 years if dividends are included) to recover and more recently the
Great Recession of 2008/2009 when stocks lost 60% of their value-it could happen again.”
There have been many market Manias and Bubbles in the past, (Holland – Tulip Mania, South Sea Bubble, Florida Land Bubble, 1960’s Technology Bubble, 2000 Internet Bubble, 2008 Real Estate Bubble) and most likely there will be many more in the future. When Manias break and Bubbles burst markets can decline over 50%.
Investors who do not have the luxury of “time as their friend” or just can't afford to have their investments lose value (even if it is temporary) will most likely need to invest in fixed income -savings and bonds. They are sacrificing potential long-term appreciation for preservation of capital.
For young investors and those who can view wealth over multiple generations, beware of low volatility investments that may result in a slow permanent loss of capital and purchasing power. And to protect against the permanent loss of capital from market crashes and downturns, invest regularly and systematically with “time as your friend.” Losses that may at first seem permanent, may very well end up being temporary.
With a better understanding of risk, you should be able to make better informed investing decisions.
6) Market Timing- Should you try to get out of the Market when it’s going down and then get back in when it is going up?
If investing was this easy. Attempting to get in and out of the market to avoid losses and capture gains is known as “market timing.” Let’s look at the odds of doing this successfully.
In Javier Estrada’s article, “Black Swans and Market Timing: How Not to Generate Alpha “he states in the article’s abstract, “The evidence from 15 international equity markets and over 160,000 daily returns indicates that a few outliers have a massive impact on long-term performance. On average across all 15 markets, missing the best 10 days resulted in portfolios 50.8% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 150.4% more valuable than a passive investment. Given that 10 days represents less than .1% of the days considered in the average market, the odds against successful market timing are staggering.”
There are many other published studies confirming the low odds to successfully time the market and attempting to do so can dramatically lower investment results.
An important point to understand is it difficult to predict when and how much the market will move up or down, but even more important is market gains happen during short bursts. Being out of the market even a few days can result in missing these important gains.
The prudent course is to remain fully invested during all phases of bear and bull markets. This is extremely difficult, especially when the market is rapidly falling and the “end to the world” seems imminent. “Genius status” is conferred upon the lucky individual(s)who got out prior to the drop.
It is as difficult to remain fully invested when the market becomes extremely frothy and overvalued. There are warnings from many that the market cannot continue to rise forever and that there will be a “crash” soon.
Develop strategies to avoid getting caught up in the emotions during these times. Being invested and staying invested will have the greatest impact on investment results. Chances are high that investments will come back after declines and investment income will remain unaffected.
“Market timing creep” can happen with investments allocated to several asset classes. Determining one’s asset allocation is the result of careful planning taking into consideration such factors as tolerance for risk, age and financial situation. There are valid reasons to adjust one’s allocation from time-to-time but if it is happening frequently, it can very much resemble market timing.
As Mark Twain famously said,
“October. This is one of the particularly dangerous months to speculate in stocks. Others are November, December, January, February, March, April, May, June, July, August, and September.”
5) Red Flags
Smart investors typical heed the warning, “If you don’t understand, don’t invest.” Be cautious of investment strategies or companies that you do not understand.
Be cautious of Fantastic or “too good to be true” investment returns. Having realistic expectations–8 % to 10% per year total return is realistic (see early essay, “Realistic Expectations”). Remember doubling your money in 2-3 years means annual returns of around 30% (rule of 72).
As mentioned earlier, – reputations, referrals and track records are important. “Flashy appearance, “slick demeanor” and “over-the-top” presentations may not equal superior investment performance.
The following are some lessons learned from the Bernie Maddoff Fraud- How he snared many unsuspecting investors using the following techniques:
Exclusivity-you and only a few others can get in. Such and such celebrity or successful entrepreneur invest with our firm – “I can get you in.”
Lack of transparency - the investments are so exclusive and complex that they are hard to value and hard to get in and out of. Your investment is locked up for months or years.
Lack of controls regarding the custody (holding) of your money - Bernie Maddoff required his clients to write him a check or ACH/Wire their money to his company. All client funds were co-mingled without adequate controls. This allowed him to “cook the books” and steal. Make sure you understand exactly how your money is held and the controls in place to protect it.
These are some of the “Red Flags “you should be on the lookout for and reason for pause and concern.
Successful investors realize that “preservation of capital” can be more important than “appreciation of capital.”
4) Fees Matter/Rule of 72
John Bogle, founder of The Vanguard Group and author of several Investment books is famous for making the point that fees are extremely important in determining an investor’s ultimate outcome. Bogle helped organize The Vanguard Group as a mutual- type company where Vanguard shareholders are the owners, thus keeping fees as low as possible.
A useful mathematical formula is known as the “rule of 72.” It calculates the time required to double your investment. For example, if your investment has a total annual return of X %, you can divide 72 by X% (or 70 for easier mental math) and the result is the number of years required to double your investment.
Let's assume your investment is worth $100,000 and is growing at 7% per year. Divide 70 by 7 and you know that in 10 years your investment will grow to $200,000. Conversely if your $100,000 investment is growing at 10% per year, it will grow to $200,000 in 7 years.
Getting back to fees. If a young investor can save 2% a year on fees or make 2% higher average annual returns, in 35 years, he or she will end up with approximately double their retirement funds! Even 1% is significant over a young investor’s retirement savings timeframe.
In situations, where parents or grandparents are interested in passing their savings to children and grandchildren, investing timeframes can easily exceed 100 plus years. 1-2% differential on average annual returns will result in significant differences in ultimate outcomes.
3) Should I Hire an Investment Advisor/Firm? If so, Who Should I Hire?
If you do not have the interest, time, and commitment to manage your investments, (it can be difficult and time consuming to do it well) my advice is to hire a competent Investment Advisor/Firm. As is the case with most professions, you will need to find an Investment Advisor/Firm you’re comfortable working with.
When interviewing an Investment Advisor/Firm, an important question is investment performance. All good firms underperform from time-to-time unless they are the “Bernie Maddoffs” of the world. Benie Maddoff went to jail for making client returns always positive and stealing client funds. Short-term underperformance should not be a concern if long-term performance is good.
If the firm manages individual accounts only and not funds, ask to see the performance of accounts that are managed as they would manage your account based upon your goals and objectives.
Ask how taxes are managed especially if your savings/investments are in a taxable account not an IRA/401-K. Lots of buying and selling (turnover) can generate taxes and lower after-tax returns. High pre-tax returns can end up lower once you subtract taxes.
It is important to understand exactly how the Investment Advisor/Firm will manage your money. Are they “value investors” who try to find undervalued-bargain priced companies? Are they “growth investors” who try to find companies with rapidly growing earnings that will propel stock prices higher? Are they a hybrid, “growth at a reasonable price “GARP.”
Do they use ETFs or other funds, or do they pick individual stocks and fixed income securities? You must understand their strategy and methodology.
Ask about fees. Fees do matter (more on fees later). The higher the fees, the greater impact on your returns. Fees for Index fund ETFs are the lowest.
As is the case when hiring any type of professional, check references. Ask around. Do a bit of leg work. Reputations are important. Remember during turbulent times your Advisor may spend as much time or more managing your emotions and fears as he or she spends managing your investments.
2) How Should I Invest my Money/Asset Allocation?
When I first started working as a trust officer thirty plus years ago, you could invest in three options – stocks, bonds, and money market funds. It was simple. Today it is more complicated.
Bank investment officers or independent investment officers may describe investments such emerging markets, private equity, hedge funds, market neutral funds, and alternative investments. Common stocks can now mean large capitalization, mid-capitalization, small-capitalization, international, and start-ups. Fixed income can mean corporate, government, international and emerging markets debt.
As mentioned in an earlier essay, Professor Siegel (Professor of Finance–Wharton School of the University of Pennsylvania) and author of” Stocks For The Long Run,” presented research showing common stocks produced twice the return of fixed income from 1802 through 1997.
Why is this? Stocks have a return advantage because companies issue bonds (fixed income) and then pay their bondholders a fixed interest rate/amount. Companies use the proceeds from the bond sales to obtain funds needed to run their businesses. If companies can’t put this money to work at a higher rate than what they pay their bondholders, they should go out of business eventually.
If you’re looking for higher returns, I suggest owning stocks. As a stock owner you become a part-owner of business that typically issues bonds to grow.
In addition to the higher rate of return for owners of stocks, stocks can provide tax advantages over fixed income.
Bond interest income is taxed as ordinary income at rates as high 37% vs 20% for stock dividends (qualified). High income individuals may pay an additional 3.8% tax on dividends.
Stocks prices typically go up over time. The increase in price (appreciation) is not taxed until you sell your stock(s). Holding stocks for a long time represents a tremendous wealth building advantage.
The tax due on the appreciation of stocks (unrealized capital gains) becomes an interest-free loan from the government that stock investors use to increase their returns. This is like the wealth building advantages of IRAs and other tax-deferred investments.
For long-term investors and especially young investors it makes sense to invest a significant amount of savings in stocks to obtain higher long-term growth.
Getting back to asset classes mentioned earlier. Diversification (having more than one egg/investment in your basket) is very important and can provide protection from losses.
Owning several stocks or an S&P 500 index fund ETF can provide significant diversification. Investing in several companies or an investment in an S&P 500 ETF, can provide asset class exposure to international, small business, and start-up businesses.
In recent years, index ETFs have become numerous allowing investors with limited funds and those not interested in selecting individual stocks to create diversified low-cost portfolios. There are ETFs for every conceivable asset class.
Options, derivatives, and commodities are used by sophisticated investors.
Investments
Investments
1) Realistic Expectations
“If it is too good to be true it probably is.”
We’ve heard this expression numerous times in various settings. In the investment world, it usually refers to investments that have extremely attractive returns (appreciation plus income). This leads to the question, “what are reasonable rates of returns achievable for long-term investments?”
Jeremy J. Siegel’s (Professor of Finance–Wharton School of the University of Pennsylvania), and author of” Stocks For The Long Run,” measured stock and bond returns from 1802 through 1997. The total return of stocks, made up of dividends and capital appreciation, averaged approximately 8.4% per year and bond returns averaged approximately 4.8% per year over this time frame.
If history is a guide, it is difficult to achieve total returns significantly more than this. A good rule of thumb is 8% to 10% per year is realistic with stocks. Be cautious and skeptical of investment strategies/services that claim double-digit returns over long periods of time.
Having realistic investment expectations is a powerful tool that can help evaluate the various investment options and strategies available.