Basics of Estate Planning

December 29, 2008

Estate Planning Is An Essential Need

A carefully prepared estate plan will allow you to achieve many goals. Ensure the financial security of your spouse; determine what should be left to the children and how their inheritances should be handled if they are young; dispose of the family business; minimize the effects of taxes on your estate; empower a reliable executor and trustee to invest and manage the assets in your estate.

The need for planning
By having a will, which is the basic estate planning tool, you can prevent two costly mistakes: lack of experienced management assistance for your family and the possible loss of thousands of dollars through needless taxation on your estate. But effective estate planning often requires more than a will.

Life insurance proceeds, for example, usually are not governed by the terms of a will. Neither are benefits payable from retirement plans. Yet such assets loom large in many estates. Your planning should encompass all the financial resources that can be used to attain your goals.

A sound foundation for your plan
Comprehensive estate planning demands teamwork. With you at the helm, our estate planning specialists can help you and your attorney design a plan to fulfill your objectives. Together we shall go through a series of important steps:

• Obtain the necessary personal data about yourself and your family.
• Help prepare a balance sheet of your assets and liabilities.
• Assist with the review of your will and any existing trusts.
• Evaluate your estate tax options, such as the best method of disposing of your share of community property—taking into account the unlimited marital deduction and the use of tax-sheltered trusts.
• Consider the best way to distribute your retirement plan benefits.
• Compute potential estate, gift and income tax liabilities, advising on the most practical and economic solutions.
• Determine the availability of liquid assets to meet potential estate expenses and taxes.

Strategy for wise decisions
From this analysis a plan will emerge. It may involve changing your will and naming us to settle your estate. It may involve suggestions for tax savings through the use of trusts, an adjustment in life insurance coverage, a program of lifetime giving. It even may result in suggestions for the orderly transition of the family business from one generation to the next.

Effective estate planning requires teamwork. We will work closely with you and your other advisers to help develop the best estate plan for you and your family.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Securities offered through LPL Financial, Member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, a registered investment advisor.

© 2006 M.A. Co. All rights reserved.
Any developments occurring after January 31, 2006, are not reflected in this article.


Income that the IRS can’t touch

December 26, 2008

Municipal Bonds

There’s one readily available and legal source of untaxed income that we know of: municipal bonds. These securities are issued by state and local governments, school districts, hospitals and other public agencies to support community projects and services. To permit these worthy endeavors to raise money economically, Uncle Sam exempts the interest that they pay from federal income tax. And state governments usually do the same for bonds issued within their borders.

As a result, these tax-advantaged “munis” only pay about 75%-90% of the interest that you’d earn on a taxable bond of comparable maturity and credit quality. So, depending on your tax bracket, munis actually may give you higher after-tax income. To figure the equivalent taxable yield of a tax-free bond, divide its yield by one minus your tax rate expressed as a decimal. Thus, if your tax bracket for 2006 is 35%, a 5% tax-free yield would be worth 5% divided by 0.65, or 7.69%.

If you live in a high-tax state, this advantage can be even more dramatic. Suppose that you pay an 8% state tax. Because you deduct state tax from your federal income, your effective state tax is 5.20% (8% x .65), and your combined tax rate is 40.20%. So you’d divide that 5% by .598 (1-.402) and get 8.36%. In that case, you’d prefer the 5% muni issued in your state to any comparable taxable bond paying less than 8.36%. The table at the end of this article shows taxable-equivalent yields for each 2006 federal tax bracket. Obviously, the higher your tax bracket, the larger the benefit of tax-advantaged investments.

Types of municipal bonds
According to their issuers and their terms, munis fall into several distinct categories.

General obligation bonds are backed by the full taxing power of the city or state that issues them.

Revenue bonds pay their coupons and repay their principal from the revenues of the projects that they fund, which can be toll bridges, airports or other public facility.

Private activity bonds are issued in support of private projects, such as industrial parks or shopping malls, intended to bring business to the community. Although income from these bonds issued after August 1, 1986, is exempt from income tax, it is hit by the alternative minimum tax when earned by investors subject to the AMT. This threat tends to push the yields of these bonds up a bit, boosting their attraction for investors not affected by the AMT.

Zero-coupon municipal bonds are sold at a large discount from their face value and pay no current interest. The investor instead receives the full face value at maturity, with all the gain tax free.

Prerefunded bonds. With the relatively low interest rates of the last few years, some municipalities have issued bonds to pay for the redemption of older, higher-yielding bonds on their call date. Until that time the money is usually parked in U.S. Treasury securities. As a result, the prerefunded older munis carry an extra measure of safety.

Risk management
As with other fixed-income securities, munis are subject to two distinct types of risk:
Interest rate risk refers to the fact that a bond loses value in the secondary market when interest rates rise. Nobody will pay full price for a 5% bond when new bonds are available that pay 6%. So, if you need to sell a bond in that situation, you’ll have to accept a price that will give the buyer a competitive yield.

On the other hand, if interest rates fall, the value of your bonds will rise. Don’t count your chickens, though. Most munis carry call provisions allowing the issuer to redeem the bonds early at a specified date, usually with the payment of a call premium. Note that any loss that you take on the sale of a muni may be used to offset capital gains plus up to $3,000 of ordinary income. Any gain, however, may be subject to ordinary income tax (not the reduced capital gains rate).

Of course, if you hold a bond to maturity, interest rate risk is not an issue. Credit risk refers to the possibility that the issuer will default on the timely payment of interest and/or principal. Albeit a rare occurrence, we had the 1994 example of Orange County, California, to impress this possibility upon us. Naturally, lower-rated issues carry higher yields, but of late the spread between high-quality and junk bonds has been little more than 1%. So it’s hardly worth accepting the extra risk for the marginal boost in income.

As mentioned above, pre-refunding can enhance the safety of a bond. More common, however, is the use of insurance to upgrade an issue’s quality. Issuers purchase private insurance that guarantees payment of interest and principal in the event of a default. Bonds thus covered automatically gain an S&P rating of AAA.

Another way to protect a tax-advantaged portfolio is diversification. Bonds of different types, from widespread issuers, and of varying maturities cushion the effect of trouble in any one sector. Because most munis are issued in multiples of $5,000 or $25,000, such diversification is not possible for most individual investors. For a tax-advantaged portfolio of less than $500,000 or so, experts recommend investing in either tax-advantaged money managers or unit investment trusts.

If tax-advantaged income at the yields available currently fits your financial needs, we’re ready to help you build a working portfolio.

Taxable equivalent yields
Equivalent Taxable Yield* by Tax Bracket in 2006
Muni Yield 10% 15% 25% 28% 33% 35%
3.00% 3.33% 3.53% 4.00% 4.17% 4.48% 4.62%
3.50% 3.89% 4.12% 4.67% 4.86% 5.22% 5.38%
4.00% 4.44% 4.71% 5.33% 5.56% 5.97% 6.15%
4.50% 5.00% 5.29% 6.00% 6.25% 6.72% 6.92%
5.00% 5.56% 5.88% 6.67% 6.94% 7.46% 7.69%
5.50% 6.11% 6.47% 7.33% 7.64% 8.21% 8.46%
6.00% 6.67% 7.06% 8.00% 8.33% 8.96% 9.23%
*Federal tax only. If an investor is subject to state and local income taxes, equivalent yields would be higher.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Securities offered through LPL Financial, Member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, a registered investment advisor.

© 2006 M.A. Co. All rights reserved.
Any developments occurring after January 31, 2006, are not reflected in this article.

Managing Risk with a Diversified Portfolio

December 22, 2008

Diversified Stock Portfolio

Diversification is a fundamental investment concept that most investors have no trouble understanding. If, for example, an investor owns equal dollar amounts of only two stocks, and one suffers a 50% loss, his or her portfolio has gone down in value by 25%. But if the investor owns ten stocks, and one drops by 50%, his or her portfolio has suffered only a 5% loss.

With a diversified stock portfolio, risk may be reduced because different stocks tend to rise and fall independently of each other. On a broader scale, combinations of different investment assets may help balance out each other’s fluctuations in price, lowering, though not eliminating, the overall risk.

Categorizing risk
The ultimate goal in a diversification strategy is to improve investment performance while managing risk. One way to categorize risk is to distinguish between unsystematic risk and systematic risk.

Unsystematic risk is risk that is specific to a company. Often, this risk involves some kind of dramatic event such as a strike, a fire or some natural disaster. A company’s slumping sales also fall within this category. Diversification among the stocks of many companies reduces unsystematic risk because, of course, it’s highly unlikely that every one of the unhappy events listed above will occur in all companies.

Conversely, some events can affect all companies at the same time. This systematic risk includes such occurrences as inflation, war and fluctuating interest rates—generally, those events that influence the entire economy. Of course, diversification cannot eliminate the likelihood of these events happening. Systematic risk accounts for most of the risk in a diversified portfolio.

A diversified stock portfolio: how much?
One way that academic researchers measure investment risk is by looking at stock price volatility. A classic 1968 study by J.L. Evans and S.H. Archer, “Diversification and the Reduction of Dispersion,” concluded that an investor who owned 15 randomly chosen stocks would have a portfolio no more risky than the market as a whole. This research confirmed earlier advice, coming from instinct and experience, that Benjamin Graham gave to investors in his 1949 book, The Intelligent Investor. Graham recommended owning from ten to 30 stocks to achieve proper diversification.

A study published in 2001 (“Have Individual Stocks Become More Volatile?” by John Campbell, Martin Lettau, Burton Malkiel and Yexiao Xu) suggests that those numbers may be too small. To replicate the risk of the market as a whole, according to the study, the “excess standard deviation” of portfolio returns needs to be brought down to 5%. In the 20 years ending in 1985, an investor could have achieved this goal by owning 20 stocks. But, in the period from 1986 through 1997, the professors concluded that one needed to own 50 stocks to reach the same result!

Choices in diversification
Of course, an investor who invests for income will diversify his or her holdings among different bonds. In this case diversification usually means owing long-, intermediate- and short-term government bonds. Other categories might include, when appropriate, municipal, corporate and, sometimes, high-yield (“junk”) bonds.

It is possible for an entire asset class to do poorly for an extended period of time (as we have seen in recent years). Therefore, it’s a common diversification strategy for investors to spread their money across asset classes—including, for example, stocks, bonds, cash instruments, and real estate—in their portfolios.

Finally, some investors may want to think in global terms. By investing outside of the U.S., investors are addressing the risk of extended bear markets at home. Global investing includes additional risks, however, such as currency fluctuations and political uncertainty.

May we offer our assistance?
Risk always will be a cause for concern. There’s always a fear of the unknown. Still, knowledge and experience can help improve the odds that you’ll achieve success as an investor in the long term.

We’ll be glad to help you develop a strategy that meets your specific needs as an investor. One designed and implemented to take only the risks with which you are most comfortable. We look forward to the opportunity to tell you more.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price. Stock investing involves risk including loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. Past performance is no guarantee of future results.

Securities offered through LPL Financial, Member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, a registered investment advisor.

© 2006 M.A. Co. All rights reserved.
Any developments occurring after January 31, 2006, are not reflected in this article.

A Valuable Business Tool: Buy-Sell Agreements

December 19, 2008

How To Prepare For Possible Changes In Your Company

When you own a company, by yourself or together with one or more partners, you pour heart and soul into making it a success. Indeed, the process of bringing a business into existence and then nurturing it and building upon its success is so engrossing and exhilarating that it’s easy to lose sight of one sobering fact: You and each of your co-owners (partners or shareholders) one day will take leave of the company. It may be by retirement, disability or death. Someone may feel the need to move on. A partner may be tempted by a third party’s offer for his or her share of the enterprise.

Potentially, any of these situations can throw a going business and/or the family of a deceased owner into chaos. A family may be forced to sell its share to cover taxes on the estate—if it can find a willing buyer. Remaining partners may not be able to get along with an interloper who comes into the business through purchase or inheritance. In an S corporation, the new shareholder may not be of a class eligible to hold such shares, thus forcing a reorganization.

A versatile tool
Buy-sell agreements provide a powerful business succession tool that owners of small-to-medium-sized companies can use to address any or all of these eventualities. A form of shareholder agreement, the buy-sell agreement is a contract spelling out what will happen to the equity of a departing shareholder when a “triggering” event occurs.
Buy-sell agreements will generally fall into one of two categories:
• In a cross-purchase agreement, the shares or interest of the departing partner are to be bought by the surviving or remaining partners. In a sole proprietorship, the designated purchaser would be the owner’s chosen successor, whether a family member involved in the business or a key employee vital to its continuation.
• In a stock redemption plan, the equity or shares are bought and retired by the corporation or partnership, thereby increasing the remaining shareholders’ share of the company’s equity.

The choice between these options will depend on the company’s structure and the resources available to fund the purchase. Agreements may set varying terms for different triggering events. For example, a lower price may be paid to a partner leaving to set up a competing business. Purchases might be mandatory upon the death or disability of a partner, whereas voluntary or forced withdrawals might give the business only “the right of first refusal”—to match a first legitimate outside offer, if it so chooses.

Funding choices
Often life insurance and, less frequently, disability insurance are used to fund buy-sell agreements. The contractual buyer purchases a policy on the prospective seller’s life. The proceeds are earmarked to purchase the business interest from the heirs of the deceased owner, and the cash value is available to fund purchases in other situations. In cross-purchase agreements each owner needs to have a policy on the life of each of the other owners.

Because this process can be quite cumbersome when there are multiple owners, a stock redemption plan may be more workable. In that case, the business owns and funds a single policy on each owner’s life. Life insurance cash value is carried as an asset on the corporate balance sheet and will not be considered an excess accumulation of earnings if it does not exceed the reasonable needs of the business.

The hard part
Placing a value on a closely held business can be a challenge. Placing a future value is nigh on impossible. For this reason it may be best to specify a reasonable method that will be used to determine the price to be paid, or to recalculate the price periodically.

Methods that may be appropriate, depending on the nature of the business, can be to: capitalize average earnings over a period of years; calculate the loan amount that the company’s cash flow will support; total the tangible assets on the balance sheet; place a value on the business’ intangible assets (often its customer base); or simply apply an industry rule of thumb. Any method specified in a buy-sell arrangement that represents a true arm’s length valuation will be binding on the IRS for estate tax purposes.

The payoff
A well-structured buy-sell agreement can provide a panoply of benefits:
• ensuring an orderly transfer of business interests, preventing forced liquidation;
• protecting the heirs of minority owners who otherwise might end up with a holding of restricted, non-dividend-paying stock;
• preventing a sale to outsiders or inheritance by someone not active in the business;
• persuading a key employee to remain in the business;
• establishing the value of a deceased owner’s shares for estate tax purposes.

If you run a business, we’re always ready to work with you and your advisers to develop buy-sell agreements and all other financial services available to help your enterprise thrive.

Securities offered through LPL Financial, Member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, a registered investment advisor.

© 2006 M.A. Co. All rights reserved.
Any developments occurring after January 31, 2006, are not reflected in this article.

Planning For Long-Term Care

December 17, 2008

Understanding Long-term Care Insurance

As anyone with an elderly relative or friend who is unable to provide for his or her own care can tell you, the cost of that care—whether at home or in a facility—is a major expense. The financial outlay for such care, because of advanced age or chronic illness or injury, may not be an issue for the very rich, with significant personal resources, or the very poor (who qualify for government assistance). But, for the vast majority of people, whether to purchase a long-term care insurance (LTCI) policy is a worthy topic for discussion. Below we provide a few questions and answers that may assist in determining whether you want LTCI coverage.

1. How likely is it that you will need long-term care?
According to the National Council of Insurance Commissioners, one person in three who turned 65 in 1990 will stay in a nursing home, with one in ten staying five years or more. On the other hand, according to recent statistics, over 25 million people in the U.S. between age 65 and age 84 are living independently. Other statistics suggest that those who do spend time in a nursing home usually remain there under a year.

But what about the chances that you will need long-term care? Perhaps one of the best steps that you can take is to evaluate your family’s medical history. You are more likely to need LTCI if there have been instances of early onset of dementia, heart disease or stroke in your family. Longevity may be a factor, too. If your parents, grandparents or their siblings have lived into their 90s or later, it’s not an unrealistic assumption that you will, too—thereby increasing the chances that you will need some kind of professional care or assistance.

2. What does LTCI cover?
Terms differ from policy to policy. Generally, LTCI covers care in a qualified nursing home, in an assisted living facility or in your home. But, often, policies will pay less for care given in the home than in a facility. As is the case with most insurance, coverage offers protection from catastrophic loss of your assets and income should you require assistance. Coverage varies, but the ability to perform a certain number of “activities of daily life” (ADLs) is a common measure of when benefits will be paid. The most common ADLs are: eating, dressing, bathing, transferring in and out of bed, toileting and continence.

3. What kind of LTCI coverage do you need?
LTCI policies offer a wide variety of options. The good news is that you should be able to fashion a policy that closely suits your needs. The not-so-good news is that you are going to have to spend a significant amount of time reviewing different policy options.

Some examples: Based upon your financial circumstances, you may be able to pay for home care and thus need coverage only if you enter a facility. Do you have a relative or a friend who might provide care? Then you’ll want a policy that permits payments to unlicensed caregivers. Again, based upon your resources, you may want to lengthen or shorten the waiting period before coverage begins. You might consider inflation protection, as well.

4. What does it cost?
The cost of LTCI coverage depends upon a variety of factors. Your age at the time that the policy is issued will determine your annual premium. The terms of the policy as well as your health at the time that the policy is issued also will be a factor.

Another consideration is whether your premiums are locked in or may be adjusted in certain circumstances, such as for inflation. Don’t automatically reject a policy that doesn’t lock in your premium rate. It may not necessarily be a good idea: An insurer with insufficient income to meet claims may go bankrupt and, possibly, be unable to pay benefits.

5. Are there any tax breaks available with LTCI?
LTCI premiums are deductible in the same manner as your regular health insurance. Your expenditures are added to your medical expenses, and you may deduct the amount that exceeds 7.5% of your adjusted gross income. The deduction is capped, based upon your age.

Benefits received from LTCI policies may be exempt from federal income tax—if the LTCI policy is “qualified” (i.e., meets government standards). Generally, qualified LTCI policies cannot exclude coverage by type of treatment, medical condition or accident. Pre-existing conditions can be excluded only for the first six months of coverage. And the policies may not be cancelled for reason of nonpayment of premium. Most states now are offering some form of tax incentives for LTCI policyholders as well.

For tax issues involving LTCI in your personal circumstances, contact your tax advisor before taking any action.

Securities offered through LPL Financial, Member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, a registered investment advisor.

© 2006 M.A. Co. All rights reserved.
Any developments occurring after January 31, 2006, are not reflected in this article.