10 Facts About Capital Gains and Losses

1. Almost everything you own and use for personal purposes, pleasure or investment is a capital asset.
2. When you sell a capital asset, the difference between the amount you sell it for and your basis – which is usually what you paid for it – is a capital gain or a capital loss.
3. You must report all capital gains on your income tax return.
4. You may deduct capital losses only on investment property, not on property held for personal use.
5. Capital gains and losses are classified as long-term or short term, depending on how long you hold the property before you sell it.  If you hold it more than one year, your capital gain or loss is long-term.  If you hold it one year or less, your capital gain or loss is short-term.
6. If you have long-term gains in excess of your long-term losses, you have a net capital gain to the extent your net long-term capital gain is more than your net short-term capital loss, if any.
7. The tax rates that apply to net long-term capital gains are generally lower than the tax rates that apply to other income.  For 2010, the maximum long-term capital gains rate for most people is 15%.  For lower-income individuals, the rate may be 0% on some or all of the net capital gain.  Special types of net capital gain can be taxed at 25% or 28%.
8. If your capital losses exceed your capital gains, the excess loss can be deducted on your tax return and used to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately.
9. If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you incurred it in that year.
10. Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040.

Calculations

To determine tax treatment, your short-term capital gains (STCG) and short-term capital losses (STCL) are “netted”, and the same is done with your long-term capital gains (LTCG) and long-term capital losses (LTCL), as in the following equations:

STCG – STCL = Net STCG(or L)

LTCG – LTCL = Net LTCG(or L)

If the amount of loss (in either equation) is greater than then amount of gain, you have a net capital loss (either short or long).  Likewise if the amount of gain is greater than the amount of loss, you have a net capital gain.  These amounts are then netted against each other, as follows:

Net Capital Gains = Net STCG(or L) + Net LTCG(or L)

Tax Treatment Situations

If you have only short-term gains and losses, any net gain will be taxed at your ordinary income tax rate – that is, it is added to your other income from wages and the like, taxed just the same as income.  A net loss can be deducted from your income to the extent of the $3,000 annual limit discussed previously.  Any remaining net loss can be carried over to future years and deducted against net capital gains first, and then at the $3,000-per-year rate against your ordinary income until the net loss is exhausted.

Likewise, if you have both short-term and long-term gains and losses and the net short-term gains are greater than any net long-term losses, the remaining difference is taxed and treated as ordinary income.

If you have only long-term gains and losses, any net gain will be taxed at the applicable long-term capital gains rates (typically 0% or 15% for 2010).  Any net loss is treated the same as the net short-term capital loss described above.

If you have net long-term gains and net short-term losses that are less than or equal to the net long-term gains, in the “netting” discussed above, your net long-term gains will be reduced to the extent of your net short-term losses.

If the nettings result in net capital gains for both long-term and short-term, your net short-term gains will again be taxed at your ordinary income tax rate, but the net long-term gains will be taxed at the applicable long-term capital gains rate (typically either 0% or 15% for 2010).

And lastly, if the nettings result in net capital losses for both holding periods, this net loss is (as you might expect) allowed to be deducted from ordinary income at the $3,000-per-year rate.  Any amount of loss that remains is carried over to future years (as described previously).

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

But what does this mean?  There are plenty of folks out there (in the mass media) who will tell you that stock market investing is no longer a wise move… why, after all, if you’d had your money in a savings account you’d have done better!  So does this mean it’s time to chuck all of your stock investments and switch everything to bonds?  Of course not.

Remember, it’s long term

No matter who you are as an investor, if you expect to achieve any return above inflation, you have to include equities (stocks) in your portfolio to some extent.  And when developing portfolio allocations, pretty much anyone under age 70 should be considering a time horizon of 30 years or more – and those over age 70 should be thinking similarly, since your chance of living to age 95+ is continuing to increase every year.

What I mean by this long-term view is that you need to stop thinking about stocks in a day-to-day, quarter-to-quarter, year-to-year or even decade-to-decade context, but rather in the context of thirty, forty, fifty and more years.   A college graduate, just starting a new job this year and investing in a sparkly-new 401(k) may likely be continuing to take distributions from that 401(k) in the year 2080, for example.  Even if you’re retiring this year at age 62 – you may still have 30 or more years of investment activity ahead of you.

Think about all that has happened in our history over the past 30, 40, 50, 60, and 70 years – 70 years ago we were still over 18 months away from Pearl Harbor and the US entry into World War II.  We’re talking about a significant amount of history that has occurred – and a likewise significant amount of returns that stocks have provided over that time.

So let’s look at the numbers for the S&P 500 more closely:

* These annualized numbers are inflation-adjusted and include re-invested dividends

Notice how the numbers fluctuate pretty wildly among the 10-year periods, but begin to calm down as you look at the longer-term time horizons.  While there is nearly a 20% differential between the best and worst 10-year periods, when you look at the 30-year periods the differential is less than 4.75%, and over the 70-year periods the differential is even less:  only 2% separates the best period from the worst.

So, while you may have an off decade or two in your overall investing experience, in the long term you’re likely to approach the average return, as long as you keep your head and remain vigilant with your investment allocation in good times and bad.

Why A Decade?

The other thing about this “lost decade” business that bothers me is that it’s an arbitrarily-chosen timeframe – why do we only want to measure in terms of an exact decade?  What if we started these periods in March of the years ending with 3?

* These annualized numbers are inflation-adjusted and include re-invested dividends

As you can see, within reason, these periods averaged out very similar when compared to the exact decades, but the differential between the best and worst decades was much different (this would be referred to as the “deviation” of the returns).  And as we noted in the first table, as the time horizon increases, the deviation reduces to very near the average for that timeframe.

So, don’t get hung up on an arbitrary measure such as this to begin with.  Recent history has a very poor track record for predicting the future (in short term views, especially) – remember how heady the market was after the 1980′s and 1990′s dramatic returns?  No fool would have suggested that you shouldn’t be in stocks at the turn of the millennium – but look at what has happened since then.  Same thing goes for the end of the 1970′s – stocks looked like a terrible place to be, but then along came the bull markets of the 1980′s and 1990′s.

Taking another view – when there’s a downswing in the markets, when you’re in the position of continual investing, you’re actually getting more shares for your money than in the upswing periods.  In the long run this gives you a much better footing than a single lump sum invested at (perhaps) the wrong time.

The Point

The point of all this is that if you have a long-term horizon (and we all do, to some degree) and you hope to earn something more than the level of inflation, stocks are your best bet.  And holding your properly-diversified portfolio of stocks through thick and thin is the best method for investing in the market – lost decade or not.  Because in the long run, stocks are most likely to return their historical long run average – which is much better than any other alternative investment out there.

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This is a follow-up to the article Open a Roth IRA for Your Child, where we talked about how beneficial it can be to set up one of these accounts for your child. One of the points we talked about in that article was how the account can only be funded with of the lesser of $5,000 (for 2010) or total taxable compensation.  It’s very important to know what exactly can be considered “taxable compensation” for this purpose.

Taxable Compensation

Of course, any wages reported in Box 1 of a W-2 form from the employer is considered taxable compensation.  In addition, any tips, professional fees, or other amounts you receive for providing personal services are compensation as well.  If your scholarship or grant is included in Box 1 of a form W-2, this is also considered taxable compensation.  Commissions, self-employment income, alimony, military differential and non-taxable combat pay (even though it’s non-taxed!) are also included in determining the total amount of taxable compensation for the purpose of determining IRA contribution limits.

But most of these sources of income are not common for children, especially younger children – unless they happen to make money as a model, actor, or other sort of entertainer.  Usually for younger children the paper routes, lawn mowing, and babysitting jobs are just a bit beyond their reach.  So, well-intentioned parents often get the idea to “invent” income.

Invented Income

In general, if the activity isn’t something that you would normally have to pay someone to do (like taking out the trash, making your bed, doing the dishes, etc.) then it’s probably not taxable compensation you’ve paid the child.  If the child is doing the activity for your neighbor for a reasonable compensation then that’s a different story – just use your head and make sure that it’s really compensation and not an allowance.  You’re doing this to help the child get started with a Roth IRA – not to establish a criminal record as a minor!  (Okay, not exactly a criminal record, but definitely afoul of the IRS – just as bad at any age!)

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

Hold on there, cowboy!  There’s a problem with your kooky little scheme – the IRS has planned for just such an eventuality.  Effectively, any amount that you withdraw from your Roth IRA that is not previous contributions or conversions, will be subject to tax in the year that you withdraw it, until you’ve paid the tax on the conversion.  This is in addition to the amounts that you owe tax on during that year due to your election to spread the tax.  Gobbledygook, right?  Right – howza bout an example?

An Example

You have an IRA worth $100,000, and in 2010 you decide you’d like to convert it to a Roth IRA.  You have an existing, five-year-old Roth IRA, with $20,000 in it.  In 2011, you withdraw $30,000 from the Roth IRA.  At the end of the year, instead of owing tax on $50,000 (half of the conversion amount of $100,000), you actually owe tax on $60,000.

This is calculated as:  your withdrawal was $20,000 from earlier contributions, and $10,000 from the conversion.  That $10,000 must be added to the previously-agreed-upon $50,000 amount that you knew you’d owe tax on for 2011.  And then in 2012, you will owe tax on the remaining $40,000 from the conversion.

So, in other words, the IRS has determined that this two-year tax deferral is not going to be used as a tax-free method for achieving tax-free withdrawals from your IRA – once the amounts have remained in the account until 2012, any amount can be withdrawn without tax.  But of course, you’ve already paid the tax on the conversion by that point (or rather, you will by tax day in 2013).

So what happens if you withdraw the funds in 2010 after converting earlier in the year?  Effectively this is treated as a distribution from your original IRA (actually recharacterized from the Roth conversion), so you’d owe tax on that amount in 2010, and the remaining amount would be split between 2011 and 2012.

The “Hole”

I suppose that technically there is a time period where you could have access to 100% of the funds having paid zero tax:  between January 1, 2012 and April 15, 2012, when the tax bill is due for the first half of your conversion amount.  So you have three and a half months to unleash your devilish scheme on the world… not sure what you’ll do with this information, but perhaps there is some advantage that you might receive by leveraging the amount.  I doubt there’s much advantage to be had, especially given the loss of deferral if you withdraw the funds, but maybe you have a plan.  Go to town!

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Credits

There are two different kinds of tax credits currently available in tax year 2010:

American Opportunity Credit – This credit is available for students (and parents of students) that are in their first four years in a degree program at college.  The credit is a maximum of $2,500, and is calculated as:  100% of the first $2,000, and 25% of the next $2,000 of Qualified Higher Education Expenses (QHEE) paid for that student.  QHEE is limited to tuition, fees, books, supplies, and other equipment required for the course of education at an accredited institution of higher learning.

Up to 40% of the credit can be refundable – meaning that, even if you don’t pay any tax at all, you may be eligible to receive as much as $1,000 in refunded credit.  (Note:  if you’ve been around the college tax credits block in recent years, this credit has replaced – or rather expanded – the old Hope Credit.)

Lifetime Learning Credit – This credit can help you to pay for any level of postsecondary education, including professional degree courses, graduate courses, and courses to improve job skills.  The credit is equal to 20% of the first $10,000 of QHEE paid for all students on the tax return, for a maximum of $2,000 in credit for the family.  There is no limit to the number of years that this credit can be applied to.

Deductions

There are two types of deductions available for education-related expenses as well:

A tuition and fees deduction is available for parents and students – which is a reduction to your Adjusted Gross Income (AGI).  Depending upon your income, you may be eligible to deduct as much as $4,000 in QHEE.

In addition, a Student Loan Interest Deduction is also available to help ease the pain of those student loans after college.  This deduction also reduces your AGI – and it doesn’t just have to be for a qualified student loan.  If you’ve used a home equity loan, a credit card, or other personal loan that was used exclusively for QHEE, the interest can also be deducted.  But be careful, the exclusive use provision can catch you – if any part of the non-qualified loan is used for a purpose other than QHEE, the interest is not deductible.

College Savings Plan Benefits

There are also two types of college savings plans that can be used on a tax-benefited basis, to help you pay college expenses.

Section 529 Qualified Tuition Programs – These programs, often referred to as 529 plans or QTPs, provide a vehicle for families to save up for college expenses on a tax-favored basis.  With a 529 plan, families can contribute amounts to the savings plan, and the account is invested – as the account grows, if the distributed funds are used for QHEE (in this case, including room and board), there is no tax on the growth.  The only limit to the amount of contributions is in relation to gift tax limitations – for most folks this isn’t a problem, but consult your advisor if you have questions.

Coverdell Education Savings Accounts (ESA) – ESAs are similar to 529 plans, with a few differences.  ESAs can also be used for private elementary or high school expenses, in addition to QHEE.  In addition, there is a specific limit of $2,000 in contributions per student per year.  The same tax treatment as the 529 plans applies to ESAs – as long as the distributions are used for education expenses, there is no tax on growth in the account.

Coordination of Benefits

The Lifetime Learning Credit and the American Opportunity Credit cannot be claimed for the same student in the same year.  Likewise, neither credit can be applied to the same student in the same year as a tuition and fees deduction.  You also cannot claim the same expenses as the offset for distributions from a 529 or an Education Savings Account.  As you might have guessed, the same holds true for coordination between the tuition and fees deduction and a 529 or ESA – the costs used for either cannot be used for the others.

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

This provision primarily affects Social Security benefits when you have earned a pension in any job where you did not pay Social Security tax and you also worked in other jobs long enough to qualify for Social Security benefits.    However, federal service where Social Security taxes are withheld (Federal Employees’ Retirement System) will not reduce your Social Security benefits.  The WEP may apply if:

• you reached age 62 after 1984; or
• you became disabled after 1985; and
• you first became eligible for a monthly pension based on work where you did not pay Social Security taxes after 1985, even if you are still working.

Here’s How It Works

True to form, the Social Security Administration doesn’t make it easy to figure all this out…

You start out by understanding your Primary Insurance Amount, which begins with your Average Indexed Monthly Earnings (AIME), and then take the Bend Points for the current year into account.  For 2010, the first Bend Point is $761 and the second Bend Point is $4,586.  As we discussed in the article on Primary Insurance Amount (PIA), the amount of your AIME that makes up the first Bend Point is multiplied by 90%; the amount from the first Bend Point to the second Bend Point is multiplied by 32%; and finally everything over the second Bend Point is multiplied by 15%.  These three figures are added up to create your PIA.

However – if the WEP applies to your situation and you reached age 62 after 1989, the 90% factor (applied to the first Bend Point) is reduced to 40%.  Effectively, this reduces the PIA for most folks by $380.50 per month (for 2010).  The reduction factor is phased in if you reached age 62 between 1986 and 1989.

Exceptions

Again true to form, the SSA has exceptions to the rule.  If it turns out that your service in the Social Security taxed job was for 30 years or more and you earned “substantial” wages (substantial is defined as $19,800 for 2010 and has been indexed over the years), then your 90% factor is not reduced at all.  If you had “substantial” earnings for at least 21 years but less than 30 years, the 90% factor is reduced by 5% each year less than 30 years that you had “substantial” earnings in the Social Security-taxed job, with the lowest factor being 40%.

Additionally, the WEP doesn’t apply to Survivor’s benefits (but the Government Pension Offset does).  Other exceptions include the following:

• You are a federal worker first hired after December 31, 1983;
• You were employed on December 31, 1983 by a nonprofit organization that did not withhold Social Security taxes from your pay at first, but then began withholding Social Security taxes from your pay;
• Your only pension is based on railroad employment; or
• The only work you did where you did not pay social Security taxes was before 1957.

Parting Shots

There is a limit to the amount that your Social Security benefit can be reduced: no matter what your factor has been reduced to (from the original 90%), the resulting reduction cannot be more than 50% of your pension based on earnings after 1956 on which you did not pay Social Security taxes.

And lastly, the WEP also applies to Disability benefits from Social Security, using the same factors.

As always, if you have questions, leave a comment below (or use one of the other contact methods to the right!).

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

In the olden days…

Under the old law (through December 31, 2009), there was a special provision that allowed an IRA owner who is at least age 70½ to make a charitable contribution of up to $100,000 directly from the IRA account to a qualified charity.  This money was never counted in your income, and as such making such a move had no impact on your current income tax situation – positive or negative.  The benefit came about with regard to your estate, since those funds were no longer counted as part of your estate.  Plus you got to feel really good about making a contribution to your favorite charity.

In 2010 and beyond…

Under the present law (beginning on January 1, 2010), the special provision mentioned above is no longer in effect.  But you can still make charitable contributions from your IRA account – the only problem is that you must first count the distribution from your IRA as income, and then you account for the charitable contribution among your Schedule A Itemized Deductions.  The end result is the same, right?  O contrare, Mona Me.

The problem is that, by having to count your IRA distribution as income, you will increase your Adjusted Gross Income (and therefore your Modified AGI), both of which can have a significant impact on other items on your tax return.

Example

Let’s run through an example:  you’re retired, age 72, have an IRA worth $50,000, and you want to contribute the entire amount to your favorite charity.  Your other income, along with your spouse’s income, totals $70,000.    Included among your tax return items is $10,000 in medical expenses, along with other deductions (real estate tax, home mortgage interest, etc.) amounting to $15,000.  You had no other charitable contributions for the year.

Under the 2009 rules, your AGI is $70,000. Your itemized deductions amount to $19,750 – because your medical expense deduction is limited to the amount over 7.5% of your AGI.  Since 7.5% of $70,000 is $5,250; we subtract that amount from $10,000 and come up with $4,750, which we then add to the rest of your itemized deductions for a total of $19,750 in deductions.  Subtract the itemized deductions from your AGI ($70,000 minus $19,750) equals $50,250.  Then subtract your personal exemptions of $7,300 from that and you get $42,950 in taxable income.  Tax on this amount is $5,607.50.

Under the 2010 rules, your AGI is $120,000. (The IRA distribution of $50,000 is added to the rest of your income.)  Itemized deductions are now $66,000, because your medical expense deduction was reduced to $1,000 – $120,000 times 7.5% equals $9,000, subtracted from $10,000 equals $1,000.  We add the rest of your itemized deductions (including the $50,000 charitable contribution deduction) and come up with $66,000 ($15,000 plus $1,000 plus $50,000).  Subtracting the itemized deductions from your AGI equals $54,000, and then we subtract the personal exemptions of $7,300 (it didn’t change for 2010) to come up with taxable income of $46,700.  Tax on this amount is $6,167.50.

Under the new rules, you just lost $560.  Or rather, you paid 10% more in taxes than you did with the same circumstances as the year before.  So, while it’s still possible to make a charitable contribution from your IRA account, it’s more costly to do so.

Other items affected by AGI

There is a significant number of items on your tax return that are impacted by the amount of your AGI – listed below are some of the more common ones:

• taxable amount of Social Security (or Railroad Retirement) benefits
• allowable losses from rental real estate activity with active participation
• deductible traditional IRA and spousal IRA contributions
• ability to contribute to a Roth IRA
• miscellaneous itemized deductions, including non-reimbursed employee job expenses
• and a number of miscellaneous credits

These and many other components of your tax return can be impacted by an increase in your AGI, so you can see why this change in laws has had a significant impact on many folks.

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

Below I’ve listed several of the more important economic indicators and what makes up the indicator, along with my commentary on what the indicator may tell us.  If I’ve left out any of your favorites, let me know!

Key Economic Indicators

Gross Domestic Product (GDP) – this is the value of all goods and services produced in the United States, minus the value of imported goods and services.  This broad measure of economic health shows the quarter-by-quarter growth or shrinkage of the US economic output.  Comparisons are most often made between the current figure and the previous quarter and year.  These numbers are reported quarterly, and are revised in following months as more complete data is gathered.

The main number that you’ll see referenced is the “real” GDP or “real” GDP growth – meaning that the numbers are inflation-adjusted to a reference point (these days the reference is to the year 2005).  In other words, real GDP growth for a year is based upon the GDP figure from the previous year to the most current figure, with inflation factored in.  For the most recent quarter reported, you can go to the website of the Bureau of Economic Analysis.

As you might expect, it’s a positive sign to see the real GDP growing.  In the past year though, GDP has reduced, which is why our current economic cycle has technically been called a recession.  A recession is defined as two quarters of decline in GDP, amounting to less than a 10% decline.  If the decline is 10% or more, the economic cycle is technically a depression.  From the second quarter of 2008 to the second quarter of 2009, we saw four quarters of GDP decline in a row, amounting to a total decline of 9.6% – close to a depression, but no cigar.  Since that point, we’ve seen two quarters of GDP growth through the fourth quarter of 2009 (most recent data as of this writing).

Although this is an important number to understand what has happened in our economy – because it can help explain the real outcome economic activity – it’s usefulness is limited since it is reported so long after the fact.  Knowledge of this index is helpful in your decision-making process, but you need more information to make good decisions about your investments.

Consumer Price Index (CPI) – this index, which is based upon the cost of a basket of consumer goods and services such as housing, transportation, food, energy and clothing, is a good measure of inflation within our economy.  The current figure, reported monthly and adjusted as more data becomes available, is compared to the previous month, quarter, and year (typically) to determine the rate of increase in the costs of these items to the consumer.  This particular index is used to develop cost-of-living adjustments (COLAs) for things like Social Security benefits.

As you might expect, we would always like to see this index increasing at a controlled pace – annually in the 3% to 4% range is considered “normal” – since increasing costs of goods and services presumably indicates that the overall economy is growing.  Put differently, if the consumer is willing and capable of paying an increased cost for a basket of goods and services, then the economy has grown, providing the consumer with additional funds to pay the increased cost.  It’s not a perfect way to measure economic growth, but it’s what we have.

In the past year, for example, we’ve seen an annual inflation increase (as evidenced by CPI) of roughly 1.8% through February of 2010 (most recent data as of this writing).  Annual inflation from 1980 to the present has ranged from 10.3% to -0.37%, and has averaged 3.37%.  You can view the most recent data at the Bureau of Labor Statistics Consumer Price Index site.

As with the GDP growth discussed above, CPI is interesting to understand general overall increases in inflation and very important in determining COLAs, but being a historical piece of data that lags in reporting by months, it really doesn’t help us much as we plan for the future.  CPI does give us indication of what inflation we’ve experienced in the past so that we can estimate future inflation, but as always, the past doesn’t necessarily predict the future.

Consumer Confidence Index – this is a survey of 5000 consumers regarding their attitudes concerning the present economic situation and expectations for the economy going forward.  This report can be helpful to understand how the current economy is affecting the point of view of “everyman” – and it often is an insightful prediction of the direction of the economy.

The Consumer Confidence Index’s month-to-month changes are the most important viewpoint to consider:  any time there is an increase or decrease of 5 points or more, it’s worth noting.  The amount of the change isn’t as important as the direction of the change, as a significant change in either direction often denotes a trend for the overall economy in that particular direction.    You can view the most recent information on the Conference Board’s Consumer Confidence Index website.

Producer Price Index (PPI) – this index is pretty much the same as the CPI, except that the pricing is taken at the wholesale, or producer level, rather than at the retail level.  This index, especially the core PPI (made up of food and energy prices alone) is a useful indicator of future increases in the CPI.  The Bureau of Labor Statistics also maintains the Producer Price Index.

Leading Economic Index (LEI) – while not a perfect prediction of the future, the LEI gives us a forward-looking view of economic activity.  This index is made up of 10 separate components:

• Average weekly hours (manufacturing sector)
• Average weekly jobless claims for unemployment insurance
• Manufacturer’s new orders for consumer goods and materials
• Vendor performance (slow delivery diffusion index)
• Manufacturer’s new orders for non-defense capital goods
• Building permits for new private housing units
• S&P 500 stock index
• Money Supply (M2)
• Interest rate spread (10-year Treasury vs. Federal Funds target)
• Index of consumer expectations

With all of these factors compiled, this index gives a somewhat reliable forecast, especially of recessionary periods, but as I mentioned earlier, it’s not without fault.  The index often gives a false signal of recession just prior to an economic upswing, and so should not be utilized alone as your determinant of future economic activity.  You can see the LEI and its components at the Conference Board’s Leading Economic Index website.

What’s very interesting is to review the LEI’s activity as a composite index, and then take a look at the activity of the underlying components.  If the entire index is indicating a downturn (legend has it that three consecutive months of downturn foretell a recession, but this is the false signal referred to above, as well), then review the data for all of the underlying components.  If there is a broad-based downturn noted by all (or most) of the components, chances are the indication of future economic downturn is real.

Beige Book – anecdotal information on general economic conditions is gathered by each District of the Federal Reserve System and then combined into this report.  The Federal Open Market Committee (FOMC) uses this information, along with other economic indicators, to help make decisions regarding the rate of Federal Funds, which often drives changes to rates across the overall marketplace.

While this data may not make a difference in your own investment decisions, it’s helpful to see the information that the Fed is using to make their decisions – although it’s not always readily apparent why they’ve made one decision or another, even seeing the Beige Book information.  You can view the Beige Book at the Federal Reserve website.

Unemployment Rate – pretty much self-explanatory, the unemployment rate is the percentage of potential workers in our economy who are not currently employed.  This factor is also a useful gauge of the overall health of the economy, as reductions in the unemployment rate indicates that companies are expanding operations (and payrolls) in preparation for growth.  You can see the current Unemployment Rate at the BLS website as well.

Summary

While no single index or economic indicator is the best or most important piece of information, those I’ve presented above are some of the more common and insightful indicators of economic activity.  Paying attention to these indicators and their trends over time can be insightful as you make decisions about your financial life.  Don’t imagine for an instant that there is a cut-and-dried predicter of the future in all of these – there’s no such thing as a crystal ball.  So pay attention, but don’t put all your faith in the numbers…

How about you?  Do you have a particular index or indicator that you follow religiously?  Tell us all about it in the comments below!

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These are mostly myths.  So what is the truth?

How The Social Security System Works

In a way, the Social Security system actually does resemble a Ponzi scheme, in that the early participants paid in very little and received an inordinately large benefit (by comparison to what they paid in) – while later participants will be paying in a far larger amount, likely more than they will ever get back out in benefits.  To be a true Ponzi scheme though, the later participants would be told that they can expect the same return on investment that the earlier folks received.  I think we’ve understood for quite some time that this isn’t an investment, but a tax – and that we may get very little out of the system compared to what we put in it.

From the beginning, the Social Security system has overtly been a “pay as you go” system, meaning that current receipts from tax withholding are used to pay present-day recipients of benefits.  Most of the time during its 75-year existence, the system has been paying out less in benefits than it is taking in from withholding, and so the surplus has been placed in a “trust fund” to help pay for benefits in the future.  This trust fund amounts to roughly $2.5 trillion these days.

This design was based upon the (incorrect) assumption that each succeeding generation would be larger than the previous generation, therefore the receipts would always be greater than the payouts.  That was before the Baby Boom.

It has been projected that, beginning in 2017 (although I’ve seen it reprojected to 2016 lately) that the system will begin drawing from the trust fund regularly, although the interest alone on the trust fund’s account will be enough to cover the excess needs of the system through 2027.  At that point, it is projected that the principal in the trust fund will be accessed to pay benefits, and the trust fund principal is expected to be exhausted by 2041.

So – What’s Going to Happen?

I can’t tell the future, but I have a couple of guesses as to what may occur.  But first, I wanted to point out a couple of recent developments:

1) In 2010, due in part to the economic downturn, the Social Security system is expected to pay out more than it takes in.  This is not a catastrophe, and not expected to be a long-term trend, nor is it the first time this has happened.  It is, however, unexpected, and may have a big impact on the crossover point projected in 2017 2016.  This is primarily due to unemployment staying high (less money coming in due to smaller payrolls).  Stay tuned, but also see #2.

2) The long-term trend that will likely have the greatest impact on the health of the Social Security system is the delay of retirement among many Americans, specifically the troublesome Baby Boom generation.  According to some recent data from the Rand Corp., the percentage of folks between 65 and 75 that are still active in the workforce will be 25% in 2010, versus 17% in 1990.  That’s a significant fact, because those folks are continuing to pay into the system, and either delaying receipt of benefits or receiving a smaller benefit (at least until Full Retirement Age) than was projected.

The combination of these two factors is likely to improve the outlook for the overall system, although we’ll have to wait for the witch doctors actuaries to sift through the numbers to know what the new projections will look like.

My Guesses

In the meantime, here’s my guess as to what will happen:  like anyone with a finite budget, when it comes time to begin paying out of principal, I expect for benefits to be reduced across the board – possibly by as much as 25%.  But before that happens, I expect that we’ll see increases to the ages for benefits, such as bumping up the early retirement age from 62 to 64, and the maximum benefit age from 70 to 72.  These increases would match the increase in the Full Retirement Age that has been in place for some time now.  And lastly, plan on the fact that pretty much any benefit you receive will be taxed to some degree.

Regardless, all this talk about going bankrupt is pretty much ill-founded.  Since the system has the ability to draw in tax rolls it cannot be bankrupted; benefits can reduce and ages for benefits can increase, but it can’t go completely broke.  It’s bad, but not catastrophic.  It’s sort of like if we were to discover that, after all of the sightings and legends over the years, it turns out that Bigfoot isn’t really an unknown species, but rather that it was just members of The Allman Brothers Band wandering about in the wilds.  Frightening, but not the end of the world.

So What Can You Do?

Write your congressmen & women.  Light a candle.  Wring your hands, and say “oh my”.  And then just get over it, realizing that Social Security should not be counted upon as a significant portion of your retirement income – especially if you were born after about 1955.  Concentrate on your savings, and then, if the Social Security fairy happens to leave something under your pillow when you are retired, consider it gravy.

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Ten Tips for Deducting Charitable Contributions

1. Contributions must be made to qualified organizations to be deductible.  You cannot deduct contributions made to specific individuals, political organizations and candidates.
2. You cannot deduct the value of your time or services.  Nor can you deduct the cost of raffles, bingo or other games of chance.
3. If your contributions entitle you to merchandise, goods or services, including admission to a charity ball, banquet, theatrical performance or sporting event, you can deduct only the amount that exceeds the fair market value of the benefit received.
4. Donations of stock or other property are usually valued at the fair market value of the property.  Special rules apply to donation of vehicles.
5. Clothing and household items donated must generally be in good used condition or better to be deductible.
6. Regardless of the amount, to deduct a contribution of cash, check, or other monetary gift, you must maintain a bank record, payroll deduction records or a written communication from the organization containing the name of the organization, the date of the contribution and amount of the contribution.  For donations by text message, a telephone bill will meet the record-keeping requirement if it shows the name of the organization receiving your donation, the date of the contribution, and the amount given.
7. To claim a deduction for contributions of cash or property equaling $250 or more you must have a bank record, payroll deduction records or a written acknowledgement from the qualified organization showing the amount of the cash and a description of any property contributed, and whether the organization provided any goods or services in exchange for the gift.  One document may satisfy both the written communication requirement for monetary gifts and the written acknowledgement requirement for all contributions of $250 or more.
8. If your total deduction for all noncash contributions for the year is over $500, you must complete and attach IRS Form 8283, Noncash Charitable Contributions, to your return.
9. Taxpayers donating an item or a group of similar items valued at more than $5,000 must also complete Section B of Form 8283, which requires an appraisal by a qualified appraiser.
10. To deduct a charitable contribution, you must file Form 1040 and itemize deductions on Schedule A.

For more information on charitable contributions, refer to Form 8283 and its instructions, as well as Publication 526, Charitable Contributions.  For information on determining value, refer to Publication 561, Determining the Value of Donated Property.

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).