When I was studying economics at Princeton in the 1960’s, Keynesian economics was all the rage. One of the tools that Keynesian economists used was called the Phillips Curve, named after the work of a British economist appropriately named A.W. Phillips.  His research led him to the conclusion that  there  was  a  trade  off  between  inflation  and  unemployment,  and  that  any  gains  in  reducing unemployment came at the cost of increasing the prospects for inflation.  Further, reducing inflation likewise produced increases in unemployment.   The relationship was expressed as a concave sloping curve that was taught as one of the underpinnings of macroeconomics.

In the 1980’s and 1990’s, the relationship between inflation and unemployment broke down, and the “monetarists” discarded the Phillips curve, along with many other Keynesian doctrines.  However, what might have really happened at that time was that the curve shifted DOWNWARDS so that at any given level of inflation, the equilibrium unemployment rate was lower.  In other words, the curve might have moved in the 80’s and 90’s from the SRPC2 to the SRPC1 as shown in the chart below.

The structural change happening now appears to be that this relationship has reestablished itself at a higher level again.   So we have shifted back to SRPC2 again, and the International Monetary Fund has estimated that “structural” unemployment may now be at a level of 6.75%, up from 5%.  This means that any attempts to reduce the high unemployment we see today will be met with an increase in inflation expectations.  A Keynesian tool reincarnated!

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QUALITY STOCKS

I have often mentioned Jeremy Grantham in our newsletters as one of the most rational investors on the planet.  His insights are widely followed so we were interested in his thoughts as summarized in his “Summer Essays” this year.  Below I have taken quotes from his essays and included explanatory thoughts of my own.

“In a rational market, structural selling pressures that are not related to long-term value will create a modest mispricing opportunity into which sensible money will be drawn.  That would be a nice, boring world to live in.”

Instead,  Grantham  contends  that  there  is  now  MASSIVE,  not  modest,  mispricing  of  quality stocks in our current investment environment.  He believes that these top quality stocks are quite undervalued right now, and thus there is an opportunity for higher than average gains by investing in these stocks.   How much higher could these returns be?

“… the excess return for quality could be over 40 percentage points! (This is reflected in our seven-year forecasted difference of 7.3% for high quality and 1.1% for the rest of the S&P 500, compounded over seven years as of June 30.)”

He goes on to elaborate on how long this opportunity is likely to last, and how this compares with the last twenty years for stock investors.

“Supply-demand issues … can be powerful in distorting prices in the short run and even the quite long run, but it is like holding a ping pong ball under water: it needs constant pressure to keep it there. Remove the pressure even for a short while and the normal equilibrium will quickly be restored. In this way, quality stocks might possibly spend much of the next several years underpriced, but from time to time will bounce back to fair value. This is all that patient investors need. It is the converse of the market pattern of the last 20 years: mostly overpriced, but occasionally spiking down to fair value.”
- Summer Essays – July 2010 GMO

While there is plenty of sentiment today for selling all stocks, even quality ones, and substituting bonds for stocks, it is reassuring to read positive thoughts on stocks from one of the masters. RKM Advisors has been recommending that clients concentrate their equity portfolios on quality, both in the US and overseas.  We still suggest holding substantial fixed income investments, as well as global stocks and bonds, supplemented by a stake in funds that offer protection against inflation.

Over the course of twentieth century, such a diversified well balanced portfolio achieved an average return of approximately 3% to 5% above the average rate of inflation.  US stocks alone posted an average return 6.5% above average inflation.  If inflation over the next seven years averages 3%, a relatively optimistic view, it would not be unreasonable to expect stocks to post returns close to 10% and for a prudently diversified portfolio to achieve average returns in the 6% to 8% per year range.

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OTHER INVESTMENT STRATEGIES

Investors have been looking far and wide for better total returns with the returns from cash and bonds so low, and with the stock market being so uncertain.  For a while last year, commodities were providing a handsome return, but those have faded along with the prospects for resurgent inflation.  There has been a nice recovery in Real Estate Investment Trusts, but those have flattened out.   Investments in Asia have done better than elsewhere, but those markets are particularly volatile.

OPTIONS Some investors have explored investing techniques they have never used before, that of writing options on the stocks or ETF’s they hold or want to buy.   Writing a covered call on a position you hold or selling a put option on a company you want to buy provides an income flow that supplements the total return being provided by the portfolio.

PRIVATE EQUITY Investors have looked outside of the traditional investment universe at private equity and venture capital.      Prior  to  the  2008-09  market  meltdown,  only  the wealthiest investors were afforded opportunities like these, but  more  private  equity  has  moved  into  the  mainstream, including a micro private equity fund Richard May manages called the West Chester LLC.

ANNUITIES There are also annuities.   More investors have looked favorably on the returns being offered by the insurance industry.  Fixed and variable annuities offer a tax free accumulation of assets, with the option for a lifetime cash flow in retirement.
Several unusual investments have done better over the past four years than traditional investments. The list below was found on the Huffington Post.

CARS Collectible automobiles have been a profitable investment.  Though collector cars were   down slightly more than the S&P this year, the collector car index has increased more than 61 percent since September 2006, compared with a 16 percent loss in the S&P over the same time period.

WINE The wine equivalent of the S&P 500, the Liv-ex 100 Fine Wine Index, is up 12 percent in   the last three years.  The most rapidly growing market in the world for wine is in China.

GOLD Concerns about an impending economic doomsday are driving the rush to buy up gold, which has taken this precious metal to unprecedented levels.

COLLECTIBLES Antique furniture, artwork, old maps, vintage firearms and other collectibles have found new buyers as investors have fled the traditional investment markets.

Returns from alternative investment strategies tend to be NON correlated with those of stocks  and  bonds,  and  they  allow  an  investor  to  capitalize  on  evolving  opportunities  in  an  ever changing environment.  As the Huffington Post says “Irregular times call for irregular investment strategies.”

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“TAXES” THE NEW FOUR LETTER WORD

No matter what you think about the stimulus and the surge in government spending, one thing absolutely certain is that taxes are going to go up.  As we move further into 2010 without any agreement in Congress about the future of the Bush-era income tax provisions, it becomes more and more likely that “lawmakers will punt and continue the Bush tax cuts for everyone in 2011..the 35% top rate on income and the 15% rate ceiling on capital gains and dividends”. – Kiplinger Tax Letter, 7/23/10

After the mid-term election, probably in 2011, the Feds will start working on comprehensive tax   reform.  Everyone will favor the elimination of loopholes and abusive tax shelters and deductions, at least until they realize that some of these have helped reduce their own tax bill.   After the dust settles on a new Federal tax system, no one will be happy.  Expect less tax breaks, higher rates for both individuals and businesses, and more enforcement.  This is just at the Federal level.

At the state level, there is no end to budget shortfalls.  Tax revenues are down with the economy,   and demand for social services is up, with more people unemployed and more of the population destitute.  New Jersey will continue to slash spending.  Expect Pennsylvania to eventually tax retirement income.  Look for less funding everywhere for education, human services and health care.

Between now and the end of the year, we will be communicating with our clients, offering suggestions to position themselves better for future taxes.  Although no one knows the form of the tax reform, we can identify things to do now to protect oneself against the new reality of taxes in America.

For the past fifteen years, interest rates have been in a cyclical decline, moving from double digit rates to rates today which are very close to zero.   Despite the decline in the income being produced by bonds over this span of time, there have been opportunities for appreciation of fixed income securities, since bond prices rise while interest rates fall.

The massive infusion of money into the economy and the banking system over the past sixteen months has changed the supply and demand characteristics for fixed income securities.   Bond managers say that the result of this is that “government intervention is keeping interest rates artificially low and left to their own devices, rates would go higher.”    Therefore, when the current conditions return to normal, interest rates have nowhere to go but up.   Dan Fuss believes that “we are in the early stages of a long term rise in interest rates.  Managers will be swimming upstream against rising interest rates”.

Credit fundamentals at federal and municipal levels are “absolutely awful” and Fuss does not think it will be possible to bring the US deficit below 4.5% of GDP, almost twice its historical level.   At a recent conference, three prominent bond managers agreed that their asset class will deliver below average and possibly negative returns over the long term.

The headwinds posed by a secular rise in interest rates will be very powerful.

Therefore, RKM is advising clients to substantially reduce the percentage of our clients’ portfolio allocated to and invested in fixed income.     Further, as we have already started doing, more of the specific investments within the bond asset class will be floating or adjustable rates securities and eventually more inflation bonds.

STOCKS

The same fifteen years that saw interest rates in cyclical decline have seen two boom and bust cycles for stocks.   During the late 1990’s and into the year 2000, we saw the technology and internet stock boom that took the Dow Jones Industrial Average above 10,000 for the first time and took the NASDAQ (right) to the unsustainable 5,000 level.   From there, we had a tech meltdown with declines in value of stocks not unlike the crash of 1929-1932.   From peak to trough, the NASDAQ, heralded at the time as the stock market of the future, dropped by 80%.

From the lows in 2003, markets around the world recovered much of the losses experienced from the tech meltdown, with many including the DJIA reaching new highs.   All seemed to point toward continued gains until the sub prime meltdown struck in 2008.   The subsequent 50% decline in most indices left investors wondering about the future of capitalism itself.   Just as many investors were ready to throw up their hands and give up, the recovery of 2009 happened.

It is a little bit too easy to see this recovery as a return to the good old days of the nineties or the middle of the decade just ended.   The problems that caused the financial meltdown last year have not been fixed, and the will to fix them has dissipated.    Banks are back to creating the same type of financially engineered products that took us to the brink of depression.   The Obama Administration, despite its mandate of change, has changed very little about our financial system.  The current Treasury Secretary is one of the major players from the past decade.   He is a creature of the system and not an agent of change.

The respected analyst, Jeremy Grantham * predicts “seven lean years” for companies around the globe, but he suggests that these seven lean years will bear less heavily on the blue chip companies.   RKM believes that only the most established global companies with solid finances, low debt, good franchises, and tested management will be above the fray this decade.  The Coca Cola’s and the Disneys of the world will not be touched as significantly by the seven lean years expected.   Asian auto companies and European pharmaceutical companies are global companies that could prosper in this environment.

REAL ESTATE/ALTERNATIVE/SPECIAL SITUATIONS

At RKM, we consider inflation hedges and alternative investments to be a separate asset class, as these investments have established performance different from traditional asset classes over time.  During much of the last fifteen years, real estate and energy have been substantial parts of our strategies here at RKM.    More recently, we have encouraged clients to establish stakes in commodities and currencies, which have provided more diversification and good returns.   In 2009, we have added timber and agricultural stocks to this class of assets, which have provided excellent returns this year.

*Grantham’s got an impressive track record when it comes to making the right investment calls…
1982: Said the U.S. stock market was ripe for a “major rally.” That year was the beginning of the longest bull run ever.
1989: Called the top of the Japanese bubble economy.
1991: Predicted the resurgence of U.S. large cap stocks.
2000: Correctly called the rallies in U.S. small cap and value stocks.
January 2000: Warned of an impending crash in technology stocks, which took place two months later.
April 2007: Said we are now seeing the first worldwide bubble in history covering all asset classes.

Although we know that history does not necessarily repeat, we believe that insight can be derived by looking at stock market cycles from history. We found an appropriate one from the 1937-1938 BEAR market, with specific relevance to today’s stock market, as represented by the NASDAQ.

Just like the NASDAQ from 1993 to 2000, the Dow in the 1920’s rose more than six fold, from 63 to 381. From the high in 1929, it had dropped by almost 89% to 41 by 1932. Likewise, the NASDAQ dropped from 5000 in the year 2000 to a low of 1000 by 2003.

Recovering over the next four years, the Dow reached 194 by 1937 while the NASDAQ topped out at 2800 in 2007. What followed in 1938 was a decline of almost 50%, just as the NASDAQ did in 2008-2009. If you lay the current NASDAQ chart over the old Dow chart, there is an uncanny parallel. Our current recovery has taken the NASDAQ back to a level of 2000, below its previous peaks, just as the Dow in 1939 recovered by more than 50%.

What did the 1939 stock market do after this recovery? The next two years were mostly flat, and it took six years and a world war to get the market moving to a level above the recovery peak of 1939. Could it possibly take six years to move the NASDAQ higher now?

One school of thought claims that the efforts to rein in big business and to achieve more even income distribution will stunt growth and profits. This is well articulated by Jeremy Grantham on the GMO web site, who says that we should start getting used to lower growth and higher prices. As the economy sorts itself out from the recent financial turmoil, we are very likely to have lower growth rates for many years.

Another view is offered by Chris Martenson, PhD., MBA, on his web site and blog. He expects moments of relative calm and seeming recovery punctuated by rapid and unsettling market plunges and marked changes in social perspective. We’ll see food scarcity and shortages and price spikes (like last year’s gas prices), but even when relative calm returns, prices still not recovering to their previous levels.

The last view is that we will somehow again muddle through, with the Fed and Congress successfully fighting off recession, deflation and inflation, without major changes or significant adjustments. The problem with this is if indeed we muddle through without fixing the problems that brought us to the brink last fall, we are doomed to repeat the experience.

Only time will tell, but looking at history is instructive. – Richard K. May

NEW ROTH IRA CONVERSION RULES AND ISSUES

Starting January 1, 2010 the qualifying income limits that have prevented many individuals from converting a traditional IRA to a Roth will be eliminated. This change is one of the most important on the IRA landscape in years. The question most frequently asked is, “Should I convert my traditional IRA to a Roth IRA?”

There is no simple answer but here are several important considerations.

• When interest rates are going down the conversion likely makes no sense.
• When rates are going up the conversion is more likely to make sense.
• Conversions are better for the person who doesn’t need to live off the funds. There are no required distributions associated with a Roth IRA. With traditional IRAs, you must begin tapping your account after reaching age 70½. In doing so, you increase your taxable income starting in your 70’s.
• Conversions are generally better for a person that has other funds to pay the taxes. Paying taxes with IRA assets defeats the purpose.
• Conversions for a couple may make sense.
• Conversions for a person with estate tax issues will make more sense than for a person without. Your estate ends up with a higher percentage in tax-favorable retirement plans.
• Conversions to leave a Roth IRA to grandchildren often have merit. Because Roth IRA owners are not subject to required minimum distribution rules, the assets in the account continue to grow tax-free. And over a period of years this growth can be exponential. Although Roth beneficiaries are required to take distributions each year, the withdrawals are tax-free, making the Roth a great retirement asset for which to transfer the greatest amount of wealth.
• Conversions for a person with net operating losses or other loss carry-forwards can make sense. In order to realize this favorable tax attribute there is the option of using a Roth IRA conversion to “offset” the loss or carry-forward.
• Conversions can be costly. If sale of taxable assets are required to pay the resulting tax bill, effectively the benefit of the tax deferral that might otherwise normally occur is lost.
• Conversion to the tax free Roth IRA can provide flexibility to keep taxes low in retirement. Retirees who need funds will be in a position to withdraw less money overall. There won’t be tax liabilities generated by withdrawals from the tax free account.

WHO QUALIFIES?

For 2009 you can’t convert traditional IRA assets to a Roth if your household’s modified adjusted gross income exceeds $100,000. A married person who files as “married separate” is prohibited from converting—no matter what their income level. While the income limits for funding a Roth will remain, the rules for conversions are about to change.

As part of the Tax Increase Prevention and Reconciliation Act, the federal government is eliminating the $100,000 income limit for Roth conversions, as well as the restriction on spouses who file separate tax returns. These changes will allow more retirees—who rolled over their holdings from 401(k)’s and other workplace savings plans into IRAs—to convert to Roth IRA’s.

When you convert assets from a traditional IRA to a Roth, you have to pay income tax on all pretax contributions and earnings included in the amount you convert. However, there’s a special rule in place for 2010 only that will allow you to recognize 100% of the conversion income in 2010 or split it equally between the next two tax years (2011 and 2012). The two-year option is a one-time offer for 2010 conversions.

If you are age 70½ or older and taking required minimum distributions from a traditional IRA, you can convert remaining traditional IRA assets to a Roth.

If you hold traditional IRAs made up largely of pretax contributions, such as a 401(k) rollover, your tax bill could be steep. One way to mitigate the tax-bill pain is to get your tax advisor to help you determine how much you could convert within your current tax bracket each year without bumping yourself into a higher one. Interestingly, the new rules come at a time when many IRAs have significantly declined in value, meaning the taxes on such conversions will likely be lower. With taxes expected to rise in coming years, the idea of an account that’s safe from tax increases may appeal to you.

If you expect your income to be lower in retirement—and tax rates to stay about where they are—then a Roth conversion might not make sense. Whether you convert or not basically depends on what you expect to happen with your income in retirement, compared with your income while working, and whether you’re more comfortable paying taxes sooner at current rates or betting on lower taxes later.

THE NEXT STEPS

Organize paperwork for any nondeductible IRA contributions you’ve made in the past. By taking that step, you should be able to come up with an estimate of how much of your potential conversion would be taxable. If you expect your 2010 income to be similar to 2009 you can look up the tax brackets at www.irs.gov to get an idea of the taxes that will be due. Or contact us and we will run the numbers for you. Conversions to Roth IRA’s will be an appropriate investment, tax, and / or estate planning step for many, but not all. Be sure to access all the angles before you take that step.

- Chris Blakely

Sources: The Wall Street Journal, IRS.gov, rothconversion.com

On December 31, 2009, we will have completed thirty years in business. We now supervise nearly $200 million in assets, and complete over 300 tax returns each year.

Over the years, we have grown from tax and accounting to a firm that today offers comprehensive financial services, including non-discretionary supervision of investment accounts, retirement planning, college planning, tax planning and preparation, and financial advisory services. Looking forward, we will continue to offer these services, personalized on an individual basis, as well as expand our management of alternative assets for clients. Such non-traditional investments as managed timber, agribusiness, and commodities will become an increasingly important part of our service to clients.

WE ARE ALWAYS PLEASED TO ACCEPT NEW CLIENTS.

Investment and tax professionals rely primarily on referrals from existing clients to grow their businesses. At RKM, we have signed over 30 new advisory relationships since the start of the year. We consider a referral a high form of compliment, a validation of our mission, which has always been to provide the best tax and investment advisory services we can at a reasonable cost. This level of endorsement means that we have earned your respect, and it pleases us that you are comfortable giving the name of RKM Advisors to your friends and family. We have been in growth mode this year and are encouraged by our progress so far and are poised to accept your continued referrals. Thank you for your long standing support!

RKM ADVISORS PERSONNEL UPDATE

We are happy to announce that Vanessa Geiger is pregnant with her first child. Her maternity leave will come at a bad time for RKM Advisors, the months of February, March, and April. As many of you know these are our busiest months with tax season. She will do some work from home but we cannot expect her to work at the same full time capacity. We are looking for temporary tax season help. If you or someone you know has experience in preparing taxes and would like to work for a few months please have them contact us. We can use either two part time people or one full time person for the tax season months. We are planning to maintain our usual tax season efficiency despite her joyful “interruption”. However on the off-chance that Vanessa’s temporary replacement(s) can’t equal her tax preparation skills and talents, we may seek a few extension volunteers.

In his most recent article, Jeremy Grantham describes seemingly reasonable people, armed with
terrifyingly accurate data, foretelling of the end of the world. Investors with lots of cash become inert
objects, mired in cement, and too terrified to invest. Those investors who are fully invested move
from fear to denial and finally to panic, at the end becoming catatonic.

Grantham encourages all investors, before rigor mortis sets in, to evaluate where they currently are,
where they want to be, and how they can get there. A clear “battle plan”, developed by taking
motivation from both your head and your stomach, he says, should clear the way for investors to
overcome “investment paralysis”.

Grantham calculates the “fair value” of the S&P500 at 900, approximately 30% above where the
index sits now. Although he believes that the index has a 50/50 chance of dropping below 600, he
also thinks that many stocks and funds will post a double digit return per year above inflation for the
next seven years. This might not be the absolute bottom of the market, but it is so close to a bottom,
prudent investors are now investing.

- RKM

Click here to read the full Spring 2009 Newsflash article.

For years, the word “One billion” has been bandied about. It has become so common that we pay it little attention, and even the politicians who use it seemingly don’t comprehend it. How often has a speaker said, “the plan calls for a million – I mean a billion – dollars?”

Here’s a story that helps illustrates how much a billion dollars is: Around 20 AD a young man went into business. His fabulously wealthy uncle hadn’t much faith in the young man’s ability, so he set aside a trust fund of a billion dollars of gold coins that his nephew could draw on as needed.

The young man lived up to his Uncle’s low expectations. His first day he lost a thousand dollars; the second he lost another thousand. And so it went, a lost thousand dollars each day throughout the nephew’s entire life, drawing from the trust fund. The second generation took on the business and then the third, all losing a thousand dollars a day. And so it continued for centuries.

Now at what point was the billion in the trust fund exhausted? 944? 1180? 1620?

As of this month, there is still enough of the billion left to last 700 years longer. How many billions or even trillions of dollars of debt are we piling on our grandchildren’s shoulders each year?

Maybe it doesn’t matter, because it is probably just monopoly money anyway. As long as the other players in the game continue to accept it as the universal currency, we are all okay..

Thanks to Jim Martin, Palmyra

A New Taxation Reality

President Elect Obama will be faced with the most serious economic crisis since the Great Depression. However, his administration has proposed a plan that is pro-jobs, and includes plans to eliminate America’s dependence on foreign oil.

The Obama-Biden agenda for the economy is available in its entirety at http://change.gov but some highlights follow:

>> Invest $150 billion in the next 10 years in a clean energy economy and create 5 million new green jobs. Investment would go to advance the next generation of bio-fuels and fuel infrastructure, accelerate the commercialization of plug-in hybrids, promote development of commercial scale renewable energy, low emissions coal plants and begin transition to a new digital electrical grid.

>American Jobs Tax Credit will provide a temporary tax credit for companies that add jobs here in the United States.
> End tax breaks for companies that send jobs overseas.
> One million jobs saved through immediate investments to rebuild America¡¦s roads and bridges and repair our schools
> Partner with America¡¦s automakers to help save jobs and ensure that the next generation of clean vehicles is built in the United States.
> Provide tax relief for small business and start up companies
> A tax cut for workers and their families ¡V plus seniors.
> Penalty free hardship withdrawals from IRAs and 401(k)s.
> Instruct the Treasury to allow seniors to delay required withdrawals from 401(k)s and IRAs.
> Instruct the Secretaries of the Treasury and HUD to use their existing authority to more aggressively modify the terms of mortgages.

The headline on December 19th was sobering:

WASHINGTON – Wholesale prices surged in November by the largest
amount in more than three decades, led by huge increases in the cost
of gasoline and new cars and trucks.

We had been told that inflation was moderating, and then all of a sudden, inflation jumps by 2% in one month. What is happening? West Chester’s own Economy.com reassures us that this one month number is an aberration, and that inflation is indeed cooling. But we have seen this before…in the 1970’s.

We started out that decade with rising but still moderate inflation that quickly abated. Then the second leg began, taking inflation and interest rates higher, but that surge was short lived and soon moderate price increases were the rule again. But then the third leg developed, taking inflation and interest rates into double digits. Interest rates on US Treasury bonds reached 16% and beyond. To break this ever escalating cycle of price increases required some draconian measures by the Federal Reserve. It broke the back of inflation for more than two decades. This all happened only thirty years ago.

Although we are not doomed to repeat history, it is only upon past experiences that we can draw in projecting future events. If the three leg inflation experience of the 1970’s does repeat itself in coming years, then we have just completed the first (and rather insignificant) leg of perhaps three legs with ever increasing inflation.

What does this mean for investors? It is probably unnecessary to cite the performance of the stock market during the last inflation decade. Between 1968 and 1982, the market went absolutely nowhere. Bonds lost more than half their purchasing power during the decade of the seventies. It was not a good time for financial assets. Hard assets such as real estate and commodities tend to outperform stocks and bonds during periods of protracted inflation; likewise, other currencies and gold, if the inflation is tied to currency devaluation (meaning a declining US dollar).

Most Americans have never heard of Rahm Emanuel, but soon they will. He is the US Representative from Illinois, specifically from the Chicago area, and Mr. Emanuel is probably the person most responsible for the Democrats taking back the US House of Representatives last November. He is also an influential member of the US House Ways and Means Committee, which has jurisdiction over taxes. His “reward” from the House for his leadership in the Congressional elections, will more than likely be in the form of new tax policies that he supports.

Therefore, we have read the tax plan of Rahm Emanuel, as seen on his WEB site. Here is what he has proposed, and here is what we may soon be looking at:

►The Tax Code is too complicated. Reduce Form 1040 to one page.
►Reduce tax brackets to three; 15% 25% and 35%.
►Narrow the gap between taxation of wages and taxation of capital gains and dividends.
►Institute a higher Standard Deduction to assist the middle class; as high as $15,000 for singles and $30,000 for married couples.
►Eliminate the Alternative Minimum Tax.
►Reduce special breaks for corporations.
►Allow a mortgage interest deduction even for those that don’t itemize.
►Create a Universal Pension to replace the 16 different IRA type accounts that exist.

It is safe to predict that all new tax legislation will be directed toward benefiting the middle class at the expense of wealthier taxpayers and corporations. As more details become available, we plan to assist our clients to position themselves in such a way that they can enjoy the benefits and avoid the pitfalls.

TAX TIPS

CHARITABLE GIFTS
In both 2006 and 2007, taxpayers over 70 ½ who have required minimum distributions from IRA’s may contribute up to $100,000 directly from the IRA to charity. This contribution will count toward their minimum distribution requirement. They may not take it as a charitable contribution on their tax return, but it will not be added to their Adjusted Gross Income and therefore will not be taxed.

EXCISE TAX/TELEPHONE TAX REFUND
The IRS and Federal government backed down after several successful court cases ruled in favor of the consumer that the Federal Excise taxes assessed on telephone bills was illegal. All taxpayers will be eligible to receive a refund/credit for excise taxes paid between March 2003 and July 2006. The standard credit of $10 per exemption reported on the tax return, will be allowed with a maximum credit per family of $60. If however, the taxpayers have their telephone bills for that time frame, the actual tax can be calculated on Form 8913 and a credit will be issued for that substantiated amount. Businesses will also receive the credit, but it must be calculated by a formula devised by IRS based on telelphone bills from that same time frame.

RKM DECEMBER 2006

We have noted three themes for this year’s tax planning letter, the first two of these selected from Yahoo’s top ten planning tips and the last from Suzy Ormond.

► First, we offer a reminder for those of you with medical reimbursement plans NOT to leave any money on the table, so to speak.
► Second, start up costs for the small business you have intended to launch for years can save money on taxes if done now.
► Third, as we have advised before, consider a conversion of IRA money to Roth IRA, especially if you are likely to be in a higher income tax bracket after retirement.

Use up your medical reimbursement plan

New for 2005 / 2006: you have until the end of March to finish getting treatment and submitting those bills through your reimbursement account at work.

Review the medical bills you have now, and those coming up next year. If you haven’t spent as much as you’d planned, take care of a few things before the year is up. So go see your optometrist or ophthalmologist. Get new glasses or contacts. Get your teeth cleaned or that filling replaced.

Planning any elective surgery, like laser eye surgery? Prepay enough to use up that whole shortfall. You can still schedule the surgery for next year — and allocate those expenses to next year’s medical reimbursement plan.

Setting Up Your New Business Now for Tax Advantage
It’s never too early to start thinking about how to reduce your tax burden. New business startups are especially promising so you can make decisions today that can help save you money on April 15th. Following these tips will make getting the new business started this year:
• Open a separate checking account for the business.
• Then keep all of your business expenses separate by paying for them only from the business checking account. And don’t pay for anything nonbusiness-related from this account. Reimbursing yourself for anything you have already spent on this prospective business.
• Buy accounting software to help maintain control of your records.
• Think about how your business entity structure can affect your liability, and consider if you need additional insurance.

CONVERSION OF IRA’S TO ROTH IRA’S

Currently, not everyone can convert a Traditional IRA to a Roth IRA. As of right now, you can convert a Traditional IRA to a Roth only if your adjusted gross income is below $100,000. That’s the limit whether you’re single or married.

A Real-World Scenario
Here’s where things get interesting. There has been legislation liberalizing the rules on conversion to Roth IRA’s. Come 2010, the $100,000 conversion limit vanishes. Anyone, regardless of income, can convert money in a non-deductible or Traditional IRA into a Roth IRA. No strings attached.
That brings us back to my original point: The best gift for high-income earners is to open a non-deductible IRA, because in 2010 you’ll be able to convert the money into a Roth IRA.
Yes, you’ll owe taxes on any account gains that have accrued between now and your conversion, but once you get the money into a Roth you have a 100-percent tax-free account.
Let’s say you’re 35 years old and decide to open up your first Traditional IRA by investing the maximum $4,000 this year, and then another $4,000 in 2007. When the max rises to $5,000 in 2008, you stash that sum away in 2008, 2009, and 2010. That’s a total of $23,000.
Let’s assume that in 2010 the IRA’s total value has risen to $28,000. That’s $5,000 in gains over what you originally deposited. If you convert the Traditional non-deductible IRA into a Roth, at that point you’ll only owe income tax on the $5,000 in gains your account accrued.
The new law even makes it easy to handle the conversion tax bill. If you convert in 2010, you can spread your tax bill over two years — 2011 and 2012. (You can also choose to convert smaller amounts over as many years as you want as a way of minimizing your tax bill in any single year.)
Once you convert the money, that $28,000 grows tax-free. And if for whatever reason in 2016 (five years after your conversion) you happen to need money, you can withdraw any amount from your converted Roth IRA up to the $28,000 without any additional tax or penalty, even though you’d only be 45 old.
But let’s assume you won’t touch the money. If you convert the $28,000 in 2010 and it keeps growing at an average of 8 percent a year for the next 20 years, you’ll have more than $130,000. That’s $130,000 that Uncle Sam doesn’t get a penny of.
Even better; if you don’t need the money in retirement, you can just let it sit untouched for your heirs to eventually inherit. With a Traditional IRA, you must start making withdrawals by age 70-1/2.
Now do you see why I think you can’t afford to pass this up? It’s a potential six-figure-plus gift to yourself or your heirs.

“But in this world nothing can be said to be certain, except death and taxes.” This quotation is credited to Ben Franklin who first wrote it in a letter to Jean Baptiste Le Roy in 1789. How little things have changed in the intervening two hundred and seventeen years! Speaking of taxes….

The Federal budget deficit has actually been reduced in the latest fiscal year. This fact has encouraged those who have a large vested interest in the present tax structure in believing that reform is unnecessary. In fact, according to a recent report from the Tax Policy Center, “the federal government’s fiscal status has continued to deteriorate, with the enactment of tax cuts, a massive new Medicare entitlement, increased spending on defense and homeland security, and related economic developments.” When reality once again grabs the attention of the fiscal caretakers, they will realize that serious work needs to be done to fix our deficit problem. They cannot continue to offer “short-term smoke and mirrors that only make the long-term situation more bleak”- Urban Institute ‘06.

So what do you suppose this serious work will be. Hey, I know! Higher taxes. It matters less who is elected President in 2008, since either party will be forced to roll back some of the tax cuts of the past six years. One can only guess at the potential casualties and eliminated loopholes in the next comprehensive tax reform, but let me make a few guesses. The 15% tax on qualified dividend income will disappear. It is certainly possible that capital gain rates will move back up to at least 20% if not higher. We might see the top personal brackets begin to expand again from the current maximum of 35% and corporate rates could join them in advancing. Second home interest and tax deductions might be limited. We might even see Congress discuss a national sales tax or a Value Added Tax. What our President has called “death taxes” will not be eliminated, validating Ben Franklin’s quote at the start.

The chief point is this. We are probably enjoying the lowest tax rates now that we will see in our lifetimes. Some of our clients remember the 1970’s when the top bracket was 70% and many ordinary folks were in a marginal tax bracket of 40% or more. It is not inconceivable that we would move back there. Most of the rest of the world deals with tax rates at that level. So what does one do?

Yesterday traditional tax advice was to defer income and to accelerate expenses, since tax rates were falling AND there was a time value of money advantage in deferral. Today, one might argue the opposite. Taking income today that could be deferred into 2009 might be very prudent. Converting an IRA to a Roth IRA today for those who can may make perfect sense. Putting money away in one of the new Roth 401K plans seems made to order. So the new mantra could be “Never put off until tomorrow, what you can pay taxes on today”. We plan to address many of these issues for our clients between now and the end of the year, certainly before Election Day 2008.

Marc Faber is a Hong Kong based investment manager who was born in Zurich, Switzerland, and, at the age of 24, obtained a PhD in Economics from the University of Zurich – finishing magna cum laude. He is now recognized as a leading representative of the “doom and gloom” side of the investment outlook spectrum.
Mr. Faber believes strongly that we are seeing a shift in power from the West to the East with profound implications for global commodity prices and currencies. His argument is similar to that of Jim Rogers, featured in an earlier newsletter. The thesis is that there are long term cycles in commodities lasting up to fifty years. After the last peak in the early 1980’s, we enjoyed twenty years of declining commodity prices and for the most part rising equity prices. He thinks that this cycle has now turned in the opposite direction, as it did in the early 1920’s and the late 1960’s. If he is correct, this is the SIXTH such cycle turn since 1800.
In a separate point, he argues that poor US fiscal management has made the US dollar increasingly vulnerable to trading lower against not only other currencies, but against the ultimate store of value, GOLD. Therefore, he paints a VERY optimistic and opportunistic prospect for the ownership of GOLD. What about gold?
The price of gold has been creeping upwards since 2002, as you can see in the chart at left. Last year at this time, it accelerated and this year it reached a level we haven’t seen since 1979.
Is this an aberration that will end the way technology stocks ended after year 2000? Is this truly the beginning of one of the long commodity bull markets in which REAL assets have more value than PAPER or financial assets? Without providing an answer to that question, it can be said that portfolios without any participation in precious metals are missing one of the principal reasons to diversify. A portfolio diversified across global regions, across business sectors, across asset styles and capitalization types, is not fully diversified if it does not contain some real assets.
Hold some gold.

RKM September 2006