Disclaimer:  I am not an accountant or a tax professional and any advice here should be verified with a professional before acting upon it.

I’m doing my taxes this week.  It’s going to be painful and I’m not going to like the answers it gives me, but I might as well bite the bullet.  If you’re in the same boat you may be looking for strategies to help you minimize your taxes this year.  There are several categories of expenses that we should consider as possible sources of tax deductions:

Business Expenses

Most of the minimization strategies you will see are for people with small businesses.  You open up a world of deductions by starting a business, however this who area of deductions doesn’t apply to most of us.  Consider starting a business if you have one in mind, but we’ll cover individual deductions instead since they are of the broadest interest.

Tax Time is Coming

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Tax-Deferred Accounts

Make sure you put any money into your IRA, 401(k), HAS or any other tax advantaged accounts you have.  Not having to pay taxes can be a huge savings by itself.  When you throw in the capacity of some of the accounts to grow tax-free, this is a no brainer.

Unemployment

This is very relevant to all of us in this economic climate.  If you lost your job, many of the expenses that you incur in your job search are tax deductable.  Phone calls, agency fees, travel to potential employers as well as costs for printing resumes may all be deductible.  Be sure to take advantage of any opportunities to lessen your tax burden in this climate.

Medical

If you had serious medical expenses in 2009, you may be able to deduct some of them.  Most people will not qualify, but if you spent more than 7.5% of your adjusted gross income on medical expenses, you may be able to deduct the excess.  Once again, this can be beneficial to those of us who are experiencing this kind of hardship.

Charitable Donations

Be sure to keep these in mind as well.  You may have been glad to get rid of that bundle of clothes, but it also had some value and you may be able to deduct that amount.  Did you donate some money to Haiti?  You may have just wanted to help your fellow man, but why forget to take the tax deduction?

House Expenses

Do you still have receipts for any home improvements you did?  People often forget that these are deductible.  You also of course can deduct mortgage interest as well as property taxes.

Conclusion

Sadly there are not as many deductions available to individuals as there are for businesses.  Still it never makes sense to pay more in taxes than you have to.  Be sure to think back long and hard before you assume you didn’t make any donations or have any home improvement expenses.  They’re very commonly forgotten, but can often add up to a fair savings.  Minimizing your taxes is a great way to make your wealth build faster.  Make sure you take the time to make sure you do it well.

Photo Credit: Scott*Eric

Post from: Personal Finance And Investing

Tax Minimization Strategies

As a general rule I think options are a terrible idea for the casual investor.  For those who are simply trying to match the markets without spending a tremendous time watching their investments, options represent a significant danger.  Even for those who have experience with options, understanding all the implications of buying or selling an option can be confusing.  Covered calls however, may have a useful place in the typical investor’s portfolio.

Option Terminology

Options are defined by several values.  For the purposes of discussing options here we will assume we’re talking about an options contract on a stock, which is not always the case.  First of all, be aware that an options contract is for 100 shares of the stock.  Thus you don’t deal in tremendously small lots when dealing with options.

Each option is either a call or a put.  A call option is an option to buy a stock at a particular price on or before a particular date.  A put option is an option to sell a stock at a particular price on or before a particular date.  In both cases the date by which the decision must be made is the expiration date and the price at which you have the option to buy or sell is called the strike price.  These options also have a price which is listed in terms of a price per share.  So for example if you see a price quoted as $0.25, that means twenty-five cents per share, or $25 for the full contract, since contracts are for 100 shares.

If all of this sounds confusing let’s look at an example:

Supposing we have a stock X which is currently trading at $35 per share and it is currently January 1^st.  Now suppose I buy 10 call contracts on this stock with a strike price of $37.50 and an expiration date of February 23^rd (Note that expiration dates are the third Friday of a month).  Let’s suppose I pay a price $1 per share for each of these options ($100 total for each and $1,000 total since I’m buying 10 contracts) and look at what happens depending on how stock X’s price changes in that time.

If stock X does not exceed $37.50 before February 23^rd my options will expire as worthless and I will lose 100 percent of my investment, assuming I do not sell the contracts before then.  If on February 23^rd the price of the stock is higher than $37.50, I will be able to buy the stock at a discount, which will hopefully exceed my $1,000 investment.  So for example if the stock is at $42.00 I will make $4.50 per share on the 100 shares per contract for 10 contracts, thus making $4,500 less my initial $1,000 investment.  This means I made $3,500 on a $1,000 investment.  As you can see, options have a high risk and high reward.

In general, people often close their position before the expiration date, which of course affects the economics as well.  If I have a call option, for example, with some time left before the expiration date and the option is already “in the money” (meaning the share price is higher than the strike price for a call), then I will probably be able to sell it at a premium to the difference in the prices, because of the potential to make more money before the expiration date.

Covered Calls

So now let’s suppose instead that I want to sell a call on stock X.  I can do this without owning one; I simply have to buy it back before the expiration date.  This is very similar to shorting a stock.  Let’s look at the economics of this.  If I sell a $37.50 call for $1 per share then I make $100 per contract.   As long as the stock doesn’t go above $37.50 before the expiration date, I will get to pocket that $100 per contract.  However if the stock goes skyrocketing I will have to pay the difference between the price and my $37.50 strike price.  As you can see, this is very risky.  However, I can make this a much safer bet if I already own the stock.

Suppose I have 1,000 shares of stock X and I do not expect the price to rise significantly.  I might go ahead and sell a call with a strike price a bit above the current price.  Thus if the stock price doesn’t move above that strike price I will pocket a little money.  If the stock price does move I will still make money because of the difference between the current price and the strike price and the premium I was paid when I sold the contract (the contract’s price).

Thus if the stock goes down, I’m better off than I would have been without the call because I get the money for selling the contract.  If the stock stays flat I’m better off for the same reason.  The only time I lose is if the price goes enough above the strike price to exceed the value I was paid for the contract.  Thus I’m limiting my downside, but I’m also limiting my upside.  If stock X doubles, I’m only going to get my strike price for it, which could be thoroughly discouraging.

Why Sell Covered Calls?

There are many reasons you might not be bullish about a stock price in the short term, but not ready to sell the stock.  Tax considerations could be one example.  Another might be that the stock pays a dividend, but you’d like to limit your exposure to the stock going down in the meantime.  In fact, combining covered calls with dividend stocks can be a good way to increase your yield and limit your risk.  You might also simply want to limit your risk when entering a position by reducing your downside and upside at the same time.

Obviously there is much more to understanding the risks and benefits of covered calls, however they represent one of the few options strategies that might make sense for a casual investor.  Be sure that you thoroughly understand them before considering them however.  The vast number of variables and outcomes can confuse even the most seasoned investor.

Post from: Personal Finance And Investing

Selling Covered Calls

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The term “Dollar Cost Averaging”, or DCA, can have many different meanings.  Oftentimes when referring to “Dollar Cost Averaging,” people actually mean “Automatic Investing.”  DCA typically refers to investing over a period of time an amount you could have invested initially.  So for example, if you had $10,000 to invest, instead of putting it all in now, you invest it over a period of several months in equal dollar amount increments.  Automatic Investing on the other hand is simply taking a set amount out of your income and investing it every month.  This is what the majority of people think of as Dollar Cost Averaging.

The Theory

Proponents of DCA claim that it reduces risk, because you tend to buy more shares when prices are low and fewer shares when prices are high.  This argument makes some sense in an oscillating market that isn’t moving overall in any particular direction.  One question remains, however: why would you want to be investing in an oscillating market that isn’t trending in one direction?  Typically most people’s faith in investing in stock markets is that over time they go up.  If the market is on average going to move upwards, why am I holding back investing a portion of my investment?  On average this simply means I’m going to get a higher price.

The Worst-Case Scenario

If we think about this matter anecdotally it seems intuitive however that by holding back some money to invest we’re reducing our worst-case scenario.  Suppose for example that we invest all our money today and tomorrow the stock drops precipitously.  We’ve avoided that risk.  At the same time however, what if the stock rises sharply and never returns to our original price.  While we may be reducing our worst-case scenario somewhat, we’re also risking leaving a lot of money on the table.  Still there seems to be some merit to increasing your exposure over time.

In Practice

In reality the way most of us “Dollar Cost Average” is that we invest a certain amount each month out of our paycheck into the stock market.  This is what is more accurately referred to as “Automatic Investing,” and is sort of a no-brainer.  However if you do receive an influx of funds and are trying to decide what to do with them, Dollar Cost Averaging may not be all it’s cracked up to be.  There can be psychological advantages to moving your money in over time, but transaction fees can add up quickly, depending on how your brokerage charges.  Think carefully before assuming Dollar Cost Averaging is right in all situations.

Post from: Personal Finance And Investing

Some Thoughts on “Dollar Cost Averaging”

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2009 is a dreadful year to try to invest.  While we have seen a massive rebound in stocks, there are a variety of factors that make long term planning very difficult.

Asset Class Difficulties

The first thing that makes the current economic climate so difficult is the correlation between asset classes.  Under normal circumstances declines in one asset class involve money moving to another asset class.  Thus when stocks go down, bonds or gold or another asset class is usually the beneficiary.

What makes the current economy so difficult is that you see capital essentially being “destroyed” by the deflationary spiral.  Forced liquidation on the part of many funds caused by redemptions and margin calls contribute to this problem as well.  While this problem was particularly pronounced in 2008, you continue to see deflationary pressures affecting all asset classes.

Government Intervention

One of the most obvious difficulties of building a long term plan in 2009 is the frequency and fervor of government intervention.  Policy makers are attempting to walk several fine lines and thus are constantly exerting strong forces upon the market.  In their zeal they make it very difficult to draw long range conclusions about what makes sense.

Take for example the Treasuries market.  One might be inclined to think that prices would drift lower in this market, given the massive amount of debt the government is planning on issuing.  The Federal Reserve however, is actively purchasing some of these treasuries, driving prices up.^[1] The dramatic influence of the government on the markets is a serious deterrent to investing in 2009.

Differing Long-Term and Short-Term Dangers

This problem is particularly severe and affects both investors and policy makers.  We are faced with the exact opposite problems in the long term and the short term.  Right now the government is facing deflation and economic slowdown.^[2] Under normal circumstances, this suggests increased spending, even at a deficit.  At the same time in the long term we have an incredible debt burden which is just part of a number of reasons to fear inflation.^[3]

Thus the government wants to stimulate our consumer driven economy in the short term, but doesn’t want rampant inflation to destroy us in the long term.  At the same time the massive amount of total credit market debt our country has may make inflation unavoidable.  This can affect the ways in which the government interferes with the markets as well as how the markets themselves price assets.

The government can seem to affect the market very capriciously because they are trying to walk a fine line.  Because our economy is highly consumer driven, they want to stimulate spending and consumption.  At the same time we have to get our debt under control before it buries us.  Thus they can appear to make conflicting policy decisions.  As we’ve already discussed, the scope of this interference is vast, so it’s particularly distressing for it to be so difficult to predict.

For an investor it is difficult to price assets, even without government interference.  For example, let’s discuss gold.  Its long term prospects may be fairly good because of the dire threat of inflation.  However with the short term calling for deflation, you have no idea how much your asset might depreciate before the inflation kicks in.  It’s very difficult to tell when that corner will be turned, and markets are erratic accordingly.

How to React

One approach is to simply “go to cash.”  Unfortunately that is not a neutral decision.  If you have the majority of your net worth in cash you are betting against rampant inflation.  What all these competing factors suggest to me is a balanced and conservative approach.  It may be time to add some variety to your portfolio, including both inflation and deflation hedges.  I also think it is pivotal to take a long range view and not try to maximize in the short term.  This is an economy without historical precedent, so it makes sense to take a defensive approach.

It is a good time to start learning about how to hedge your stock market positions.  While you may have only invested in stocks up to this point, the time may have come to learn about other opportunities.  ETFs in particular can offer an easy way to create some balance in your portfolio.

Post from: Personal Finance And Investing

The Difficulty of Investing in 2009

1. Fed To Buy Long Term U.S. Governmnt Debt – Reuters
2. Fed Warns of Global Slowdown That Adds to U.S. Deflation Risk – Bloomberg.com
3. US debt sets stage for inflation – MSN Money

Photo by: Patrick Smith Photography

This post is step 3 in our Investing Template.

Once you have cleared out all your debt and created an emergency fund, it’s time to think about why you’re investing.  It is impossible to have a strategy without knowing what the strategy is intended to accomplish.  The investment strategy of a 20-something trying to buy a house, a 40-something trying to save for their children’s college, and a 50-something trying to catch up for retirement are very different.

The key component of all these things is this:

How Soon Do You Need The Money

The sooner you need the money, the less risky that segment of your portfolio should be.  Riskier investments typically give better returns over the long haul, but in the short term they can be disastrous.  The when of your strategy will be the single most important question in determining an investment strategy.

Milestones

Lay out your investing milestones.  Think about all the major life changes you would like to have and write them down.  This can be invaluable in deciding what investments are appropriate for you.  If you are going to need a certain amount of money for a house in 5 years, at which point you also want to have kids, you should be very cautious until you have a comfortable cushion to make those plans happen.  Look for all the major events that are going to affect your investing strategy and note them in a time line.

Be Realistic

When you’re designing your strategy make sure that your goals are realistic.  If you’re 55 and you have nothing saved, retiring in 5 years is probably not a viable option unless you want to move to a much cheaper country.  Similarly, do not be anxious to undertake major investments like a house.  Plan for the long run, and don’t overextend yourself.  You may not be able to retire as soon as you like, but taking gambles in the hope to get there faster can lead you to never getting to retire at all.

Other Considerations

Some other things to factor in your goals include:

Risk Aversion:  Some people are simply averse to risk.  They might want the returns a more risky investment could give them, but aren’t willing to take the additional risk.  There’s nothing wrong with this, and it’s important to realize if you are this kind of person.

Comfort: In addition to being realistic in your goals, you should be realistic in how much of your income you will be able to put toward investments.  At the same time, you need to be realistic about which expenses are necessities and which should be deferred.

Conclusion

This step of strategy building is simply to get a broad idea of your goals.  You need to know how much risk you should be willing to take and how soon you are going to need your money.  You don’t want to commit yourself to a 30-year bond if you’re going to need the money to buy a house in 5 years.   Create your milestone timeline and be diligent in assessing what makes the most sense for you.

Post from: Personal Finance And Investing

Investing Prerequisite #3: Goals and Time Horizon

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This post is step 2 in our Investing Template.

Many people will debate the details and priority of this, but quite simply there is no reason to begin investing until you have enough liquid cash to survive for a reasonable period.  Unfortunately, this can mean different things to different people.

What Kind of Survival?

One pivotal question in figuring out how big this fund should be is how you would like to live during a financial emergency.  Suppose, for example, that you lose your job; are you comfortable cutting expenses severely so that you can keep more money in better investments?  The stress of finding a new job may be enough on its own without deprivation to boot.

Additionally, you need to really think about which expenses are necessary.  While you don’t want to keep too little in your fund, you don’t want to keep too much either.  This is an emergency fund, so you don’t necessarily have to keep every element of your current lifestyle during this emergency.  You can probably eat out less and see fewer movies, but would want to keep enough funds to pay for your kids’ private school.  Use a budget (you do have one, right?) to get a real idea of what you would need per month to survive and what you want that survival to look like.

What Is A Reasonable Period?

Once you know how much per month it takes you to live, the next question is how long you would reasonably need to live this way.  While some people advocate fairly small emergency funds, it is often desirable to put away enough money to live for a considerable amount of time.  If you lose your job, you don’t want to be forced into taking an inferior job, or cash out investments prematurely, simply because your money is running out.  You may have a realistic idea of how long it would take you to find a job, but I say be very pessimistic when enacting your emergency fund.  I believe 3 months living expenses is a minimum. This is only my personal opinion, but I think giving up potential investment returns is well worth the security this extra time buys.

What is Liquid?

Liquidity is a measure of how quickly you can get the cash.  The most liquid accounts are savings accounts or money market accounts.  Accounts where you can either write a check against it, or get the money into a checking account within hours, not days.  Generally however, liquidity comes with a price.  The more liquid an asset, the worse the returns typically are.  Certificates of Deposit (CDs) for example, offer better returns generally, but require you to leave the money on deposit.  This may sound like a deal breaker, however an ideal solution can involve CDs.

CD Ladder

For those who wish to have a large emergency fund, but don’t want to earn terrible returns on the money, a CD ladder may be an ideal solution.  A CD ladder is a series of CDs that mature often enough that you can use them as your emergency fund.  For example, you might go every month and open a 6 month CD with enough to live on for one month.  If you did this every month for 6 months you would now have a CD ladder.  Every month a CD will mature with enough for you to live on for that month.  If you need that money, retrieve it and don’t allow the CD to renew. If you don’t need the money, leave it there and allow it to compound.  There are many tricks and optimizations for starting a CD ladder, but it can be an optimal way to build your emergency fund.

Now that you’ve eliminated your debts and created your emergency fund you are ready to start making more intricate decisions for your investment strategy.

Post from: Personal Finance And Investing

Investing Prerequisite #2: Expanded Emergency Fund

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This post is step 1 in our Investing Template.

Deciding when and how to pay off your debts is not a simple matter.  While it can be comforting to be debt-free, that may not always be the most financially expedient approach-nor is it the whole picture. Here are a few steps, including analyzing and paying off debt, that really make your money work FOR you.

Step One: The Basic Emergency Fund

The absolute first thing you need to have is something to pay for unforeseen events.  I personally recommend keeping this fund as small as possible at the beginning.  We’ll get to creating a larger cushion later, but right now the goal is simply to get enough money so that you’re covered if your car breaks down or something else untoward happens.  In fact, in some cases I’d recommend skipping this step altogether.  If you have friends or family you believe you can reliably rely on in case of an emergency, get right down to paying off any debts.  Once your debts are paid off, go on to creating an expanded emergency fund.

Step Two: Minimum Payments

Paying off your debts is one of the best investments you can make, but it isn’t always the best.  You need to take a lot of things into account to decide when and how to pay off your debts, and the analysis isn’t always simple.  One main rule is this:

Always Pay Your Minimums

You cannot possibly hope to match the interest rate you will be charged with late fees and penalties, so you have to pay at least the minimum to every debt you have.  So no matter what other options are open to you, do not let yourself be subjected to these kinds of charges.  If you cannot meet your minimum payments, it’s time for another job, or to sell some things.  Getting your head above water is a separate subject, but make sure to do it.

Step Three: Tax-Deferred Options

Now despite the allure of being debt-free, there are some rare occasions that your bottom line will be better served by contributing to your tax-deferred savings.  Quite simply, if your company matches your tax-deferred account at 50% or better, you may be better off contributing to that account.  This is of course only true up to the amount that they match. Do not contribute more than they match until your debts are all paid off.

For example, if my company will match up to 3% of my salary in my 401(k) at 100%, I am possibly better off making this contribution instead of paying off my debts.  I will make 100% return on that money put into my 401(k), while I will probably be charged 20% on the debts I leave unpaid.

Generally speaking however, unless your debt is relatively small compared to your income, or you are very secure that your income will continue, you are probably still better off just paying the debt.

Step Four: Pay Off Your Debts

There is no sense investing in anything when you have the option of paying off your debts.  The only debt you may want to carry is a house or a car, and even those are questionable.  Even beyond the dangers of high-interest debt, it simply provides a security blanket to have your debt cleared.  There are various approaches to paying off your debt, but get it done before you start investing your money elsewhere.  Moreover, when in doubt: pay off your debts sooner than later.

Post from: Personal Finance And Investing

Investing Prerequisite #1: How To Deal With Debt

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My next several posts will be attempting to define a basic investment template.  Basically I’d like to develop a checklist to help anyone figure out where and how their money should be invested.  Most investment advice I read is very vague.  While most contain good advice it is usually in a vacuum.  You’d have to read hundreds of these articles to develop a coherent strategy and you still might miss a key point.  I will update this post as I create each installment and may reorder and edit them based on your input and questions.  I will also be posting much more frequently until the template starts to take shape.  Please feel free to start putting any questions below and I will attempt to answer them as I go.

Investing Prerequisites

• Step 1: Dealing With Debt
• Step 2: Your Expanded Emergency Fund
• Step 3: Goals and Time Horizon

Tax-Deferred Accounts

• Step 4: Tax-Advantaged Overview
• Step 5: Retirement Accounts
• Step 6: College Saving Accounts
• Step 7: Homeownership Accounts
• Step 8: Health Spending Accounts

Implementation

• Step 9: Allocation
• Step 10: Techniques

Post from: Personal Finance And Investing

Basic Investment Template

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As the savings rate dipped to historic lows, people argued that this was not a cause of concern due to the appreciating value of stocks and real estate.^[1] People we’re leveraging themselves, but it was considered justified because their houses and stocks were worth more. This of course has proven to be far from guaranteed. People watched as those assets, which were often serving as collateral, spiraled lower and lower in price.

As the markets have plummeted, many people have adopted a “wait and see” strategy. They are “waiting to see the markets recover” before they put any more money into their retirement funds. This begs the question: Why were you investing in the first place?

If these investors thought the Dow Jones was a buy at 14,000, why are they reticent to buy it now at a fraction of that price. Ultimately, the problem is these investors never had a strategy. They’ve only stopped to think about what makes sense investment-wise now that they’ve already experienced large losses.

Is It Too Late?

The simple answer is it’s never too late to have a strategy. However, the strategy you may develop may not paint a rosy picture. Many of us should take this opportunity to do what we should have done before the economic crisis: decide what actions really make sense for us. If you’re hoping to retire in the next few years, should your money be in stocks? Many hopeful retirees’ answer to that question is: I have to leave my money in stocks so I can make back what I’ve lost. My one piece of advice to those who are looking to recover losses in their 401Ks is:

Do not try to “get your money back.”

Until you’ve sold your stock, you haven’t “earned” any of that money. You had an asset that was worth more than when you bought it, and now it’s worth less. That’s the nature of assets. Just because you were up at one point at the casino, that doesn’t mean you get to take home the most you were ever worth while you were there. Ultimately if you had no strategy up until now, there’s no time like the present.

Don’t let the fact that you didn’t develop a strategy earlier keep you from developing one now. Spend some time thinking about 1.) how much money you can expose to risk, and 2.) how soon you’re going to need your money. The right strategy varies from person to person and family to family, and there are countless paths to take. If you want to play “market speculator” and wait for the market to recover, feel free; but understand the risks of this approach. If you want to ignore the stock market that burned you, this may be a valid strategy; but make sure you’re picking the strategy for the right reasons.

Make your strategy now! The next time something like this happens, you’ll be ahead of the game.

Post from: Personal Finance And Investing

Is It Too Late For An Investing Strategy?

1. Wall Street Journal: Don’t Dismiss Our Dismal Savings Rate