Outlook - January 2011

I want to start the new year with the answers to a few questions and then provide some insight to the new tax laws.  The second portion of this outlook is dedicated to the tax law and may provide some insight.  I caution you to consult with a CPA regarding tax issues.  My intent is not to provide tax advice, but merely to give you some food for thought.

Earlier in the year, I wrote about the current secular bear market and the mini bull markets that often occur with the secular bear.  In my opinion, when the current bull market runs its course, perhaps some time in the next year or so, we may get one more cyclical bear market that would end the secular trend.

I also wrote with regards to the devaluation of the dollar.  I believe that the U.S. dollar is the world’s reserve currency. I think the dollar’s reserve status should enable our interest rates to remain lower than they otherwise would be; which, in turn, should help prevent the kind of debt spiral that some countries (Japan) experience when they reach a debt trap (the point at which they have to borrow in order to keep paying interest on their debt).  And, now that the Federal Reserve has become the world’s largest owner of Treasuries (more than China or Japan), the U.S. appears to be less vulnerable to a “buyer’s strike” from abroad, should one occur.

The mid-term election has come and gone and the message is clear. As the author P.J. O'Rourke said in The Weekly Standard, "This is not an election on November 2. This is a restraining order."1 The question now is whether gridlock is good or bad. One could argue that it is good because it could end the regulatory and fiscal uncertainties that are so often cited as the reasons why corporate America hasn’t hired anyone. But, it could also be bad in that it may prevent the two political parties from coming up with any meaningful entitlement reform. After all, our debt problems are structural. Without addressing Social Security, Medicare, and Medicaid, I believe there is no hope of reducing our federal debt in any meaningful way.

One thing is for sure: The financial restraint wave is currently playing out before our eyes at the state and local level. Witness the sharp widening in municipal bond spreads during the week of November 22-26, 2010.

The Fed is printing money as part of its second quantitative easing program (QE2). I believe that’s dollar negative. Now the ECB may be forced to print Euros if the contagion spreads beyond Ireland. I believe this will be euro negative. And back and forth it goes in the race to the bottom.

Who will “win” this race? My guess is the dollar. After all, the Americans are plagued by memories of the deflationary depression of the 1930s, while the Europeans are plagued by the German hyper-inflation of the 1920s. Plus, the U.S. has a dual mandate—to maintain price stability and promote economic growth—and the ECB doesn't. This suggests to me that the Fed will be more likely to print and debase than the Europeans.

QE2- Ever since the Fed started QE2 the leading economic indicators have trended up.  This suggests to me that 2011 may be a year of continued economic recovery and higher stock prices.

This does not mean that the Fed is about to prematurely end QE2; not as long as unemployment stays

high. The San Francisco Fed’s Taylor rule3 suggests that the Fed Funds target rate is about 600 basis

points (bps) too high. Since policy rates are zero-bound, this has forced the Fed to use unconventional

measures to compensate for its “tight” policy, which means balance sheet expansion in the form of large-scale asset purchases. 

Studies at the New York Federal Reserve conclude that every $500 billion or so of QE is the equivalent of

reducing the federal funds rate by 75 bps.2 With about $2.3 trillion of QE (QE1 + QE2), this suggests that

the funds rate is now -3% or so. In other words, they are only halfway there. That still leaves another 300

bps to get to a zero interest rate. By the Fed’s math, that equates to another $2 trillion of QE.

What might QE3 look like if and when it happens? My guess is municipal debt. I said this last summer

when speculation was running rampant regarding the nature of a possible QE2. Instead, the Fed chose

treasuries. But now muni interest rate spreads over treasuries are blowing out again as state and local

governments struggle to balance their books. For the first time since 2008, muni yields are higher than

treasury yields.

I think buying munis is a slam dunk for the Fed. In effect, the Fed would be lending money directly to the

states, thereby replacing the fiscal stimulus bill and replacing the Build America Bonds program, which

is scheduled to expire at the end of the year.

How the new tax law may affect you

What it means for your take-home pay, investments, and more

After weeks of heated congressional negotiations on Capitol Hill, a tax bill has finally been cleared for

President Obama’s signature. The bill temporarily extends the 2001 and 2003 federal income tax rate

cuts, extends unemployment insurance for 13 months, provides new payroll tax breaks, reinstates the

estate tax, and more.

The good news: The new law will give taxpayers a bit of clarity—and an opportunity to plan with relative

confidence, knowing that the playing field won’t change dramatically (at least for two years). But beyond

that, an increase in the Medicare tax for upper-income Americans is slated for 2013. And more changes

are likely in the future, given the pressure to raise revenues to reduce the deficit, and talk of sweeping tax

reform.

“Passage of this tax bill ensures that individuals at all income levels won’t face an automatic tax increase

in January,” says Shahira Knight, Fidelity’s vice president of government relations. “The bill provides

taxpayers with some certainty, but Congress will be back at the table having the same debate in two

years”

So what can you do now? Let’s take a look at how the new law may impact you in four key areas: your

take-home pay, your investments, your estate and gifting plans, and, if you’re over age 70½, qualified

charitable distributions from your IRA. We’ll summarize what’s changed, and what you should be thinking

about for both year-end and longer-term tax planning.

One important caveat: an extension of the minimum required distribution (MRD) suspension is not part of

the new tax law, so retirees must take applicable MRDs for 2010 or face a hefty penalty.

How it affects your take-home pay

NEW—Payroll tax relief: There is now a 2 percentage point reduction in an employee’s share of the

Social Security portion of the FICA tax, from 6.2% to 4.2%, in 2011. So, if you make $80,000 a year, you

could take home an additional $1,600 a year in 2011.

What to consider now:

− Increase any tax-advantaged retirement account contributions: If you are not already maximizing

pretax contributions to your 401(k) plan, 403(b) plan, or other workplace savings plan, consider

increasing your payroll deduction by 2%, or at least enough to garner the full company match. In

2010 and 2011 you can contribute up to $16,500 to 401(k) plans (up to $22,000 if you’re 50 or

older), and $5,000 to IRAs ($6,000 for ages 50 and older). Fidelity believes this is a smart plan of

action, unless you have high interest-rate credit card debt. If so, consider using the extra money

from the payroll tax relief to pay down your plastic first.

What to consider going forward:

− Automatic increases in your workplace savings plan: If you are still not maximizing your

workplace savings contributions, consider increasing automatic payroll deductions in 2011.

Extended—2001 and 2003 income tax cuts: The new tax law provides a two-year extension of the

2001 and 2003 Bush-era income tax cuts (through 2012), regardless of a person’s income level. This

means there will be no change in the income tax rates for the next two years although the alternative

minimum tax (AMT) patch extends only through 2011 and is not indexed for inflation in 2011.

What to consider now:

− A Roth IRA conversion: You may want to consider converting a traditional IRA or other eligible

retirement balance to a Roth IRA3 before December 31, 2010. For conversions made in 2010,

because of a special one-time tax rule, you can elect to either pay the entire tax bill on your 2010

return, or pay it over the next two years by splitting the taxable income generated evenly between

your 2011 and 2012 tax returns. The extension of the current tax rates may make the latter a

better option. However, although spreading out the tax bill from your conversion over two years

may sound appealing, there are other considerations to take into account; so you should carefully

weigh the pros and cons.

− Your income and deductions: Tax advisers often suggest that those who itemize deductions

should defer income into future tax years while accelerating deductions into the current tax year.

While you may end up with virtually the same tax bill, you would pay it at a later date. In the

meantime, you may be able to benefit from the use of that money. Since tax rates will stay the

same next year, this popular year-end tax move may be helpful in 2010 and 2011 as well, with

one important exception. If you are or may be subject to the AMT, you may be better off doing the

opposite. As always, you should consult your tax adviser. And don’t dally: You only have until

December 31, 2010 to make these moves.

Extended—AMT relief: There is now a two-year extension (through 2011) of the AMT "patch".

How it affects your investments

Extended—Capital gains tax: The top rate on long-term capital gains will remain at 15% for the next two

years.

Extended—Qualified dividends tax: The top rate for qualified dividends—those on certain stocks held

longer than 60 days—will remain at 15% for the next two years.

What to consider now:

− Employ an effective tax-loss harvesting strategy: Tax-loss harvesting is the practice of selling

investments that have lost value to offset current and future-year capital gains. Unlike one-time or

occasional-loss sales, however, a systematic tax-loss harvesting strategy requires diligent

investment tracking and detailed tax accounting.

− Exploit the 0% capital gains rate: You also may have the opportunity to eliminate taxes on the

capital gains you realize from taxable accounts. In 2010, taxpayers in the 10% and 15% federal income tax brackets can realize long-term capital gains (and qualified dividends) without triggering capital gains taxes. (In 2010, the 15% bracket tops out at $68,000 of taxable income for married couples filing jointly.) The result: If your taxable income falls into the two lowest tax brackets, selling stocks held longer than a year may be a highly tax-efficient way to generate cash flow. If you’re retired, this strategy may be most advantageous if you have a relatively high proportion of your retirement assets in taxable accounts.

What to consider going forward:

− Plan ahead for future tax increases: No one can predict how or when tax rates might rise or what

form proposed tax reforms may take. But at least one new tax is already slated to hit the net

investment income of upper-income taxpayers in 2013: an additional 3.8% Medicare tax, which

will affect married couples filing jointly with a modified adjusted gross income (MAGI) of more

than $250,000 ($200,000 for single filers). The tax will apply to the lesser of net investment

income or MAGI over the threshold. Investment income would include income from interest,

dividends, capital gains, annuities, rents, and royalties.

− It’s not too soon to begin preparing for this 2013 tax change. You’ll want to consider maximizing

savings in tax-advantaged accounts such as IRAs and 401(k)s, because withdrawals from them

will not be included when determining investment income for the new Medicare tax. Further,

qualifying Roth IRA withdrawals aren’t considered investment income or an addition to your MAGI

under current law—possibly making conversions and contributions to Roth-type accounts more

relevant for the near term. If you don’t have a Roth IRA, you may want to consider converting to

one.

How it affects small businesses and the self-employed

NEW—Business Expensing: The new law provides for 100% expensing of qualified capital investments

in 2011 and 50% expensing in 2012.

How it affects estate planning and gifting

NEW—Estate tax rate and exclusion: The new law reinstates the estate tax in 2011 and 2012 at a

maximum rate of 35% with a $5 million exemption per person. This compares to a 45% maximum rate

and $3.5 million exclusion in 2009. The new rules will sunset after 2012. Beginning in 2013, there will be

a $1 million per person exclusion with a 55% estate and gift tax rate unless further legislation is enacted.

Here are some additional estate tax changes you should know about:

− Portability:  New portability rules allow any unused exemption to be passed to a surviving spouse,

so a married couple can exempt up to $10 million.

− Estates of decedents who died in 2010: The new law gives executors of these estates a choice. They can distribute assets to heirs estate-tax-free but with a carryover basis (generally the original

purchase price), or step up the basis to the market value (generally at time of death) and pay the

35% rate on anything above the $5 million exemption. A step-up in basis means the value of an

appreciated asset is readjusted at a higher market value for tax purposes upon inheritance versus

what the value of the asset was when it was originally purchased.

− Gift Tax exemption: The new law reunifies the federal estate tax exemption and the federal gift

tax exemption. This means that the new lifetime gift tax exemption is $5 million per person ($10

million per couple) beginning in 2011. Taxable gifts made in 2011 and 2012 will be taxed at the

rate of 35%.

− Generation Skipping Transfer Tax (GSTT): Beginning in 2011, the generation skipping transfer

tax exemption will also be $5 million per person ($10 million per couple) with a 35% tax rate.

Note: The GSTT is not portable.

− Extension of time for certain filings: The new law extends the time to file certain estate and gift tax

returns to nine months after the enactment of the new law.

What to consider now:

− Make tax-smart charitable year-end contributions if you haven’t already. For this year, given the

stock market’s gains, donating long-term appreciated securities may be a particularly tax-savvy

strategy. As a general rule, donations of long-term appreciated securities (either stock or mutual

funds) directly to a qualified charity are deductible at their fair market value on the date of

contribution; and you don’t pay capital gains taxes on the donated security. For those considering

a major gift in 2010 (or 2011), combining a charitable gift with a Roth IRA conversion may help

offset the tax cost of the conversion, and perhaps allow you to convert a larger amount at a lower

tax cost.

− Consider generation skipping transfers. The generation skipping transfer tax remains repealed for

2010. Individuals thinking of making gifts to grandchildren, gifts that would otherwise be subject to

GST tax, have until December, 31, 2010, to complete these gifts.

− Weigh the tax elections for 2010 estates. Executors of 2010 estates over $5 million with highly

appreciated assets should consider whether it may be better to subject the estate to the new law

or choose the zero estate tax law of 2010. If you choose the former, the first $5 million of estate

assets will be exempt from federal estate taxes, but any amount above $5 million may be subject

to estate tax. However, the entire estate will receive a full step up in basis. If the latter is chosen,

no federal estate tax will be assessed on the estate, but all of the estate assets may not receive a

step-up in basis. In this case, the executor can allocate $3 million in basis adjustments for assets

passing to a surviving spouse, and another $1.3 million in basis adjustments to property passing

to a non-spouse.

This is a complex decision. Contact your attorney, tax adviser, or your Alamo Representative to understand your options.

What to consider going forward:

− Set up a meeting with your tax adviser or estate planning attorney to review your estate plan and

make any necessary changes.

− Consider a Grantor Retained Annuity Trust (GRAT): A Grantor Retained Annuity Trust (GRAT) is

an irrevocable trust that pays a fixed annuity to the grantor for a defined period, then pays the

remainder to a non-charitable beneficiary. Contrary to expectations, the new law did not restrict

GRATs. And, with the increased gift tax exemption, a grantor can now potentially put even more

money into a GRAT without having to pay gift taxes. Current low interest rates are also beneficial to GRATs, because they help increase the value of the annuity while lowering the value of the remainder interest. So, the grantor may potentially use even less of the new gift tax exemption.  As always, consult your Fidelity representative or speak with your attorney or tax adviser before making any decisions.

How it affects retirees

Extended—qualified charitable distributions (QCDs) from IRAs: The new tax law extends provisions of

the Pension Protection Act of 2006 that allow investors age 70½ or older to make a qualified distribution

of up to $100,000 from an IRA directly to a qualified charity for both 2010 and 2011.

Not extended—Minimum Required Distribution (MRD) suspension: The new tax law does not extend the

2009 suspension of MRDs. Retirees are generally required to take MRDs from their retirement accounts

for the year in which they turn 70½, and all subsequent years, by December 31. Failure to comply with

this IRS regulation could result in a 50% penalty on the amount that should have been distributed.

What to consider now:

− Make sure you take an MRD in 2010. If you’re 70½ or over, take a moment to ensure you’ve met

your MRD obligation for 2010. If you were born before July 1, 1939, your 2010 MRD deadline is

December 31, 2010. If you were born between July 1, 1939, and June 30, 1940, your deadline is

April 1, 2011. Just remember, you’ll have to take two MRDs in 2011 (one for 2010 and one for

2011).

− Think about QCDs and MRDs together. Qualified charitable distributions from IRAs made directly

to qualifying charities count toward any MRD. For example, if you have a $75,000 MRD for 2010,

you can make an IRA distribution of up to $100,000 directly to a qualifying charity and $75,000 of

that $100,000 is counted as your MRD.

− One other important note: Any QCDs made through January 2011 can count towards your 2010

MRD, but if you already took your MRD in 2010, it appears you cannot take advantage of the

QCD this year. However, if you still have to take your 2010 RMD, you may make a 2010 QCD

and have it count toward your MRD even if you don’t complete it until next year.

What to consider going forward:

− QCDs will count as MRDs in 2011, so you may want to consider making two QCDs: one in 2010

and one in 2011. Talk to your tax adviser about IRA strategies for 2011. If you are a high-net-worth investor with high IRA balances, next year may be a tax-efficient time to give away some of that money.

*Views expressed are as of 12/16/2010 and may change based on market and other conditions.

The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and

should not be construed as legal or tax advice. Alamo does not provide legal or tax advice. Alamo cannot guarantee that such

information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may

have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are

complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax

investment results. Alamo makes no warranties with regard to such information or results obtained by its use.  Alamo disclaims any

liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax

professional regarding your specific legal or tax situation.

A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and at

least one of the following conditions is met: you reach age 59½, die, become disabled, or make a qualified first-time home purchase.

1. The Weekly Standard, October 23, 2011

2. A Taylor rule is a monetary-policy rule that stipulates how much the central bank would or should change the nominal interest rate

in response to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from

potential GDP. It was first proposed by the U.S. economist John B. Taylor in 1993..

3. FMRCo., November 30, 2010.

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This market commentary is provided for informational and educational purposes only. It is not intended as and should not be used to provide investment advice and does not address or account for individual investor circumstances. Investment decisions should always be made based on the client's specific financial needs and objectives, goals, time horizon and risk tolerance. The statements contained herein are based solely upon the opinions of Alamo Asset Advisors and are not necessarily those of WFG Investments, Inc. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Information was obtained from third party sources, which we believe to be reliable but not guaranteed.