Ken Himmler.com

Ever since the possibility of default on Greek sovereign debt has become headline news, a lot of people have found themselves wondering, "How is it possible for the financial problems of a country so small and so far away to create such turmoil in the world's markets?" What's happening in Europe is probably affecting your portfolio right now, regardless of the quality of your holdings or how well diversified you are.

Just what is all the shouting about? It's no secret that the so-called PIIGS nations (Portugal, Italy, Ireland, Greece, and Spain) are having difficulty coping with the debt that years of deficit spending have created. A robust global economy helped to mask the problem, but in recent years the burden of sovereign debt–bonds issued by sovereign governments–has become increasingly unsustainable. With debt at roughly 140% of its gross domestic product,* Greece is particularly troubled. Imposing austerity measures required by its European colleagues has added to the country's recessionary woes. That in turn has made it even more difficult to achieve mandated deficit reduction targets in order to qualify for additional installments of financial aid from the European Financial Stability Facility (EFSF) set up last year by 17 eurozone countries.

Bank exposure
One of the chief concerns about the possibility of default on sovereign debt has to do with the financial stability of banks that hold it. Some of the largest French banks have already suffered downgrades of their credit ratings because of their extensive holdings of debt from troubled European countries, particularly Greece. If a Greek default made banks reluctant to lend to one another, that could affect credit markets worldwide.

American banks hold very little Greek debt compared to European banks; however, they could face a different challenge. Understanding why requires some basic awareness of a type of derivative known as a credit default swap. Investors with large bond holdings from a particular borrower often try to protect themselves against the possibility that the borrower will default by buying a credit default swap on that debt as a type of insurance. The company that issues the credit default swap agrees to cover the bondholder's losses in case of default. The more risky the issuer–for example, Greece–the more likely bondholders are to try to protect themselves with swaps. However, in some cases, a company may have issued so many default swaps on a particular issuer that it could be overwhelmed by the claims resulting from the issuer's default.

Such derivatives can create a ripple effect in financial markets. If the company that issued the swaps can't make good on them, the institutions that relied on that protection also can find themselves in trouble, which multiplies the impact of a major default. U.S. financial institutions are major issuers of credit default swaps, and the potential impact of a Greek default on them is unclear. However, since the 2008 financial crisis, U.S. banks have been forced to hold greater capital reserves to deal with contingencies, and Treasury Secretary Timothy Geithner recently said that banks here have reduced their exposure to the debt of troubled countries.

Potential for tighter credit leading to recession
Lending worldwide hasn't fully recovered from the last financial crisis, and has helped keep global economic recovery sluggish. Fiscal austerity measures taken to try to reduce deficits have also taken their toll, hampering economic growth and making it even more difficult for countries such as Greece to balance their budgets. If banks' lending ability were impaired further by a financial crisis brought on by a default on sovereign debt, tighter credit could increase the odds of renewed recession. Also, Europe represents a major market for many American companies, and a recession there wouldn't help an already slowing global economy.

Greece could be the tip of the iceberg
Even though Greece is the immediate concern, larger economies in Europe actually could represent a bigger threat. Italy and Spain both face sovereign debt burdens and deficit problems. Italy's economy is more than five times that of Greece; Spain's is more than four times bigger.* If either country were to decide it needed to restructure its debts as Greece is attempting to do (which ratings agencies could see as a form of default), that would have a much bigger impact than Greece. If a Greek default would have a ripple effect, a default by either Spain or Italy could cause waves.

To compound the problem, as investors have become increasingly concerned about the possibility of debt contagion in Europe, borrowing costs for both Italy and Spain have risen. At recent auctions, nervous investors have been demanding higher interest rates to compensate them for the higher perceived risk of buying that sovereign debt. As any credit card holder knows, having to pay a higher interest rate makes paying off debt and balancing the budget more difficult. A Greek default could make investors even more nervous about buying other troubled countries' debt, and being frozen out of credit markets would likely aggravate fiscal problems abroad.

All politics is local
There have been signs in recent months that voters in stronger economies such as Germany are beginning to question why they should continue to support countries that have not been as disciplined about balancing their budgets. Also, investors worry that the financial support available from the EFSF may not be sufficient or available quickly enough to avert problems. Though there has been no shortage of suggestions for how to deal with the situation–issuance of euro bonds backed by all eurozone members, leveraging the EFSF's existing assets, greater fiscal integration among countries, Greece returning to its own currency–questions about the ability and willingness of other countries to support the eurozone's weaker members have caused investor anxiety worldwide.

Financial markets hate uncertainty, and the situation has contributed to the recent volatility across a variety of asset classes that don't usually move in tandem. However, Europe has the benefit of having watched the United States deal with its own difficulties during the 2008 crisis. Also, European leaders have generally reaffirmed their determination to defend the euro at all costs. Uncertainty about Europe could persist for months, but it's important to keep it in perspective. While you should monitor the situation, don't let every twist and turn derail a carefully construct
 

Just what you need, right? One more time-consuming task to be taken care of between now and the end of the year. But taking a little time out from the holiday chores to make some strategic saving and investing decisions before December 31 can affect not only your long-term ability to meet your financial goals but also the amount of taxes you'll owe next April.

Look at the forest, not just the trees

The first step in your year-end investment planning process should be a review of your overall portfolio. That review can tell you whether you need to rebalance. If one type of investment has done well–for example, large-cap stocks–it might now represent a greater percentage of your portfolio than you originally intended. To rebalance, you would sell some of that asset class and use that money to buy other types of investments to bring your overall allocation back to an appropriate balance. Your overall review should also help you decide whether that rebalancing should be done before or after Dec. 31 for tax reasons.    Also, make sure your asset allocation is still appropriate for your time horizon and goals. You might consider being a bit more aggressive if you're not meeting your financial targets, or more conservative if you're getting closer to retirement. If you want greater diversification, you might consider adding an asset class that tends to react to market conditions differently than your existing investments do. Or you might look into an investment that you have avoided in the past because of its high valuation if it's now selling at a more attractive price. Diversification and asset allocation don't guarantee a profit or insure against a possible loss, of course, but they're worth reviewing at least once a year.  

Know when to hold 'em

When contemplating a change in your portfolio, don't forget to consider how long you've owned each investment. Assets held for a year or less generate short-term capital gains, which are taxed as ordinary income. Depending on your tax bracket, that rate could be as high as 35%, not including state taxes. Long-term capital gains on the sale of assets held for more than a year are taxed at lower rates: 15% for most investors.  (Long-term gains on collectibles are slightly different; those are taxed at 28%.)

Your holding period can also affect the treatment of qualified stock dividends, which are taxed at the more favorable long-term capital gains rates if you have held the stock at least 61 days. (Those days must occur within the 121-day period that starts 60 days before the stock's ex-dividend date; preferred stock must be held for 91 days within a 181-day window.) The lower rate also depends on when and whether your shares were hedged or optioned during those 61 days. Check with your tax professional to make sure you don't inadvertently incur unnecessary taxes by selling or buying at the wrong time.

Make lemonade from lemons

Now is the time to consider the tax consequences of any capital gains or losses you've experienced this year. Though tax considerations shouldn't be the primary driver of your investing decisions, there are steps you can take before the end of the year to minimize any tax impact of your investing decisions.

If you have realized capital gains from selling securities at a profit (congratulations!) and you have no tax losses carried forward from previous years, you can sell losing positions to avoid being taxed on some or all of those gains. Any losses over and above the amount of your gains can be used to offset up to $3,000 of ordinary income ($1,500 for a married person filing separately) or carried forward to reduce your taxes in future years. Selling losing positions for the tax benefit they will provide next April is a common financial practice known as "harvesting your losses."

Example: You sold stock in ABC company this year for $2,500 more than you paid when you bought it four years ago. You decide to sell the XYZ stock that you bought six years ago because it seems unlikely to regain the $20,000 you paid for it. You sell your XYZ shares at a $7,000 loss. You offset your $2,500 capital gain, offset $3,000 of ordinary income tax this year, and carry forward the remaining $1,500 to be applied in future tax years.

Time any trades appropriately

If you're selling to harvest losses in a stock or mutual fund and intend to repurchase the same security, make sure you wait at least 31 days before buying it again. Otherwise, the trade is considered a "wash sale," and the tax loss will be disallowed. The wash sale rule also applies if you buy an option on the stock, sell it short, or buy it through your spouse within 30 days before or after the sale.

If you have unrealized losses that you want to capture but still believe in a specific investment, there are a couple of strategies you might think about. If you want to sell but don't want to be out of the market for even a short period, you could sell your position at a loss, then buy a similar exchange-traded fund (ETF) that invests in the same asset class or industry. Or you could double your holdings, then sell your original shares at a loss after 31 days. You'd end up with the same position, but would have captured the tax loss.

If you're buying a mutual fund in a taxable account, find out when it will distribute any dividends or capital gains. Consider delaying your purchase until after that date, which often is near year-end. If you buy just before the distribution, you'll owe taxes this year on that money, even if your own shares haven't appreciated. And if you plan to sell a fund anyway, you may minimize taxes by selling before the distribution date.

Know where to hold 'em

Think about which investments make sense to hold in a tax-advantaged account and which might be better for taxable accounts. For example, it's generally not a good idea to hold tax-free investments, such as municipal bonds, in a tax-deferred account (e.g., a 401(k), IRA, or SEP). Doing so provides no additional tax advantage to compensate you for tax-free investments' typically lower returns. Similarly, if you have mutual funds that trade actively and therefore generate a lot of short-term capital gains, it may make sense to hold them in a tax-advantaged account to defer taxes on those gains, which can occur even if the fund itself has a loss. Finally, when deciding where to hold specific investments, keep in mind that distributions from a tax-deferred retirement plan don't qualify for the lower tax rate on capital gains and dividends.

Be selective about selling shares

If you own a stock, fund, or ETF and decide to unload some shares, you may be able to maximize your tax advantage. For a mutual fund, the most common way to calculate cost basis is to use the average cost per share. However, you can also request that specific shares be sold–for example, those bought at a certain price. Which shares you choose depends on whether you want to book capital losses to offset gains, or keep gains to a minimum to reduce the tax bite. (This only applies to shares held in a taxable account.) Be aware that you must use the same method when you sell the rest of those shares.

Example: You have invested periodically in a stock for five years, paying a different price each time. You now want to sell some shares. To minimize the capital gains tax you'll pay on them, you could decide to sell the least profitable shares, perhaps those that were only slightly lower when purchased. Or if you wanted losses to offset capital gains, you could specify shares bought above the current price. 

During your working years, you've probably set aside funds in retirement accounts such as IRAs, 401(k)s, or other workplace savings plans, as well as in taxable accounts. Your challenge during retirement is to convert those savings into an ongoing income stream that will provide adequate income throughout your retirement years.

Setting a withdrawal rate

The retirement lifestyle you can afford will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, whether from returns or both returns and principal, is known as your withdrawal rate. Figuring out an appropriate initial withdrawal rate is a key issue in retirement planning and presents many challenges. Why? Take out too much too soon, and you might run out of money in your later years. Take out too little, and you might not enjoy your retirement years as much as you could. Your withdrawal rate is especially important in the early years of your retirement, as it will have a lasting impact on how long your savings last.

One widely used rule of thumb on withdrawal rates for tax-deferred retirement accounts states that withdrawing slightly more than 4% annually from a balanced portfolio of large-cap equities and bonds would provide inflation-adjusted income for at least 30 years. However, some experts contend that a higher withdrawal rate (closer to 5%) may be possible in the early, active retirement years if later withdrawals grow more slowly than inflation. Others contend that portfolios can last longer by adding asset classes and freezing the withdrawal amount during years of poor performance. By doing so, they argue, "safe" initial withdrawal rates above 5% might be possible. (Sources: William P. Bengen, "Determining Withdrawal Rates Using Historical Data," Journal of Financial Planning, October 1994; Jonathan Guyton, "Decision Rules and Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe?," Journal of Financial Planning, October 2004.)

Don't forget that these hypotheses were based on historical data about various types of investments, and past results don't guarantee future performance. There is no standard rule of thumb that works for everyone–your particular withdrawal rate needs to take into account many factors, including, but not limited to, your asset allocation and projected rate of return, annual income targets (accounting for inflation as desired), and investment horizon.

Which assets should you draw from first?

You may have assets in accounts that are taxable (e.g., CDs, mutual funds), tax deferred (e.g., traditional IRAs), and tax free (e.g., Roth IRAs). Given a choice, which type of account should you withdraw from first? The answer is–it depends.

For retirees who don't care about leaving an estate to beneficiaries, the answer is simple in theory: withdraw money from taxable accounts first, then tax-deferred accounts, and lastly, tax-free accounts. By using your tax-favored accounts last, and avoiding taxes as long as possible, you'll keep more of your retirement dollars working for you.

For retirees who intend to leave assets to beneficiaries, the analysis is more complicated. You need to coordinate your retirement planning with your estate plan. For example, if you have appreciated or rapidly appreciating assets, it may be more advantageous for you to withdraw from tax-deferred and tax-free accounts first. This is because these accounts will not receive a step-up in basis at your death, as many of your other assets will.

However, this may not always be the best strategy. For example, if you intend to leave your entire estate to your spouse, it may make sense to withdraw from taxable accounts first. This is because spouses are given preferential tax treatment with regard to retirement plans. A surviving spouse can roll over retirement plan funds to his or her own IRA or retirement plan, or, in some cases, may continue the deceased spouse's plan as his or her own. The funds in the plan continue to grow tax deferred, and distributions need not begin until the spouse's own required beginning date.

The bottom line is that this decision is also a complicated one. A financial professional can help you determine the best course based on your individual circumstances.

Certain distributions are required

In practice, your choice of which assets to draw first may, to some extent, be directed by tax rules. You can't keep your money in tax-deferred retirement accounts forever. The law requires you to start taking distributions–called "required minimum distributions" or RMDs–from traditional IRAs by April 1 of the year following the year you turn age 70½, whether you need the money or not. For employer plans, RMDs must begin by April 1 of the year following the year you turn 70½ or, if later, the year you retire. Roth IRAs aren't subject to the lifetime RMD rules. (Note: The Worker, Retiree and Employer Recovery Act of 2008 waives required minimum distributions for the 2009 calendar year.)

If you have more than one IRA, a required distribution is calculated separately for each IRA. These amounts are then added together to determine your RMD for the year. You can withdraw your RMD from any one or more of your IRAs. (Your traditional IRA trustee or custodian must tell you how much you're required to take out each year, or offer to calculate it for you.) For employer retirement plans, your plan will calculate the RMD, and distribute it to you. (If you participate in more than one employer plan, your RMD will be determined separately for each plan.)

It's important to take RMDs into account when contemplating how you'll withdraw money from your savings. Why? If you withdraw less than your RMD, you will pay a penalty tax equal to 50% of the amount you failed to withdraw. The good news: you can always withdraw more than your RMD amount.

Annuity distributions

If you've used an annuity for part of your retirement savings, at some point you'll need to consider your options for converting the annuity into income. You can choose to simply withdraw earnings (or earnings and principal) from the annuity. There are several ways of doing this. You can withdraw all of the money in the annuity (both the principal and earnings) in one lump sum. You can also withdraw the money over a period of time through regular or irregular withdrawals. By choosing to make withdrawals from your annuity, you continue to have control over money you have invested in the annuity. However, if you systematically withdraw the principal and the earnings from the annuity, there is no guarantee that the funds in the annuity will last for your entire lifetime, unless you have separately purchased a rider that provides guaranteed minimum income payments for life (without annuitization).

In general, your withdrawals will be subject to income tax–on an "income-first" basis–to the extent your cash surrender value exceeds your investment in the contract. The taxable portion of your withdrawal may also be subject to a 10% early distribution penalty if you haven't reached age 59½, unless an exception applies.

A second distribution option is called the guaranteed* income (or annuitization) option. If you select this option, your annuity will be "annuitized," which means that the current value of your annuity is converted into a stream of payments. This allows you to receive a guaranteed* income stream from the annuity. The annuity issuer promises to pay you an amount of money on a periodic basis (e.g., monthly, quarterly, yearly).

If you elect to annuitize, the periodic payments you receive are called annuity payouts. You can elect to receive either a fixed amount for each payment period or a variable amount for each period. You can receive the income stream for your entire lifetime (no matter how long you live), or you can receive the income stream for a specific time period (ten years, for example). You can also elect to receive annuity payouts over your lifetime and the lifetime of another person (called a "joint and survivor annuity"). The amount you receive for each payment period will depend on the cash value of the annuity, how earnings are credited to your account (whether fixed or variable), and the age at which you begin receiving annuity payments. The length of the distribution period will also affect how much you receive. For example, if you are 65 years old and elect to receive annuity payments over your entire lifetime, the amount of each payment you'll receive will be less than if you had elected to receive annuity payouts over five years.

Each annuity payment is part nontaxable return of your investment in the contract and part payment of taxable accumulated earnings (until the investment in the contract is exhausted).

For married individuals dying in 2011 and 2012, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act) added a new, temporary portability provision allowing a surviving spouse to use any unused basic exclusion amount of a deceased spouse for gift and estate tax purposes.  Portability of the exclusion between spouses and an increase in the basic exclusion amount would seem to make estate planning easier for many estates. However, unless extended by Congress, portability of the unused basic exclusion amount between spouses expires in 2013.

Planning before portability
Prior to the 2010 Tax Act, many married couples with estates that were greater than the applicable exclusion amount would set up an A/B (or A/B/C) trust arrangement. The first spouse to die would transfer an amount equal to the applicable exclusion amount to the "B" or credit shelter bypass trust. The B trust could benefit the surviving spouse and their children, but the B trust would be designed to bypass the surviving spouse's estate. The balance of the estate would be transferred to the surviving spouse, either outright or using an A marital trust. In some cases, a "C," "Q," or QTIP marital trust was also used if the first spouse to die wanted to control who received the marital trust property at the second spouse's death.

With a typical A/B trust arrangement, there would be no estate tax at the first spouse's death. The B trust portion was protected by the applicable exclusion amount of the first spouse to die, and the A trust portion qualified for the marital deduction. The A trust would be includable in the second spouse's estate, but would be protected (at least in part) from estate tax by that spouse's applicable exclusion amount. The A/B trust arrangement insured that neither spouse's applicable exclusion amount was wasted.

In some cases, especially if the married couple's combined estates would exceed the total amount of both spouses' applicable exclusion amounts, the spouses' planning would also attempt to equalize estates in order to use both spouses' applicable exclusion amounts, avoid higher graduated tax rates on the surviving spouse's estate, and reduce total tax on both estates. In other cases, especially where the combined estates were less than the applicable exclusion amount, the first spouse to die might simply transfer everything to the surviving spouse and defer estate tax (if any) to the second spouse's death.

Planning with portability
If you're planning today, you could transfer everything to your spouse and, if you die in 2011 or 2012, your estate can elect to transfer your unused basic exclusion amount to your surviving spouse. Your spouse will then have an applicable exclusion amount equal to the sum of his or her own basic exclusion amount and your unused basic exclusion amount, which your spouse can use for gift or estate tax purposes.  For example, if your estate transfers your $5 million unused basic exclusion to your surviving spouse, who also has a $5 million basic exclusion amount, your spouse then has a $10 million applicable exclusion amount to shelter property from gift and estate tax.

The new portability provision would seem to make planning easier, and there may be far less need to use A/B trust arrangements. But there are a few potential pitfalls to watch out for.
• Portability is set to expire in 2013. Will it be available when you and your spouse need it? A flexible plan might still include an A/B trust arrangement, just in case.
• If you are predeceased by more than one spouse, the unused basic exclusion of an earlier spouse could be lost. That is because you use the unused basic exclusion amount (if any) of your last deceased spouse. This may be another factor to consider when planning for remarriage.
• The unused basic exclusion amount that you transfer to your surviving spouse is not indexed for inflation after you die. If the property you transfer to your spouse appreciates after your death, the value of such property in your spouse's estate could exceed your unused basic exclusion amount and could result in estate tax. With an A/B trust arrangement, appreciation on property in the B trust would be sheltered by your applicable exclusion amount.
• In order to make the unused basic exclusion election, an estate tax return will need to be filed even if estate tax is not owed.
Using the applicable exclusion amount now

Even with portability, it may be useful to take advantage of the increased applicable exclusion amount by making gifts now that can reduce your taxable estate. Some reasons for using the applicable exclusion amount now might include:
• There are family members or individuals other than your spouse that you would like to provide for during your lifetime. The applicable exclusion amount could be used to shelter gifts to such persons from gift tax. (Consider also lifetime gifts that qualify for the annual gift tax exclusion, currently $13,000 per donor/donee, or as qualified transfers for medical or educational purposes. These gifts are not taxable and do not use up your applicable exclusion amount.)
• In the future, the available applicable exclusion amount may be less, portability may not be available, and tax rates may be higher.
• Appreciation on gifts you make is removed from your gross estate. For example, if you made a gift of $5 million now and the property doubles in value to $10 million in the future, the $5 million of appreciation would be removed from your gross estate. On the other hand, such property will not receive a stepped-up (or stepped-down) basis at your death for income tax purposes.
• If you would like to benefit your grandchildren and later generations, it may also be useful to use your $5 million generation-skipping transfer tax (GSTT) exemption now. The GSTT exemption is not portable between spouses and is scheduled to decrease to $1 million as indexed in 2013. Applicable exclusion amounts will often be used with generation-skipping transfers to protect the transfers from gift and estate tax.
• State death taxes can be saved. Most states do not have a gift tax. Making a gift can remove the property from your estate for state death tax purposes. Also, state exclusion amounts may be different than the federal applicable exclusion amount and may not be portable between spouses. Consult a tax or estate planning professional familiar with the laws in your state.
For many of the same reasons discussed above, it might also be useful to have your estate use all of your applicable exclusion amount at your death rather than transfer the unused exclusion to your spouse. For example, it might make sense if there are persons other than your spouse that you would like to benefit prior to the death of your spouse. In some cases, it may be useful to use A/B trust arrangements.

Estate plans and documents
Estate plans and documents written prior to the 2010 Tax Act may no longer carry out your intended wishes because of the new portability provision or the increased applicable exclusion amount. Your trusts and wills should be reviewed to see if they still meet your needs. For example, if you have an estate of $5 million and an A/B trust arrangement that would fund your credit shelter trust with the applicable exclusion amount, would you want your B trust to be funded with the full $5 million, with nothing passing to your spouse (other than whatever interests your spouse might have in the B trust)? Or might you want to transfer the $5 million to your spouse who would be able to use your basic exclusion amount to protect the $5 million from gift and estate tax? But what if the applicable exclusion amount is reduced or portability is not available?

Your documents and plans may need to be revised to reflect the tax changes for 2011 and 2012 and for the uncertainty for 2013 and beyond. Flexibility to deal with future changes is key. Everyone's situation is unique and the issues are complex. To help guide you through these opportunities and uncertain times, consult an experienced estate planning attorney.