The U.S. economy grew ever so slightly in the first quarter after nearly stalling late last year, but sequestration and cautious investments by businesses highlighted the sustaining pressures that could cause the recovery to weaken in the summer months.

The nation’s gross domestic product, the broadest measure of goods and services produced across the economy, expanded at an annualized 2.5% pace in the first quarter of 2013.  This followed a 0.4% rate in Q4 of 2012.

I believe the economy will and the recovery will likely remain uneven at least through the summer, despite months of optimism tied to the improving housing market and divergent from the red bull stock market that reached new all-time highs during the first three months. The growth trajectory for the economy is shallow as money is being made most weeks by investors.

I don’t see the Federal Reserve and Chairman Bernanke slowing its bond buying until sometime in 2014 especially since the mandate is to lower the unemployment rate to 6.5%.  While a 5%-10% pullback or “spring swoon” would be healthy and not surprising, it’s become increasingly challenging to buy on the dips since they too are so shallow and infrequent.

As for inflation, a key measure tracked closely by the Fed showed underlying prices – those excluding volatile food and energy costs – rising just 1.2% over the year and well below the central bank’s 2% inflation target.

With earnings season in full swing, stocks rose this past week on stronger-than-expected reports. Nearly 70% of the S&P 500 companies that reported results as of Friday the 26^th of April have beaten estimates. A large drop in weekly jobless claims also supported the market making last month’s (March) week jobs report an afterthought.  I always say to my clients – watch the revised numbers and see the bigger picture when it comes to their investment portfolios.

Nearly four years since the recession ended, the pace for economic expansion remains grindingly slow.  In fact, it reminds me of the New York Knicks and their grind it out victories in the 90s except that they couldn’t get past Michael Jordon’s Bulls when they needed to. This year is different for the long suffering Knicks fans – not withstanding a miraculous Celtic comeback from a 3-1 playoff series deficit – their optimism rules.

Optimism rules – and I’ve said it to my clients throughout this sustained red bull market rally.

The net worth of American households grew by $5 trillion in the first two years of the economic recovery, but not everyone shared in the riches. The top 7% of American families saw their wealth grow to $25.4 trillion in 2011, up from $19.8 trillion two years earlier. The remaining 93% of Americans experienced a decline in net worth to $14.8 trillion, down from $15.4 trillion, according to the Pew Research Center. The dividing line between the two sides was $836,033 in 2011. The 8 million U.S. households with a net worth at or above that amount saw their average net worth rise by 28% from 2009 to 2011. The 111 million remaining American households saw their wealth decline by 4%. The difference is because the rich are much more heavily invested in the stock and bond markets, which rallied during the recovery. Less affluent households typically have their wealth tied up in their homes, and the housing market remained flat between 2009 and 2011. By 2011, the average wealth of the top tier was almost 24 times that of the rest of Americans. Two years earlier, the ratio stood at less than 18 to 1. (Source: cnn.com)

Maybe we should view the overall economy as a picture of slow growth, and yet grinds along while the stock market is enhanced by the Fed’s quantitative easing programs. This adds to the wealth affect for households and that will sooner or later help spending and business investments which will spur economic growth. Sooner or later the Knicks will overcome the Miami Heat – Knicks fans can tell you about spring swoons.

The headlines continue to remind investors that the financial markets have sustained a bull rally without a bear in sight.  The perception among investors is that there is more reward than risk.  The day before Good Friday, the S&P 500 surpassed its previous bull market peak reached on October 19th, 2007. After inflation, the market is still ten percent below the 2007 peak, but that deficiency is almost exactly made up by dividends paid by the index so that the total real return for stocks over that period is also almost exactly zero. Regardless, the benchmark index is still well below its March 2000 peak in real terms even counting dividends. Over the past 13 years there has been a 30% nominal return (including dividends).

Although, the markets were closed last Good Friday, the government did release personal spending and income for February and the numbers were robust, prompting some economists to revise the GDP growth estimate to 3.5%. The final University of Michigan Confidence numbers were also revised up sharply to 78.6% from the preliminary release. And core PCE inflation in February remained at a low 0.1%, yielding a 1.3% year-over-year rate, far below the Fed’s threshold for tightening. This data means that the market is set to extend its gains to start April.

April is historically the Dow’s best month and I present several reasons why I expect the rally to continue:

1. The stock market is cheaper than at previous peaks.
2. New technology is alive from Silicon Valley to Silicon Alley – the Cloud, Smartphone, Tablet, Fracking, and 3-D printing – is boosting growth and creating record levels of profits.
3. The U.S. economy is tolerable of Washington.
4. Consumer confidence is growing – which will lead to an uptick in spending.
5. Global growth is slow but not collapsing.
6. Higher rates haven’t arrived while stock prices keep rising.
7. Housing remains a key source of strength.
8. Demand for mortgages has been strong.
9. American’s overall debt service costs as a percent of disposable personal income are now at the lowest level they’ve been since at least 1980.
10. ECB Chief Draghi’s promise to do “whatever it takes” to shore up Eurozone sovereigns has put a lid on rising bond yields in the currency union’s peripheral economies calming the fears of contagion and a potential break-up.
11. “Main Street” investors want to play in the game.
12. The U.S. markets are on center stage. It’s where capitalism lives.

Back in March of 2009, investors could have bought the overall U.S. equity market at a single-digit lagged P/E ratio. I started discussing a “V” shaped recovery with my clients. My thinking was pretty simple. We will get to the right side of the V but it could take a 5-7 year market cycle.  And, last week, the S&P 500 reached an all-time record high close – in other words, the right hand side of the V has been topped off.

In fact, I predicted that the S&P 500 would hit 1500 by the end of 2012 – and my prediction lagged only one month to reach that level.

Today, I estimate that this P/E ratio has risen to a little bit above its 60-year average.

In 2009, an assumption of 5% earnings growth, a 2% dividend yield and a return to average P/Es implied a roughly 15% annualized return over 5 years. Today the same set of assumptions yields a 6% – 7% annualized return.

Of course, these assumptions are optimistic. Moreover, it should be stressed that even an annual return of 6% or 7% per year is good in an investment environment of very low yields on bonds or cash. However, given a year’s worth of respectable gains that we have already seen in Q/1, I believe that investors should be focused on having a balanced approach to investing, appropriate for their time horizon and risk tolerance, with only a slight overweight towards U.S. stocks relative to that balanced approach.

Some are accustomed to the gains as the new normal; others call it a new sugar high, while still others are convinced that it’s all just a new bubble due to the Federal Reserve pumping all the liquidity into the system. I expect the rally to continue with a slight pullback that will occur at some point during the forthcoming quarterly earnings season which kicks-off next week.

Moreover, I believe the growth is real, it’s now, and we should enjoy the green arrows but remind ourselves of how quickly they can turn red.

By: Mark Martiak

Ben Bernanke isn’t budging in his support for continued bond buying.  In his semiannual report to Congress Chairman Bernanke exclaimed:
 “Keeping long-term interest rates low has helped spark a recovery in the housing market and has led to increased sales and production of automobiles and other durable goods.”

Bernanke then discussed the real reasons why long-term rates have remained so low by explaining that low interest rates are, in fact, a global phenomenon citing Germany, Canada and Japan as comparisons.

He went on further to say “Long-term interest rates are the sum of expected inflation, expected real short-term interest rates, and a term premium. Expected inflation has been low and stable, reflecting central bank mandates and credibility as well as considerable resource slack in the major industrial economies. Real interest rates are expected to remain low, reflecting the weakness of the recovery in advanced economies (and possibly some downgrading of longer-term growth prospects as well). This weakness, all else being equal, dictates that monetary policy must remain accommodative if it is to support the recovery and reduce disinflationary risks.”

With this explanation, investors can expect lower interest and higher returns for an extended period. However, as the global economy continues its recovery, higher inflation and interest rates should be expected. 

Bill Gross, the highly regarded bond expert and a founder of the investment firm Pimco said “the Federal Reserve is buying and there’s no real risk until the Fed declares the war is over. It’s looking for 6.5 percent unemployment.  By any reasonable standard, that’s going to be a long time coming – certainly not in 2013, and probably not for at least two to three more years”.

It is household wealth that the Federal Reserve has hoped to buttress with its ongoing program of bond buying.  By purchasing safe bonds, the Fed has nudged investors into risk assets and in turn made those investments appreciate in value.

For once, and given the Dow’s all time high of 14,253.77 reached on March 5^th, investors don’t need to read the tea leaves to know what the Federal Reserve will do. Fed Chairman Bernanke has made it clear that rates will stay low until at least 2015 and in essence paved the way for investors to get with the program.

Mark Martiak and Alexandra Huddleston

The applicable exclusion amount is the amount that can be sheltered from federal gift and estate tax by the unified credit. The applicable exclusion amount (the basic exclusion amount in 2011 and 2012, see more below) is $5 million in 2011 and $5,120,000 in 2012, but is scheduled to drop to $1 million in 2013. In 2011 and 2012, the unused basic exclusion amount of a deceased spouse is portable which may make it easier for you and your spouse to take full advantage of the estate tax applicable exclusion amount.

You have some flexibility over when to use some or all of your applicable exclusion amount. You could use your applicable exclusion amount to make a gift now. Your estate could use your applicable exclusion amount at your death. Or, if you are married, your estate could elect to not use your applicable exclusion amount, instead transferring it to your spouse for later use. There are potential advantages and disadvantages to using your applicable exclusion now rather than later.

Tip: The top gift and estate tax rate is 35 percent in 2011 and 2012, but is scheduled to increase to 55 percent in 2013.
Caution: Unless the current rules are extended by Congress, starting in 2013, the gift and estate tax rates increase, the applicable exclusion amount decreases, and portability of the unused basic exclusion amount between spouses expires.
Technical Note: In 2011 and 2012, the applicable exclusion amount of the surviving spouse is equal to the sum of the basic exclusion amount of the surviving spouse and the unused basic exclusion amount of the last deceased spouse. The Internal Revenue Code refers to the unused basic exclusion amount of a deceased spouse as the deceased spousal unused exclusion amount (DSUEA).

Potential upside
Since any unused exclusion amount can be passed along to a surviving spouse, you might assume that there is an advantage in doing so. But that’s not necessarily the case. Even with the current portability of the basic exclusion amount, there could be an upside to using some or all of your applicable exclusion amount now, by making lifetime gifts, or by implementing a plan that will allow your estate to utilize your applicable exclusion amount, rather than electing to transfer it to your surviving spouse. This can be the case if:

There are family members or individuals other than your spouse that you would like to benefit
during your lifetime. The applicable exclusion amount could be used to shelter gifts to such
persons from gift tax.

Tip: Consider also lifetime gifts that qualify for the annual gift tax exclusion, currently $13,000 per donor/donee, or as qualified transfers for medical or educational purposes. These gifts are not taxable and do not use up your applicable exclusion amount.

There are family members or individuals other than your spouse that you would like to benefit
after your death, but prior to the death of your spouse. At your death, you will generally need
to shelter transfers to persons other than your spouse from estate tax using the applicable
exclusion amount.

There are concerns about whether the exclusion will continue to be portable between spouses in
the future. If the exclusion is used now, the exclusion will have been used even if portability
is not available in future years. If the exclusion is not used now and portability is not
available in the future, the unused exclusion of the first spouse to die could be lost.

Example(s): Don and Lisa are married and Don has an estate of $6 million. Assume an applicable exclusion amount of $5 million, a 35 percent top tax rate, portability, and that current exclusion amounts are extended beyond 2012 and remain constant. Don dies first. Don transfers $6 million to Lisa. The transfer qualifies for the marital deduction and no federal estate tax is due at Don’s death. Don’s estate elects to transfer Don’s unused exclusion to Lisa.

At Lisa’s death some years later, assume portability is not available. Lisa’s $6 million estate is greater than her $5 million applicable exclusion amount and estate tax is due. If Don instead had transferred $1 million to a credit shelter trust for Lisa and their children, Don’s $1 million estate would have been fully sheltered by his $5 million applicable exclusion amount and Lisa’s $5 million estate would have been fully sheltered by her $5 million applicable exclusion amount, and no federal estate tax would be due at either death.

There are concerns that the applicable (or basic) exclusion amount will be lower in the future.
If the higher exclusion is used now, you will have taken advantage of the higher exclusion. If
the higher exclusion is not used now and the exclusion is reduced in later years, the total
amount sheltered by both spouses’ exclusions could be reduced.

Example(s): Rick and Tina are married and Rick has an estate of $8.5 million. Rick dies first. At Rick’s death, assume an applicable exclusion amount of $5 million, a 35 percent top tax rate, portability, and that values stay constant. Rick leaves everything to Tina, everything qualifies for the marital deduction, and no federal estate tax is owed. Rick’s estate elects to transfer Rick’s unused exclusion to Tina.

At Tina’s death, assume an applicable exclusion amount of $3.5 million, a 35 percent top tax rate, and portability (i.e., assume future provisions include a combination of 2009 and 2011 tax provisions). At Tina’s death, the $8.5 million is greater than the $7 million applicable exclusion amount (Tina’s $3.5 million basic exclusion amount and Rick’s $3.5 million unused exclusion amount) and estate tax is due. Part of Rick’s basic exclusion amount, $1.5 million, is wasted. If Rick instead had transferred $5 million (or even $1.5 million) to their children or to a credit shelter trust for Tina and their children, both estates would be fully sheltered by their applicable exclusion amounts and no federal estate tax would be due at either death.

There are concerns that federal gift and estate tax rates may be higher in the future.
Transferring property now that will not be taxed later can insure that the transferred property
will not be subject to those higher tax rates in the future. You have property that is expected
to appreciate after you make a gift. Future appreciation on the property will escape gift and
estate taxation and does not use up any additional applicable exclusion amount.

Tip: Consider a grantor retained annuity trust (GRAT) to transfer appreciation while using little or no applicable exclusion amount (where the GRAT is zeroed out). This is complex planning, so see a qualified estate planning attorney for more information.

You have property that is expected to appreciate in value after your death. Future appreciation
of the property will escape estate taxation in your spouse’s estate and does not use up any
additional applicable exclusion amount. If the property instead passed to the surviving spouse,
it could potentially outgrow any unused exclusion transferred to your surviving spouse; any
unused exclusion is not indexed for inflation.

Example(s): Dave and Ann are married and Ann has an estate of $10 million. Assume that current rules are extended beyond 2012 with an applicable exclusion amount of $5 million (that is indexed for inflation after the first spouse dies), a 35 percent top tax rate, portability, and that values (other than any unused exclusion) double over time after the first spouse dies. Dave dies first. Dave’s estate elects to transfer Dave’s unused exclusion to Ann. At Ann’s death, Ann’s $20 million estate is greater than her $15 million applicable exclusion amount (Ann’s $10 million exclusion amount and Dave’s $5 million unused exclusion), and estate tax of $1,750,000 is due. If Ann instead had transferred $5 million to Dave prior to his death, Dave’s $5 million estate would have been fully sheltered by his $5 million applicable exclusion amount (assuming Dave transfers the $5 million to a credit shelter trust or to beneficiaries other than Ann) and Ann’s $10 million estate would have been fully sheltered by her $10 million applicable exclusion amount, and no federal estate tax would be due at either death.

You and your spouse would like to benefit multiple generations and use both of your generation
skipping transfer tax (GSTT) exemptions. The GSTT exemption, unlike the basic exclusion amount
in 2011 and 2012, is not portable. The GSTT exemption is the same as the applicable exclusion
amounts in 2011 ($5 million) and 2012 ($5.12 million), but is scheduled to drop to $1 million
as indexed in 2013. The GSTT rate is the same as the top gift and estate tax rate, 35 percent
in 2011 and 2012, but is scheduled to increase to 55 percent in 2013. Applicable exclusion
amounts will often be used with generation-skipping transfers to protect the transfers from
gift and estate tax.

Tip: A reverse QTIP election could be used with a QTIP (qualified terminal interest property) marital trust to allow both spouses to allocate GSTT exemption to property that passes to the surviving spouse using the marital deduction. This is complex planning, so see an experienced estate planning attorney for more information.

State death taxes can be saved. Most states do not have a gift tax. Making a gift can remove
the property from your estate for state death tax purposes. Also, state exclusion amounts may
be different than the federal applicable exclusion amount and may not be portable between
spouses. Using some federal applicable exclusion amount at the first spouse’s death may insure
that the state exclusion (which may not be portable) is also used at the first spouse’s death.
Consult with a financial or estate planning professional familiar with laws in your state of
domicile.

Potential downside

There may be a downside to using the applicable exclusion amount (or a portion of it) now, by making lifetime gifts, or by implementing a plan that will allow your estate to utilize your applicable exclusion amount, rather than electing to transfer it to your surviving spouse. This can be the case if:

You make a lifetime gift of property, with the result that the property is no longer available
as a resource to you.

Property that bypasses your surviving spouse’s estate does not receive a step-up (or step-down)
in basis at your surviving spouse’s death. This could result in greater income tax, for
example, when property is sold. Property included in your surviving spouse’s gross estate for
estate tax purposes generally receives a step-up (or step-down) in basis to fair market value.
Your plans should attempt to balance estate tax and income tax considerations.

Using the applicable exclusion amount by transferring property to an individual other than your
spouse means that your spouse will not receive that property at your death. Many estate plans
that were designed prior to the recent substantial increases in the applicable (or basic)
exclusion amount and before portability funded a credit shelter trust with an amount equal to
the applicable exclusion amount, with the balance going to the spouse or a marital trust for
the spouse. Under today’s rules, such a plan could end up leaving everything to the credit
shelter trust and nothing to the spouse (other than whatever interests the spouse might have in
the marital trust). To avoid this situation, smaller estates may prefer to leave everything (or
an amount expected to be no more than the surviving spouse’s applicable exclusion amount) to
the surviving spouse (or to a marital trust for the surviving spouse).

Example(s): You have an estate of up to $5 million and an A/B trust arrangement that would fund your “B” credit shelter trust with the applicable exclusion amount (with the balance passing to your spouse or an “A” marital trust for your spouse). Assume an applicable exclusion amount of $5 million. Your B trust would be funded with the full amount of your estate, with nothing passing to your spouse (other than whatever interests your spouse might have in the B trust). Is this the result you would want? What if your estate or the applicable exclusion amount were larger or smaller? Does portability of the basic exclusion amount between spouses affect your decision?

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

State death taxes would increase at the death of the first spouse to die. State exclusion
amounts may be less than the federal applicable exclusion amount. This could cause state
taxation at the death of the first spouse to die if the full federal applicable exclusion
amount is used. Consult with a financial or estate planning professional familiar with your
state’s laws.

Cumulative events lead to an increase in the estate tax owed in the future. Because of the
complexity and cumulative nature of the gift and estate tax calculations (including possible
changes to tax provisions), gift or estate tax may be higher than you might ordinarily expect
in some cases. Tax benefits already taken, such as the applicable exclusion amount, could
potentially be clawed back by future changes, such as a reduction in the applicable exclusion
amount. Where there may be potential clawbacks, it may be especially useful to compare using
the applicable exclusion amount now against deferring its use. Consult with a financial or
estate planning professional.

Example(s): Nancy is married to Don. Assume an applicable exclusion amount of $5 million, a 35 percent top tax rate, and portability. Don dies and transfers $1 million of Don’s unused basic exclusion amount to Nancy. Nancy makes a gift of $6 million using Nancy’s $6 million applicable exclusion amount (Nancy’s $5 million basic exclusion amount plus Don’s $1 million unused basic exclusion amount) and no federal gift tax is owed. Nancy marries Mark. Mark dies and fully uses up Mark’s basic exclusion amount. Nancy dies with an estate of $1 million and $700,000 of federal estate tax is owed. (Tax would only be $350,000 if the $1 million were simply taxed at 35 percent. But the estate tax calculation reflects that Nancy has previously made taxable gifts of $6 million on which there is no gift tax.) However, the results are no worse than if Nancy had made no taxable gifts and her estate were $7 million at her death: estate tax would be $700,000.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act) included new gift, estate, and generation-skipping transfer (GST) tax provisions. The 2010 Tax Act provides that in 2011 and 2012, the gift and estate tax exemption is $5 million (indexed for inflation in 2012, and thus is $5,120,000), the GST tax exemption is also $5 million (indexed for inflation in 2012, and thus is $5,120,000), and the maximum rate for both taxes is 35%. New to estate tax law is gift and estate tax exemption portability: generally, any gift and estate tax exemption left unused by a deceased spouse can be transferred to the surviving spouse. The GST tax exemption, however, is not portable. These major changes are temporary: absent further legislation, in 2013, the exemptions are generally scheduled to drop to $1 million, the maximum rate will jump to 55%, and portability will be repealed. You should understand how these new and temporary rules may affect your estate plan.

Exemption portability
Under prior law, the gift and estate tax exemption was effectively “use it or lose it.” In order to fully utilize their respective exemptions, married couples often implemented a bypass plan: they divided assets between a marital trust and a credit shelter, or bypass, trust (this is often referred to as an A/B trust plan). Under the 2010 Tax Act, the estate of a deceased spouse can transfer to the surviving spouse any portion of the exemption it does not use (this portion is referred to as the deceased spousal unused exclusion amount, or DSUEA). The surviving spouse’s exemption, then, is increased by the DSUEA, which the surviving spouse can use for lifetime gifts or transfers at death.

Example: At the time of Henry’s death in 2011, he had made $1 million in taxable gifts and had an estate of $2 million. The DSUEA available to his surviving spouse, Linda, is $2 million ($5 million – ($1 million + $2 million)). This $2 million can be added to Linda’s own exemption for a total of $7,120,000 ($5,120,000 + $2 million), assuming Linda dies in 2012.

The portability of the exemption coupled with an increase in the exemption amount to $5,120,000 per taxpayer allows a married couple to pass on up to $10,240,000 gift and estate tax free in 2012. Though this seems to negate the usefulness of A/B trust planning, there are still many reasons to consider using A/B trusts.

• The assets of the surviving spouse, including those inherited from the deceased spouse, may appreciate in value at a rate greater than the rate at which the exemption amount increases. This may cause assets in the surviving spouse’s estate to exceed that spouse’s available exemption. On the other hand, appreciation of assets placed in a credit shelter trust will avoid estate tax at the death of the surviving spouse.
• The distribution of assets placed in the credit shelter trust can be controlled. Since the trust is irrevocable, your plan of distribution to particular beneficiaries cannot be altered by your surviving spouse. Leaving your entire estate directly to your surviving spouse would leave the ultimate distribution of those assets to his or her discretion.
• A credit shelter trust may also protect trust assets from the claims of any creditors of your surviving spouse and the trust beneficiaries. You can also include a spendthrift provision to limit your surviving spouse’s access to trust assets, thus preserving their value for the trust beneficiaries.
• The portability feature is in effect for two years only, and is scheduled to expire in 2013, unless Congress enacts further legislation.

A/B trust plans with formula clauses
If you currently have an A/B trust plan, it may no longer carry out your intended wishes because of the increased exemption amount. Many of these plans use a formula clause that transfers to the credit shelter trust an amount equal to the most that can pass free from estate tax, with the remainder passing to the marital trust for the benefit of the spouse. For example, say a spouse died in 2002 with an estate worth $5,120,000 and an estate tax exemption of $1 million. The full exemption amount, or $1 million, would have been transferred to the credit shelter trust and $4,120,000 would have passed to the marital trust. Under the same facts in 2012, since the exemption has increased, the entire $5,120,000 estate will transfer to the credit shelter trust, to which the surviving spouse may have little or no access. Review your estate plan carefully with an estate planning professional to be sure your intentions will be carried out under the new laws.

Wealth transfer strategies through gifting
Because of the larger exemptions and lower tax rates, 2012 provides an unprecedented opportunity for gifting.

By making gifts up to the exemption amount, you can significantly reduce the value of your estate without incurring gift tax. In addition, any future appreciation on the gifted assets will escape taxation. Assets with the most potential to increase in value, such as real estate (e.g., a vacation home), expensive art, furniture, jewelry, and closely held business interests, offer the best tax savings opportunity.

Gifting may be done in several different forms. These include direct gifts to individuals, gifts made in trust (e.g., grantor retained annuity trusts and qualified personal residence trusts), and intra-family loans. Currently, you can also employ techniques that leverage the temporarily high exemptions to potentially provide an even greater tax benefit (for example, creating a family limited partnership may also provide valuation discounts for tax purposes).

For high-net-worth married couples, gifting to an irrevocable life insurance trust (ILIT) designed as a dynasty trust can reduce estate size while providing a substantial gift for multiple generations (depending on how long a trust can last under the laws of your particular state). The value of the gift may be increased (leveraged) by the purchase of second-to-die life insurance within the trust. Further, the larger exemptions enable you to increase, gift tax free, the premiums paid for life insurance policies that are owned by the ILIT or other family members. Premium payments on such policies are taxable gifts, so these premium payments are often limited to avoid incurring gift tax. This in turn restricts the amount of life insurance that can be purchased. But the increased exemption in 2012 provides the opportunity to make significantly greater gifts of premium payments, which can be used to buy a larger life insurance policy.

The increased exemption may also prove beneficial for same-sex couples whose estate planning is limited due to a lack of gift or estate tax marital deduction. At least for 2012, assets of significant worth can be transferred between partners without gift tax consequences.

Before implementing a gifting plan, however, there are a few issues you should consider.

• Can you afford to make the gift in the first place (you may need those assets and the related cash flow in the future)?
• Do you anticipate that your estate will be subject to estate taxes at your death?
• Is minimizing estate taxes more important to you than retaining control over the asset?
• Do you have concerns about gifting large amounts to your heirs (i.e., is the recipient competent to manage the asset)?
• Does the transfer tax savings outweigh the potential capital gains tax the recipient may incur if the asset is later sold? The recipient of the gift gets a carryover basis (i.e., your tax basis) for income tax purposes. On the other hand, property left to an individual as a result of death will generally receive a step-up in cost basis to fair market value at date of death, resulting in potentially less income tax to pay when such an asset is ultimately sold.

Caution: The amount of gift tax exemption you used prior to 2012 will reduce the $5,120,000 available to you under the 2010 Tax Act. For example, a person who used $1 million of his or her exemption prior to January 1, 2012, will be able to make additional gifts totaling $4,120,000 during 2012 free from gift tax.

Tip: In addition to this limited opportunity to transfer a significant amount of wealth tax free, it’s important to remember that you can still take advantage of the $13,000 per person per year annual gift tax exclusion for 2012. Also, gifts of tuition payments and payment of medical expenses (if paid directly to the institutions) are still tax free and can be made at any time.

In December 2010, Congress extended the so-called Bush-era tax cuts. However, for investors, the legislation may have been a stay of execution rather than a full pardon. As of January 1, 2013, federal tax rates on income, qualifying dividends, and capital gains (among other provisions) are scheduled to revert to previous levels.

Given recent partisan wrangling, no one can be completely sure about precisely what will happen. Even if all the scheduled changes don’t ultimately go into effect, others likely will. In the meantime, as the clock ticks closer to some sort of decision point, it might make sense to review your portfolio and do some “what-if” planning for various scenarios. Taxes obviously are only one factor–and not necessarily the most important one–in decisions about your portfolio; think of this as a chance to fine-tune your planning efforts.

Capital gains
You’ll want to pay attention to scheduled changes in tax rates, especially if your income is more than $200,000 a year ($250,000 for you and your spouse, $125,000 if married and filing separately). Absent further action, current tax rates will be replaced by five federal tax brackets rather than six (see table) and the top long-term capital gains rate will go up.

If you’re considering selling an asset that has appreciated substantially, determine whether you should do so this year rather than next. Even if some current income tax rates are extended, individuals or households with incomes above the $200,000/$250,000 limits might still face higher rates. If you’re above the threshold, you could be hit simultaneously with a higher capital gains rate on the proceeds of your sale and a higher income tax rate.

Don’t forget the alternative minimum tax in your calculations. Although the AMT doesn’t apply directly to long-term capital gains and qualifying dividends, they’re included when calculating your taxable income under the AMT. If realizing a large capital gain indirectly increases your AMT exposure or might push you into the phaseout range for AMT exemptions, that could potentially wipe out any tax savings from selling this year.

If you think an investment will continue to be a sound one but feel you would benefit from selling prior to 2013 to take advantage of current low rates on existing gains, you could sell the investment and repurchase it later. That would give you a higher cost basis for any subsequent sale, potentially reducing your tax liability at that point. Also, even if you do decide to sell, you don’t necessarily need to do so all at once. The tax cuts that produced the current rates have already been extended once, and it could happen again. Repositioning your portfolio gradually could moderate the risk of a single badly timed sale. There also are a variety of strategies for managing concentrated stock positions; get expert help before deciding that selling is your only choice.

Dividends
There’s another reason the scheduled tax bracket changes are important. As of 2013, qualifying dividends are scheduled to be taxed as ordinary income, as they were before 2003, rather than at the lower rate for long-term capital gains. The higher your tax bracket and the more you rely on dividends for income, the more you should be aware of the potential impact of that change on you.

However, remember that taxes aren’t the only factor you should consider in making a decision. Dividends can still represent a welcome income alternative to interest rates that are expected to remain at rock-bottom levels through mid-2015. And with baby boomers beginning to reach retirement age, interest in any and all sources of ongoing income is unlikely to disappear. As with capital gains, many factors will affect your decision about the role of dividends in your portfolio.

Investment income/payroll taxes
There’s another factor you may need to be aware of. Beginning in 2013, a new 3.8% Medicare contribution tax will be imposed on some or all of the unearned income of individuals with high modified adjusted gross incomes (see table). Also, the hospital insurance portion of the payroll tax is scheduled to increase by 0.9% for higher-income individuals. However, unless you exceed the specified thresholds, neither provision will affect you.

If you expect to be affected by the new taxes and/or a higher tax bracket, the benefits of tax-free investments might become even more pronounced. Taxable bonds typically pay higher interest rates than municipal bonds, but if you’re in a high tax bracket, munis can potentially offer a better after-tax return. As with any investment decision, there are many factors to consider. Local and state governments have come under severe financial pressure, and though the default rate on munis has traditionally been low, a default is always possible. Also, interest rates have been at historic lows since the end of 2008; since bond prices move in the opposite direction from their yields, rising interest rates would not be good news for bond prices.

Good time for a checkup
If you do decide to make adjustments, this year will require a tradeoff in timing them. Postponing action may give you more clarity, but waiting until the last minute could potentially leave you caught in a stampede for the door at year’s end, or trying to make decisions during a volatile period. If you decide to sell, make sure you’ve allowed enough time to accommodate trade settlements and holiday schedules.

Investments in tax-deferred accounts, such as IRAs or 401(k)s, won’t be affected by any tax changes until you withdraw the money, so unless you’re contemplating the timing of a withdrawal, you may not need to worry much about them. However, if you’ve been considering a Roth IRA conversion, find out whether you would reduce your tax liability by converting in 2012 rather than later.
Even if 2013 seems unlikely to have much impact on you, this could be a good time for some routine portfolio maintenance. And if you think you might be affected by any of the above situations, it’s especially important to get expert help.

Tax increases and automatic spending cuts that take effect in 2013 will increase government revenue and significantly cut the budget deficit. However, that comes at the cost of economic conditions “that will probably be considered a recession.” That’s the conclusion reached by the nonpartisan Congressional Budget Office (CBO) in a recent report. The report also documents some of the factors and conditions that make addressing the situation so contentious. (Source: Congressional Budget Office , An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022, August 2012.)

Projections for the remainder of 2012
The CBO notes a modest expansion of the economy in the first half of 2012, and expects a slight increase in expansion during the last half of the year. Despite this economic expansion, the CBO does not anticipate any significant reduction in the unemployment rate, which the CBO projects to average 8.2% during the last six months of 2012. The CBO also anticipates continued low inflation and interest rates on federal borrowing. The CBO report specifically points out that projections for the remainder of 2012 reflect the view that “private-sector spending later this year will be limited by the specter of fiscal tightening and a looming recession in 2013.” In other words, even though the tax increases and spending cuts don’t take effect until 2013, we’re already feeling the effects.

What happens in 2013 (understanding the “fiscal cliff”)?
The failure of the deficit reduction supercommittee to reach an agreement in November 2011 automatically triggered $1.2 trillion in broad-based spending cuts over a multiyear period beginning in 2013 (the official term for this is “automatic sequestration”). The automatic cuts will be split evenly between defense spending and nondefense spending. In addition, a number of significant tax breaks expire at the end of 2012. The expected economic impact of the combination of mandatory spending cuts and tax increases has been deemed by many the “fiscal cliff.” 

Significant tax provisions that expire at the end of 2012 include:

 Lower federal income tax rates, part of the tax landscape for more than 10 years, return to pre-2001 levels beginning January 1, 2013. The top federal income tax rate will jump from 35% to 39.6%, and the maximum rate that applies to long-term capital gains will generally increase from 15% to 20%. Qualifying dividends, now taxed at lower long-term capital gain rates, will once again be taxed as ordinary income.

The temporary 2% reduction in the Social Security portion of the Federal Insurance Contributions Act (FICA) payroll tax, in place for the last two years, will no longer apply.

Current rules relating to the federal estate and gift tax expire (exemptions will substantially decrease, and the tax rates will substantially increase).

Lower alternative minimum tax (AMT) exemption amounts (the AMT-related provisions actually expired at the end of 2011) mean that there will be a dramatic increase in the number of individuals subject to AMT when they file their 2012 federal income tax returns in 2013.

Also beginning in 2013, two new taxes take effect. The hospital insurance (HI) portion of the payroll tax–commonly referred to as the Medicare portion–will increase by 0.9% for high-wage individuals, and a new 3.8% Medicare contribution tax will be imposed on some or all of the net investment income of high-income individuals.

CBO projections for 2013 and beyond
The CBO projects that as a result of currently scheduled policy changes, including the tax increases and spending reductions that take effect in 2013, the budget deficit will drop significantly. According to the CBO, however, this fiscal tightening will likely lead to a recession. The CBO expects growth in GDP to decline in 2013, with the unemployment rate rising to about 9% in the second half of calendar year 2013, and remaining above 8% through 2014.

It’s budget deficit considerations, in part, however, that make reaching agreement on action so difficult. Extending lower tax rates and other popular tax provisions might help in the short term–potentially preventing the projected recession–but would, the CBO says in its report, “boost deficits and debt significantly and would place the budget on a path that is ultimately unsustainable.” Under an alternative fiscal scenario evaluated by the CBO (in which most of the expiring tax provisions are extended and the mandatory spending cuts do not occur), the economy in 2013 would be stronger, but deficits over the next 10 years would be much higher in comparison; outlays would consistently outpace revenues, and debt held by the public would climb to 90% of GDP by 2022.

What to expect
There seem to be only three things that all parties agree on. The first is that something should be done to prevent the automatic spending cuts from going into effect in their current form. The second is that at least some of the expiring tax provisions should be extended. The third is that no one expects any real compromise or meaningful negotiation until after the November election. 

If, as many expect, the issue is tabled until after the election, that will leave only a few weeks to reach agreement. The likelihood of action, and the form that any compromise might take, will depend in part on the post-election political dynamics. So stay tuned.

Potential Increase in Federal Income Tax May Make 2012 Roth Conversions Attractive

When you convert a traditional IRA to a Roth IRA, the conversion is generally taxed as ordinary income (except for any after-tax, nondeductible contributions you’ve made). With the “Bush tax cuts” set to expire at the end of 2012, federal income tax rates will jump up in 2013. Unless Congress acts, we’ll go from six federal tax brackets (10%, 15%, 25%, 28%, 33%, and 35%) to five (15%, 28%, 31%, 36%, and 39.6%). While there continues to be discussion about extending the expiring tax cuts, many believe there’s little chance of resolution until after the November election.

While no one can predict what Congress will ultimately do (or not do), 2012 may present an opportunity to convert a traditional IRA to a Roth IRA at a potentially lower tax cost than if you wait until 2013.

You can convert now, or you can take a wait-and-see approach–you have until December 31 to make a 2012 Roth conversion. Either way, if converting turns out to be the wrong decision, you’ll have until October 15, 2013, to “undo” your conversion, and it will be treated for federal tax purposes as if it never occurred.

Keep in mind that the potential 2013 tax rate increase is just one factor to consider when deciding if and when you should convert a traditional IRA to a Roth IRA. If you’ll need to pay the conversion tax with IRA funds, or if you think you’ll be in a lower tax bracket when you begin taking distributions, a Roth conversion may not be right for you.

You Have Until October 15, 2012, To Undo a 2011 Roth Conversion

If you converted a traditional IRA to a Roth IRA in 2011, and your Roth IRA has sustained losses, you may want to consider whether it makes sense to undo (recharacterize) your conversion. You have until October 15, 2012, to undo your 2011 conversion. (If you’ve already filed your federal income tax return for 2011, you’ll need to file an amended return if you recharacterize.) A recharacterization can help you avoid paying income tax on the value of IRA assets that have been lost. When you recharacterize, your conversion is treated for tax purposes as if it never happened.

For example, assume you converted a fully taxable traditional IRA worth $100,000 to a Roth IRA in 2011. However, due to market volatility, that Roth IRA is now worth only $60,000. If you don’t undo the conversion you’ll pay federal (and possibly state) income tax on $100,000, even though the current value of those assets is only $60,000. If you undo the conversion, you’ll be treated for tax purposes as if the conversion never happened, and you’ll wind up with a traditional IRA worth $60,000–and no resulting tax bill.

If you recharacterize your 2011 conversion, you’re allowed to convert those dollars (and any earnings) to a Roth IRA again (“reconvert”) but you’ll have to wait 30 days, starting with the day you transferred the Roth dollars back to a traditional IRA. Keep in mind that even though the amount you recharacterized, and any earnings, is subject to a 30-day waiting period, any other amounts in your traditional IRAs are not subject to the waiting period, and you can convert all or part of those dollars to a Roth IRA at any time.

Whether it makes sense to recharacterize your Roth conversion depends on several factors, including the extent of the losses in your Roth IRA, and your expectations of where the markets may be headed. Your financial professional can help you decide if a recharacterization is right for you.

Currently, the exemptions for federal gift tax, estate tax, and generation-skipping transfer (GST) tax are at historic highs, and the gift, estate, and GST tax rates are at historic lows. But, in 2013, the exemptions are scheduled to substantially decrease, and the tax rates are scheduled to substantially increase. This raises the question of whether 2012 might be a good time to make large gifts that take advantage of the current large exemptions while they are still available.

End of 2012 changes loom

The exemptions (there is one for gift and estate tax, and a separate one for GST tax) are currently $5.12 million in 2012, but are generally set to decrease to $1 million in 2013, and the top transfer tax rate is generally set to increase from 35% in 2012 to 55% in 2013. (In general, a married couple’s exemptions would decrease from $10.24 million in 2012 to $2 million in 2013.) Of course, no one knows what the future holds for these taxes, and there is a lot of speculation about what Congress might do. The exemptions could decrease, increase, or stay the same, and tax rates could increase, decrease, or stay the same.

When evaluating whether to make a large gift in 2012, the following should generally be considered: the size of your estate and the rate at which it can be expected to grow (or decrease), whether you can afford to make large gifts, what the future of the transfer taxes might be, and whether “claw back” would apply in future years.

Claw back

Claw back refers to the possibility that the benefit of the gift using the $5.12 million exemption would be later recaptured if the exemption is only $1 million at the time of death. There is some split in opinion as to whether claw back applies to the estate tax.

 Example(s):   Assume the gift tax and estate tax change as currently scheduled in 2013 and claw back applies. Assume you make a taxable gift of $5 million in 2012 that is fully protected by your gift tax exemption and you have a taxable estate of $5 million when you die in 2013. Estate tax, after reduction by the unified credit but not the state death tax credit, is $4,795,000. The result is essentially the same as if you had not made the taxable gift in 2012 and your taxable estate is $10 million in 2013.

Assume the same facts as above, but with no claw back. Estate tax, after reduction by the unified credit but not the state death tax credit, would be $2,750,000. So, the federal estate tax is $2,045,000 lower if there is no claw back.

The bottom line

It may be useful to note that, under any future transfer tax scenario, a person who makes a large gift sheltered by the exemption now will generally be no worse off at death than if he or she had not made the gift. However, if the exemptions decrease and tax rates increase as currently scheduled and there is no claw back, transfer taxes may be saved by making the large gift now. Furthermore, if the property transferred by gift later increases in value, there may also be transfer tax savings by removing the appreciation from the transfer tax system.

An estate planning professional can help you evaluate the benefit of making a large gift in 2012 to take advantage of the current large exemptions.

Women are increasingly taking responsibility for managing their own money. That includes those who in the past may have left investing to a spouse because they were busy raising a family or had no interest in the subject, but who have since found that divorce, a spouse’s death, or the need to help a parent have forced them to learn some investment basics. However, many women, including high-level professionals who are experts in their field, may not feel confident about their investing abilities. If you’re one of them, you may have more going for you than you think. Traits such as patience, willingness to confront and deal with mistakes, and recognizing when help is needed can benefit portfolio returns, particularly for a long-term investor. Even risk aversion, sometimes a problem for women who are concerned about their investing abilities, can be an advantage if it’s applied wisely.

Feel you aren’t as knowledgeable as you should be about investing?

Chances are you’re in good company. Plenty of people know less than they should but aren’t willing to recognize or admit it; as a result, their portfolios suffer. Recognizing what you don’t know can be an asset. Being willing to ask questions and understand some basics will serve you better than sticking your head in the sand. Also, being a good investor doesn’t mean you need to do all the work yourself. A financial professional can help you set a strategy, select specific investments, monitor their performance, and make adjustments as circumstances dictate.

If you make a mistake, can you admit and deal with it?

Many investors’ portfolios have suffered because of a failure to recognize an investing mistake and deal with it; instead, their owners hang on, waiting for a turn around that may never come. As the saying goes, “Good investors know how to take profits; great investors know how to take losses.” There’s never been an investor who hasn’t experienced losses; smart ones follow a discipline that helps them know not only when to buy but also when to sell an investment or adjust a strategy that hasn’t worked.

Are you risk averse in the right way?

When people feel unsure about their investing skills, they sometimes take the path of least resistance and invest very conservatively. In some cases, this can be helpful. For example, avoiding big risky bets that can single-handedly drag down a portfolio can sometimes lead to better risk-adjusted performance. However, this trait can also be a double-edged sword if you’re investing far more conservatively than is appropriate for your goals and circumstances, either out of fear of making a mistake or from not being aware of how risks can be managed. Being unaware of how inflation can affect investment returns or how to balance various types of risks can leave you vulnerable to a shortfall in your retirement savings or other financial goals. You don’t have to become a financial wizard to understand principles that can help you manage risk. Having a child involves many risks, but it’s the rare parent who knows everything that will be needed before taking the plunge. You prepare as best you can and improve as you go along; it’s the same with investing. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investment strategy will be successful. But perhaps the biggest risk of all is not taking the steps needed to secure your financial future.

Can you be patient?

Excessive trading costs have historically been one of the reasons individual investors often underperform the stock market as a whole. One study found that because women are less likely to indulge in excessive trading, they outperform men.* A portfolio is—or should be–a means to an end, not a competitive sport. It’s a way to pursue your financial goals, rather than a measure of self-worth or a vehicle for bragging about how you “beat the market.”

Potential investments are all around

Odds are you make many purchasing decisions every day. That means you have a lot of opportunities to observe products and consumer behavior. Everyday life can be a rich source of information that can be applied to investments. For example, if all your friends seem to be flocking to a new retailer or buying a certain type of computer, you might be seeing an emerging trend or company whose value hasn’t yet been recognized by Wall Street. That doesn’t mean you should invest without additional research, of course, but your own daily experience can suggest ideas to explore. Conversely, if you notice that a trendy item that was so hot last year now seems to be showing up more often in clearance bins than shoppers’ carts, you might want to see whether the stock is a candidate for sale.

Step up your game

If you’re afraid to make decisions because you don’t know a mutual fund from a muffin top:

• Get some basic information. Your retirement plan at work might provide educational materials or assistance, and there are plenty of books, magazines, and websites that can help. Don’t be afraid to talk to friends who may have similar questions, but do your own research, too.

• Take baby steps and learn as you go. You don’t have to do everything at once; even a small step is better than none.

• Don’t postpone getting started; the longer you wait, the fewer options you may have. Even if you don’t make your own financial decisions now, the odds are good that you may someday have to do so.

• Recognize that you’re not alone. Others may have the same doubts as you about their investing abilities.

If you’ve already started working toward your goals but aren’t sure you’re on the right track:

• Clarify your investing goals, your time horizon, and your level of risk tolerance and make sure you’re properly diversified. If you’re not sure how your money is invested, get whatever help you need to develop an asset allocation strategy that’s appropriate for your goals and risk tolerance.

• Make sure your expectations for a return on your money are both realistic and sufficient to give you the best chance of achieving your goals. Don’t focus solely on risk, but also on potential reward and ways to try to manage risk. And remember that an investment’s past performance is no guarantee of its future results.

• Some investments offer potential growth, some focus on protection of your initial investment, and some provide regular income payments. Understand what you own and what role each investment fills in your portfolio. Though diversification can’t guarantee a profit or eliminate potential loss, it can help you manage the types and level of risk you take.

• An investment club can be a way to explore investing in a social setting. The National Association of Investors Corporation can help you start or find one.

If you’re money savvy:

• To ensure that you’re making the most of your money, benchmark the performance of your investments and your portfolio as a whole against a relevant index or model portfolio.

• Make sure your asset allocation adjusts to changes in your life circumstances.

• Don’t underestimate the impact of taxes, fees, expenses, and trading costs on portfolio performance. If you’ve amassed substantial assets, you might benefit from expert help in dealing with issues such as taxes, estate planning, and asset protection.

• Have a game plan to keep yourself from panicking during volatile markets. Equipping yourself to pursue your financial goals is time well invested.

Note: Before investing in a mutual fund, carefully consider its investment objective, risks, fees, and expenses, which can be found in the prospectus available from the fund.
*”Behavioral Patterns and Pitfalls of U.S. Investors,” August 2010 Library of Congress report for the SEC.