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Capital Gains and Losses and Your Tax Return


AlistairDarling (Photo credit: StCartmail)

When you own certain kinds of assets and you sell them, you may incur a capital gain or loss that is applicable to your income tax preparation.  If the original purchase price plus applicable expenses associated with the asset (known as the basis) is less than the proceeds that you receive from the sale of the asset, you have incurred a capital gain.  On the other hand, if the basis of your asset is greater than the proceeds from the sale, you have incurred a capital loss.

Capital gains are taxable to you, using a separate tax rate – and capital losses can be deducted from your capital gains for the year.  Excess capital losses (above your capital gains for the year) can be used to reduce your income by up to $3,000 per year, carried forward until used up (or for your lifetime).

The IRS recently produced their Tax Tip 2014-27 which lists ten facts about capital gains and losses that you may find useful as you prepare your tax return.  The text of the actual Tip is below:

Ten Facts about Capital Gains and Losses

When you sell a ‘capital asset,’ the sale usually results in a capital gain or loss.  A ‘capital asset’ includes most property you own and use for personal or investment purposes.  Here are 10 facts from the IRS on capital gains and losses:

  1. Capital assets include property such as your home or car.  They also include investment property such as stocks and bonds.
  2. A capital gain or loss is the difference between your basis and the amount you get when you sell an asset.  Your basis is usually what you paid for the asset.
  3. You must include all capital gains in your income.  Beginning in 2013, you may be subject to the Net Investment Income Tax.  The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates, and trusts that have income above statutory threshold amounts.  For details see
  4. You can deduct capital losses on the sale of investment property.  You can’t deduct losses on the sale of personal-use property.
  5. Capital gains and losses are either long-term or short-term, depending on how long you held the property.  If you held the property for more than one year, your gain or loss is long-term.  If you held it one year or less, the gain or loss is short-term.
  6. If your long-term gains are more than your long-term losses, the difference between the two is a net long-term capital gain.  If your net long-term capital gain is more than your short-term capital loss, you have a ‘net capital gain’.
  7. The tax rates that apply to net capital gains will usually depend on your income.  For lower-income individuals, the rate may be zero percent on some or all of their net capital gains.  In 2013, the maximum net capital gain tax rate increased from 15 to 20 percent.  A 25 or 28 percent tax rate can also apply to special types of net capital gains.
  8. If your capital losses are more than your capital gains, you can deduct the difference as a loss on your tax return.  This loss is limited to $3,000 per year, or $1,500 if you are married and file a separate tax return.
  9. If your total net capital loss is more than the limit you can deduct, you can carry over the losses you are not able to deduct to next year’s tax return.  You will treat those losses as if they happened that year.
  10. You must file Form 8949, Sales and Other Dispositions of Capital Assets, with your federal tax return to report your gains and losses.  You also need to file Schedule D, Capital Gains and Losses with your return.

For more information about this topic, see the Schedule D instructions and Publication 550, Investment Income and Expenses.  They’re both available on or by calling 800-TAX-FORM (800-829-3676).

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Market Returns Aren’t Savings

Golden Egg

In 2013 the market and those invested in it experienced a nice return on their investments. The S&P 500 rose an amazing 29.6% while the Dow rose 26.5%. Needless to say 2013 was an amazing year for investors – but try not to make the following mistake:

Don’t confuse investment returns with savings.

While it is true that the more of a return an investor receives on his or her investments the less they have to save it still does not mean that your returns should take the place of systematic saving for retirement, college or the proverbial rainy day. And by no means should you reduce the amount you’re saving thinking that the returns from 2013 and other bull years will repeat and continue their upward bounty.

Investment returns are the returns that an investor receives in a particular time frame. For 2013, if an investor was invested in the S&P 500 or an S&P 500 index fund they received almost 30% returns for the year. Not bad. But this is deceiving. Not to burst anyone’s bubble, but we are only looking at one year. If an investor was saving for retirement for over 30 years, to expect 30% returns each year for 30 years is  like expecting my chickens to lay golden eggs – it ain’t gonna happen!

But what if an investor stops systematically saving, thinking that a 30% increase in their portfolio for 2013 can offset any additional money they intended to put in? The result would be disastrous to their retirement plan. Perhaps some numbers can help explain.

Let’s assume that we have two investors, Alex and Neil. Both are age 30, both will retire at age 65 and both start with $10,000 in their IRAs at the beginning of 2013 and both are invested 100% in the S&P 500. At the end of 2013, both investors have $13,000 in their IRAs. Up until the end of 2013, both Alex and Neil had systematically contributed the maximum to their IRAs annually – about $5,000 annually. Now they can contribute $5,500 annually.

Alex decides that since 2013 rocked, he will not contribute to his IRA for 2014 thinking that 2013’s numbers will last forever. Neil decides to keep drumming away and putting in his annual amount ($5,500 for 2014) at a steady rhythm.

Neil is handsomely rewarded for his commitment and over the next 35 years, at a 6% average annual return he amasses close to $690,000 ($698,752 for those of you with your financial calculators).

Alex is sporadic. After up years in the market he doesn’t invest and after down years he thinks he needs to contribute. It turns out that there were 20 years of downs and 15 years of ups – so Alex invested his annual IRA maximum 20 times, instead of Neil’s 35.

Keeping the math simple, let’s say that the market was down for the next 20 years causing Alex to save and then up the last 15 years causing him to relax his savings commitment. In 20 years, since there were no gains Alex has $123,000 (we assume no losses in this down market).

In the next 15 years, Alex averages 6% return and contributes nothing since they are up years. At the end of 35 years Alex has roughly $295,000 ($294,777 for those of you still calculating) – or about $400,000 less than Neil.

Admittedly my examples are very simplistic and a bit unrealistic. But the point is to not confuse your investment returns with savings. They are not the same. An investor still needs to stick to their savings plan regardless of what the market does.

In up years and I would argue more importantly in down years you need to stick to your plan of saving regularly – along with the ups and downs to take advantage of compounding returns and  buying less when the market is overpriced and more when it’s under-priced.

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Why Watching the Stock Market Can Make You Sick

YuckFaceI recently read a fascinating article on the correlation between market declines and admission rates to hospitals. The authors point out that almost instantaneously; the effects of a market decline affect mental health such as anxiety. In a nutshell, the authors describe that expectations about the future play a role in investor’s utility (happiness) today.

The research in this article can be beneficial on two fronts. One the one hand, the information can be beneficial to advisors in educating their clients that once proper assets allocation for a particular client is achieved there is little to be gained by logging into an account and watching the daily and even hourly fluctuations of the market.

And every asset class will fluctuate – which is why we diversify and allocate assets accordingly such as real estate, large cap stock, small cap stocks, commodities, bonds, etc. It’s important to note that at any given time, any of these asset classes will be both in and out of favor. The more someone watches the gyrations, the more likely their headed for the antacids – or in the case of the article, the hospital!

The other benefit is self-evident for the client; not watching the market can be beneficial to your health and I would argue your wealth. The reason why it’s beneficial for your health is there’s going to be a lot less stress and worry looking at your account on a daily basis. Unless you’re a day trader (proven to be especially useless) there’s little need to look at your account more than once per month – and less if you can stand to.

The reason it’s beneficial for your wealth is that by not watching the daily movements, there’s less of a chance you’re going to act on that worry and succumb to the loser’s game of trying to time and actively beat the market. Additionally, you may be tempted to stop investing in your IRA, 401(k), or other savings plan which is the last thing you want to do in a down market; in fact, consider investing more when the market drops.

Finally, this is where a financial planning professional can be worth their weight in gold (no; that is not a recommendation to buy the metal!). Working with a professional can help you better control your emotions by helping you think objectively which can be extremely difficult in a market downturn.

That being said you still need to do your homework. Make sure your professional isn’t in the same boat when markets fluctuate. If he or she is irrational and thinking emotionally, it’s going to be difficult if not impossible to be objective. And this is your money.

Be leery of professionals that claim to be market prognosticators or actively beat the market or use funds that do so. Numerous empirical studies show that this is almost an impossible feat. And again, this is your money. Also be cautions of “order takers” – meaning professionals that do whatever you ask – as if you were ordering from the drive through.

A good professional financial planner will challenge your requests (politely) if they feel it’s not in your best interest and can help prevent you from making mistake that can be hard to recover from. Case in point: think of all the “orders” that were placed to sell in 2008 when it’s the last thing investors should have done. Some folks experienced irreversible damage to their portfolios.

To quote a wonderful line from one of my favorite investment books, The Investment Answer, “There are those that don’t know, and those that don’t know they don’t know.”

The market is much bigger than all of us so it makes sense not to worry about what we can’t control.

Chasing Returns

Wile E. Coyote and Road Runner

Looking at this morning’s financial section of the paper inevitably had a piece regarding the assets classes and the respective investors (gamblers) that did exceptionally well in 2013. There was mention of a firm that bet heavily on Japanese stocks and did very well, another investor bet against gold and achieved glamorous returns and a hedge fund that bet on US stocks and looked like gods among mortals.

But that’s the problem with these scenarios – we are mortal.

Pick up any financial magazine that reports on funds or stock returns and you’ll see examples of mutual funds, stocks and bonds that have either beaten or done worse than their counterparts. For example, US stocks did very well in 2013 – so a domestic large cap fund would look amazing based on what it did for 2013. Herein lies the problem; the publication is reporting what the fund did, not what it will do.

Investors that chase returns are falling prey to the thinking that past returns are indicative of future results when we know that that’s not the case. There’s no guarantee that the fund or stock or bond will increase in value and there’s no guarantee that it will decline. We just don’t know.

For more specific funds and stocks – there may be a good chance that the fund is going to go down although it may not happen right away. The reason is that when the publications show the funds with amazing returns, there are some people that flock to those funds since they are chasing returns. Prices temporarily increase. What happens next is that those folks that have been in the fund for quite some time sell – and sell a lot. Naturally when there’s quite a bit of selling fund prices drop – and so do the returns of those investors that chased last year’s results.

Another reason prices drop is due to mean reversion. Simply stated mean reversion is the concept that a fund’s prices will move toward their average over time. A simple, but exaggerated example of this is let’s say a fund’s average return is 10% over 20 years. In one year it returns 40% – which is very respectable. However, according to mean reversion it can be expected (although there’s no guarantee as to when) that at some point in the future the fund is going to experience a declination (either gradually or suddenly) in order to get back to its average return of 10%.

Another way to look at this concept is standard deviation (for another article later) which is really how much something flip-flops around an average. To keep things easy, let’s say this fund has a standard deviation of 10% also. With an average return of 10% and a high of 40%, means that this fund went three standard deviations above its average. This means that it could also go three standard deviations below the average or achieve a -20% return.

Without getting too mathematical or statistical on our readers it simply means that this fund flip-flops a lot and if it’s flipped 40% returns in the last year, there’s a good chance it could flop going forward.

Rather than chasing returns a wise choice is to invest broadly among asset classes and diversify accordingly. An excellent way to do this is through indexing – buying index funds of different asset classes (such as stock, bonds real estate and international stocks and bonds). This helps an investor avoid chasing returns and helps them accept that certain asset classes will rise and others will fall – but the combination of all of them in one portfolio not only lowers overall portfolio risk, but prevents an investor from chasing the next big fund – which according to the latest financial magazines – already happened.

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What’s in Store for 2014?

English: Wall Street sign on Wall Street

A few weeks ago I was interviewed by a local business journal about our firm’s thoughts as to how the market would react in 2014 and how to best prepare for that reaction. Essentially, the journal was asking us to predict where the market would be in 2014.

Most of our clients know the answer I am about to write, which was, “No one can predict the direction of the market with any degree of accuracy.” “If that were the case, (as I told the interviewer) neither she nor I would be having this interview.” In other words, we’d be clinking our glasses on our respective tropical beaches because we’d have gotten filthy rich predicting and timing the moves of the market.

Markets are pretty efficient – meaning that the price of any particular stock in any particular sector, industry or country is generally priced based on all available information about that particular security. Think of it this way: Wall Street hires thousands of analysts to comb through the financials of thousands of publicly traded companies. So the information about those companies is known almost instantaneously and the prices of those stocks react instantly to any change in information.

Rhetorical questions:

If Wall Street analysts are good at forecasting the market and different stocks, why do they still work as analysts?

 If Wall Street was any good a predicting the market, how did 2008 happen?

If I had to make a prediction for 2014 it would be this: Markets will rise and fall and be jittery and overly-emotional. They’re just like people – after all, that’s who drives markets anyway.

It can be very tempting to try to predict and time the markets and react emotionally. A few months ago we had the debt ceiling issue and there was worry that markets would crash. We recommended clients hold steadfast – and our clients are happy they did; as markets didn’t crash but actually reached new highs shortly afterward.

This wasn’t brilliance on our part – but sticking to our strategy of once we find the right mix of assets for a particular client, the majority of returns comes from that investment mix – not timing.

Not timing and not predicting prevents us from one of the major psychological flaws that can happen to money managers – confirmation bias. Say we predicted that 2014 was going to be a bullish year and we were right, now we would be tempted to enter 2015 thinking we had superior knowledge of the direction of the market instead of really admitting it was dumb luck.

The best way to predict is to own the market and diversify accordingly. This includes owning a well-diversified mix of index funds and or ETFs (which we do for our clients) and learn to manage emotions (which we try to do for our clients).

This allows our clients time to focus on things worth focusing on such as family, friends, goals and aspirations and frees them from the burden of trying to time their investments (something we admit we cannot do). It also allows us to focus more on building relationships with our clients and keeps our clients costs very low.

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The Other Life Insurance – Annuities

old man

The last few weeks I have been writing about the more conventional form of life insurance that most people are familiar with when I say ‘life insurance’ – which is protection against a premature death.

The other life insurance is that which protects your from living too long – and that insurance is the annuity.

Over the years annuities have gotten a bad rap – and rightfully so. Like life insurance, annuities are generally sold to the public via a sales force of licensed agents. In most cases, they are not the right vehicle for the individual (I know I am setting the blog up to receive the thunderous rebuttals) but there may be cases where an annuity makes sense.  The other reason annuities get a bad rap is because of the pure insurance (longevity) feature that they provide – especially pure life annuities.

A pure life annuity is simply a guaranteed income stream that lasts as long as the person’s life the annuity is based off of – called the annuitant. The downside to this annuity is that once the annuity stream has started (called annuitization); if the annuitant dies, he or she forfeits the money to the insurance company. This is why these annuities pay the most. The annuitant assumes most of the risk. They could make a payment or two and then die.

This concept is not a bad thing. Risk pooling as it is officially called is the concept of many individuals sharing in the risk of their given pool. The same concept is found in auto and home insurance. Most of us will go our entire lives without making a claim for our home burning down, but we are part of the pool that insures those people whose homes do burn down. Likewise with annuity risk pools. Those who die early pay for those who live too long.

A similar comparison can be made with Social Security – arguably a form of an annuity. A single individual could go their entire life paying into the system, retire, and then die after receiving only a few payments.

Folks interested in annuity or yet, folks that are being shown that they should be interested in an annuity need to understand that first and foremost, it’s an insurance product. This isn’t a bad thing, but it needs to be disclosed. Once you have an understanding that it is an insurance product, ask yourself, “What am I insuring?” The answer to this question is your longevity and not running out of money. Another question to ask is “Do I need an annuity right now?” The answer is that it depends on your age and what need regarding income in retirement.

Generally speaking, the younger you are, the less you need an annuity. There are plenty of other tax-favored vehicles (no, not life insurance) to build wealth over time. The older you are – then it depends. If you’re going to be receiving Social Security as well as a pension (another form of annuity) then I would argue no, as part of your retirement is already insurance against you living too long via Social Security and the pension.

Over the next few weeks I’ll explain the pro and cons of annuities. I’ll dive into expenses, add-ons (called riders), and different forms of annuities to be aware of and beware. I’ll also explain when it is generally unwise to buy an annuity and when it may make sense.

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Book Review: Winning the Loser’s Game

winning the losers game

Timeless Strategies for Successful Investing

Charles D. Ellis, the author of this book (in it’s Sixth Edition), has definitely hit the nail on the head with his subtitle.  The strategies outlined in this book are good for any investor in any economic/investing climate.

Time and again throughout the book, Mr. Ellis points out that the real key to investment success has nothing to do with finding the right stock, bond, mutual fund or ETF – and everything to do with developing a sound strategy for investing and sticking to it.

The strategy requires you to develop an understanding of your own personal tolerance for risk and your need for returns.  This can be a difficult undertaking, as it requires the investor to answer difficult questions about what kinds of losses he can stomach with his investments, as well as what sort of return you require for your investments over the long term.  It takes careful planning to develop this strategy – because you have to be truthful with yourself about your own reactions to market losses.  Losing your nerve at the wrong time can derail the process altogether.

Sometimes it is necessary to have help in the process – a financial advisor who is not vested in your investment choices can really help with building the strategy.  Look for a fee-only advisor to help with the process.

Another recommendation made throughout the book is to use indexed mutual funds as the basis for your investments.  As you’ve heard from me before, indexed mutual funds are really the best, smartest option in the marketplace.  Mr. Ellis puts it best with these three bullets, his conclusion to the book:

  • The number of brilliant, hardworking investment professionals is not going to decrease enough to convert investing back into the winner’s game of the 1950’s and 1960’s.
  • The proportion of transactions controlled by institutions – and the splendid professionals who lead them – will not decline.  Investing, therefore, will stay dangerous for the most gifted amateur.
  • Maybe some day so many investors will agree to index that the “last stock pickers standing” will have the field all to themselves.  Maybe.  But that’ll be the day.  So, be sure to call me.  Meanwhile, I’ve got better things to do – and so do you, where we can play to win with both my time and our money.

If all of this sounds eerily familiar, it’s because this is another author who I agree with completely – and I believe this book provides an excellent guide for the average investor.  It’s no wonder that this book has had such a successful run, and this latest edition just carries on the great tradition.  Go get it!

Avoid the Trap

English: Venus Fly trap in detail. Taken with ...Eating and dining out all the time can drain our money and potential retirement savings without us even being aware of it. We get asked from friends to go to lunch, coffee or we find ourselves skipping breakfast and getting in the line at the coffee shop for a scone and latte. Before we know it, we’re left asking, “Where did the money go?” Or worse, “I can’t afford to save for retirement.” What’s happened is we’ve fallen into the trap – a habit really, but it can be broken and we can relearn. Here’s how:

The first thing you can do is to pass on that latte or scone all together. Instead, make yourself breakfast at home. Invest in a coffee maker if you don’t have one, and make your own coffee. Then make a nice meal of scrambled eggs and whole wheat toast, a cup of cottage cheese with fruit, or one of my favorites – a thick, mixed berry protein smoothie. It’s quick, easy and cheap – much better than the latte and scone. And trust me, if you work at a sit-down job, the protein in place of the simple carbohydrates will keep your energy level sustained, and your metabolism going fast. That’s very important if you’re stuck in a chair all day long.

Next, pocket the $2-$3 that you would have spent on the latte and scone. Put it in a jar, put it in the bank, put it anywhere you can save it. There’s a great start! Think about it. $2-$3 per day times an average of 30 days is an extra $60-$90 in your pocket every month!

Now, if you eat fast food at lunch or find yourself eating out a lot, make a commitment to pack your lunch. Resist the temptation to go to lunch with your office. If you go to lunch on a daily basis, that will average $5-$10 per lunch, at least. That’s an extra $100-$200 saved! Put them together and you’ve saved $160-$290 – in one month!

I’m not saying never go out to lunch. I have friends of mine that I meet for lunch every now and again. The point being that I don’t make a habit of it. On the other hand, once you have made a habit out of saving this extra money and have learned to discipline yourself to save, then it’s not going to hurt you to go out every once in a while.


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What is Risk Tolerance?

Happy Tums

What is risk tolerance and why is it important to investors? As an investor you’ve probably been asked this question by yourself, or your financial advisor. It’s not an easy question to answer and not a question that can be answered with one word or a quick sentence.

Risk tolerance is simply a particular investor’s appetite for risk. Some investors have little appetite for risk and their stomach churns when they think about losing money in the market. Generally these investors are considered risk averse or risk intolerant.

Other investors aren’t really concerned about the ups and downs of the market and are willing to accept these market gyrations in or to receive the benefit of potentially higher returns. This is called the risk/return trade-off. In order for investors to receive higher returns they generally have to be willing to accept more risk for those returns. In other words, these investors are risk tolerant.

So why is this concept important for investors? It’s important for a number of reasons. The first is that it helps the investor and their advisor properly line up the correct investment portfolio for that particular investor. A risk averse investor will generally be more at ease in a low-risk portfolio with few, if any equities, more exposure to high-quality bonds and cash. A risk tolerant investor would be more tolerant of risk – such as more exposure to equities, and riskier assets.

But determining what an investor’s appetite for risk isn’t that easy. There are a number of risk tolerance questionnaires used by various companies and professionals to help investors narrow down their true tolerance. This is hard to do depending on the day – literally!

The reason why is because on any given day the market could be way up, way down, or flat. Someone who is really risk averse may feel risk tolerant in a bull market (isn’t everybody?), but that same person will run for the antacids the second the market drops; which leads to this point:

Investors’ real appetite for risk appears in bear markets.

So what can investors do? Find a professional that asks a lot of questions and takes the time to get to know you. Yes, a risk tolerance questionnaire can be used and is a good thing, but the questionnaire should be only a piece of the conversation. Investors can ask themselves questions too.

Imagine you have $100,000 invested and in two weeks it grows to $150,000. How do you feel? In another two weeks it plummets to $75,000. Now how do you feel?

You answer will determine nodding in expectation or running to the medicine cabinet.

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Why Diversify?


Diversity (Photo credit: Wikipedia)

Remember Enron? I think we all do. Enron was once a powerhouse company that saw its empire crumble and took the wealth of many of its employees with it. Why was that the case? Many of Enron’s employees had their 401(k) retirement savings in Enron stock. This was the classic example of having all of your eggs in one basket and zero diversification.

Let’s say that the employees had half of their retirement in Enron stock and half in a mutual fund. Enron tanks but their mutual fund stays afloat. This means that they lost, but only lost half of their retirement, all else being equal.

Imagine if they had only a quarter of their retirement in Enron and the remaining 75% in three separate mutual funds. Enron’s demise is only responsible for a fourth of their retirement evaporating. This could go on and on.

The point is that when you choose to diversify you’re spreading your risk among a number of different companies. That way if one goes belly-up you’re not left with nothing.

Mutual funds are an excellent way to diversify among an asset class. For example, if you purchased a total stock market index fund you’d have nearly the entire US Stock Market in your portfolio which amounts to approximately 4,100 different stocks.

That’s great diversification but we can do better. The US equity market is only one area. We can diversify into domestic bonds, international stocks, international bonds, real estate, and so on. This is called diversifying among asset class. The point is that you want to spread your risk and diversify as much as possible so one market or asset class doesn’t ruin your entire portfolio.

A term we use often in the industry is correlation. This simply means how one particular security moves in relation to another. If I own two large cap growth funds they’re pretty closely correlated; meaning that if large cap companies fall both of these funds are going to fall very similarly.

If I own a large cap fund and a bond fund, then if large cap stocks fall, the bonds may rise or may stay the same or even fall slightly. This is because they are a different asset class and move differently than equities. Keep adding different assets to the mix and you have a potential portfolio that can withstand the dip and turns of the market.

Even the Oracle of Omaha, Warren Buffett diversifies. Granted he may have all of his eggs in one basket, Berkshire Hathaway, but own Berkshire Hathaway stock and you’ll get exposure to insurance, bricks, candy, cutlery and underwear to name a few. Admittedly, not many people have $175,000 to buy just one share of BRK stock, but the point is that even Mr. Buffett diversifies.

Diversify. It works.

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