EagleStone Tax & Wealth Newsletter – March 2016

A long period of low yields has been challenging for many fixed-income investors, but owning bond investments in a rising interest-rate environment could become even trickier. When interest rates go up, the prices of existing bonds typically fall. Consequently, the Federal Reserve’s rate-setting decisions could affect the entire fixed-income market.

Still, bonds are a mainstay for conservative investors who prioritize the preservation of principal over returns, and for retirees in need of a predictable income stream. Although diversification does not guarantee a profit or protect against investment loss, owning a diversified mix of bond types and maturities is one way to manage interest-rate and credit risk in your portfolio.

Consider duration

Overall, bonds with shorter maturities are less sensitive to interest-rate fluctuations than long-term bonds. A bond’s maturity is the length of time by which the principal and interest are scheduled to be repaid. A bond’s duration is a more specific measure of interest-rate sensitivity that takes cash flow (interest payments) into account.

For example, a five-year Treasury bond has a duration of less than five years, reflecting income payments that are received prior to maturity. A five-year corporate bond with a higher yield will have an even shorter duration, making it slightly less sensitive to interest-rate fluctuations. If interest rates increase 1%, a bond’s value is generally expected to drop by approximately the bond’s duration. Thus, a bond with a five-year duration could lose roughly 5% in value. (U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest.)

Build a ladder

Bond laddering is a buy-and-hold strategy that could also help cushion the potential effects of rising rates. This process puts your money to work systematically, without trying to predict rate changes and time the market.

Buying individual bonds provides some certainty, because investors know how much they will earn if they hold a bond until maturity, unless the issuer defaults. A ladder is a portfolio of bonds with maturities that are spaced out at regular intervals over a certain number of years. When short-term bonds from the low rungs of the ladder mature, the funds are reinvested at the top end of the ladder. As interest rates rise, investors may be able to increase their cash flow by capturing higher yields. A ladder may also help insulate bond portfolios from volatility, because higher yields on new bonds may help offset any paper losses on existing holdings.

Bond ladders may vary in size and structure, and could include different types of bonds depending on an investor’s time horizon, risk tolerance, and goals. Individual bonds are typically sold in minimum denominations of $1,000 to $5,000, so creating a bond ladder with a sufficient level of diversification might require a sizable investment.

Rise with rates

Adding a floating-rate component to a bond portfolio may also provide some protection against interest-rate risk. These investments (long offered by U.S. corporations) have interest payments that typically adjust based on prevailing short-term rates.

The U.S. Treasury started issuing floating-rate notes with two-year maturities in January 2014. Investors receive interest payments on a quarterly basis. Rates are tied to the most recent 13-week Treasury bill auction and reset weekly, so investors are paid more as interest rates rise and less as they fall.

Note: Bonds redeemed prior to maturity could be worth more or less than their original cost, and investments seeking to achieve higher yields also involve a higher degree of risk. Interest payments are taxed as ordinary income. Treasury bond interest is subject to federal income tax but exempt from state and local income taxes.

Whether you’re preparing your own tax return or paying someone to do it for you, tax season can be a stressful time of year. Make things easier on yourself by pulling all your information together sooner rather than later–that includes a copy of last year’s tax return, W-2s, 1099s, and any deduction records you have.

File on time

The filing deadline for most individuals is Monday, April 18, 2016. That’s because Emancipation Day, a legal holiday in Washington, D.C., falls on Friday, April 15, this year. If you live in Massachusetts or Maine, you have until Tuesday, April 19, 2016, to file a federal income tax return because Patriots’ Day, a legal holiday in both states, is celebrated on April 18.

If you’re not able to file your federal income tax return by the due date, you can file for an extension using IRS Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return. Filing this extension gives you an additional six months (until October 17, 2016) to file your federal income tax return. You can also file for an automatic six-month extension electronically (details on how to do so can be found in the Form 4868 instructions).

Note: Special rules apply if you’re living outside the country, or serving in the military outside the country, on the regular due date of your federal income tax return.

Pay what you owe

One of the biggest mistakes you can make is not filing your return because you owe money. If the bottom line on your return shows that you owe tax, file and pay the amount due in full by the due date if at all possible. If you absolutely cannot pay what you owe, file the return and pay as much as you can afford. You’ll owe interest and possibly penalties on the unpaid tax, but you will limit the penalties assessed by filing your return on time, and you may be able to work with the IRS to pay the unpaid balance (options available may include the ability to enter into an installment agreement).

It’s important to understand that filing for an automatic extension to file your return does not provide any additional time to pay your tax. When you file for an extension, you have to estimate the amount of tax you will owe; you should pay this amount by the April 18 (April 19 if you live in Massachusetts or Maine) due date. If you don’t, you will owe interest, and you may owe penalties as well. If the IRS believes that your estimate of taxes was not reasonable, it may void your extension.

Limited planning opportunities may still be available

Though the opportunity for many potential tax-saving moves closed on December 31, the window is still open for IRA contributions. You generally have until the April due date of your federal income tax return to make contributions to a traditional or Roth IRA for the 2015 tax year. That means there’s still time to set aside up to $5,500 ($6,500 if you’re age 50 or older) in one of these tax-advantaged savings vehicles.

Note: To contribute to either a traditional or a Roth IRA for 2015, you (or, if you file a joint return, your spouse) must have received taxable compensation during the year. Provided that you did not reach age 70½ by the end of the year, you’re able to contribute to a traditional IRA. Eligibility to contribute to a Roth IRA depends on your filing status and income.

With a traditional IRA, you’re generally able to deduct the full amount of your contribution, provided that you’re not covered by a 401(k) or another employer-sponsored retirement plan; if you or your spouse is covered by an employer plan, the ability to deduct some or all of your contribution depends on your filing status and income. With a Roth IRA, there’s no up-front deduction, so contributing won’t affect your 2015 tax situation, but it’s still worth considering given that future qualified Roth distributions are free of federal income tax.

You also have until the due date of your return, including any extension, to undo (“recharacterize”) a 2015 Roth IRA conversion. For example, if you converted a fully taxable traditional IRA worth $100,000 to a Roth IRA in 2015 and that Roth IRA is now worth only $50,000, the $100,000 will be included on your 2015 federal income tax return. If you recharacterize the conversion, however, it’s as though it never happened–you have a traditional IRA worth $50,000, and no income or tax resulting from the conversion. If you do recharacterize a 2015 Roth conversion in 2016, you’re allowed to convert those dollars (and any earnings) back to a Roth IRA after a 30-day waiting period (taxes due as a result of such a reconversion would be included on your 2016 federal income tax return).

You don’t have to do it alone

When it comes to your taxes, you want to make sure that you get it right. A tax professional can answer any questions you have, help you evaluate your situation, and keep you apprised of any legislative changes that might affect

Do you find yourself treading water financially even with a relatively healthy household income? Even with your new higher-paying job and your spouse’s promotion, do you still find it difficult to get ahead, despite carefully counting your pennies? Does your friend or relative halfway across the country have a better quality of life on less income? If so, the cost of living might be to blame.

The cost of living refers to the cost of various items necessary in everyday life. It includes things like housing, transportation, food, utilities, health care, and taxes.

Single or family of six?
Singles, couples, and families typically have many of the same expenses–for example, everyone needs shelter, food, and clothing–but families with children typically pay more in each category and have the added expenses of child care and college. The Economic Policy Institute (epi.org) has a family budget calculator that lets you enter your household size (up to two adults and four children) along with your Zip code to see how much you would need to earn to have an “adequate but modest” standard of living in that geographic area.

What areas have the highest cost of living? It’s no secret that the East and West Coasts have some of the highest costs. According to the Council for Community and Economic Research, the 10 most expensive U.S. urban areas to live in Q3 2015 were:

Factors that influence the cost of living

Let’s look in more detail at some of the common factors that make up the cost of living.

Housing. When an area is described as having “a high cost of living,” it usually means housing costs. Looking to relocate to Silicon Valley from the Midwest? You better hope for a big raise; the mortgage you’re paying now on your modest three-bedroom home might get you a walk-in closet in this technology hub, where prices last spring climbed to a record-high $905,000 in Santa Clara County, $1,194,500 in San Mateo County, and $690,000 in Alameda County. (Source: San Jose Mercury News, Silicon Valley Home Prices Hit Record Highs, Again, May 21, 2015)

Related to housing affordability is student loan debt. Student debt–both for young adults and those in their 30s, 40s, and 50s who either took out their own loans, or co-signed or borrowed on behalf of their children–is increasingly affecting housing choices and living situations. For some borrowers, monthly student loan payments can approximate a second mortgage.

Transportation. Do you have access to reliable public transportation or do you need a car? Younger adults often favor public transportation and supplement with ride-sharing services like Uber, Lyft, and Zipcar. But for others, a car (or two or three), along with the cost of gas and maintenance, is a necessity. How far is your work commute? Do you drive 100 miles round trip each day or do you telecommute? Having to buy a new (or used) car every few years can significantly impact your bottom line.

Utilities. The cost of utilities can vary by location, weather, usage, and infrastructure. For example, residents of colder climates might find it more expensive to heat their homes in the winter than residents of warmer climates do cooling their homes in the summer.

Taxes. Your tax bite will vary by state. Seven states have no income tax–Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. In addition, property taxes and sales taxes can vary significantly by state and even by county, and states have different rules for taxing Social Security and pension income.

Miscellaneous. If you have children, other things that can affect your bottom line are the costs of child care, extracurricular activities, and tuition at your flagship state university.

To move or not to move

Remember The Clash song “Should I Stay or Should I Go?” Well, there’s no question your money will go further in some places than in others. If you’re thinking of moving to a new location, cost-of-living information can make your decision more grounded in financial reality.

There are several online cost-of-living calculators that let you compare your current location to a new location. The U.S. State Department has compiled a list of resources on its website at state.gov.

For all you parents out there, how knowledgeable are you about college financial aid? See if you know whether these financial aid statements are myth or fact.

1. Family income is the main factor that determines eligibility for aid. Answer: Fact. But while it’s true that family income is the main factor that determines how much financial aid your child might receive, it’s not the only factor. The number of children you’ll have in college at the same time is also a significant factor. Other factors include your overall family size, your assets, and the age of the older parent.

2. If my child gets accepted at a more expensive college, we’ll automatically get more aid. Answer: Myth. The government calculates your expected family contribution (EFC) based on the income and asset information you provide in its aid application, the FAFSA. Your EFC stays the same, no matter what college your child is accepted to. The cost of a particular college minus your EFC equals your child’s financial need, which will vary by college. A greater financial need doesn’t automatically translate into more financial aid, though the more competitive colleges will try to meet all or most of it.

3. I plan to stop contributing to my 401(k) plan while my child is in college because colleges will expect me to borrow from it. Answer: Myth. The government and colleges do not count the value of retirement accounts when determining how much aid your child might be eligible for, and they don’t factor in any borrowing against these accounts.

4. I wish I could estimate the financial aid my child might receive at a particular college ahead of time, but I’ll have to wait until she actually applies. Answer: Myth. Every college has a college-specific net price calculator on its website that you can use to enter your family’s financial information before your child applies. It will provide an estimate of how much aid your child is likely to receive at that college.

5. Ivy League schools don’t offer merit scholarships. Answer: Fact. But don’t fall into the trap of limiting your search to just these schools. Many schools offer merit scholarships and can provide your child with an excellent education.

Traditional IRAs and employer retirement plans such as 401(k)s and 403(b)s offer several tax advantages, including the ability to defer income taxes on both contributions and earnings until they’re distributed from the plan.

But, unfortunately, you can’t keep your money in these retirement accounts forever. The law requires that you begin taking distributions, called “required minimum distributions” or RMDs, when you reach age 70½ (or in some cases, when you retire), whether you need the money or not. (Minimum distributions are not required from Roth IRAs during your lifetime.)

Your IRA trustee or custodian must either tell you the required amount each year or offer to calculate it for you. For an employer plan, the plan administrator will generally calculate the RMD. But you’re ultimately responsible for determining the correct amount. It’s easy to do. The IRS, in Publication 590-B, provides a chart called the Uniform Lifetime Table. In most cases, you simply find the distribution period for your age and then divide your account balance as of the end of the prior year by the distribution period to arrive at your RMD for the year.

For example, if you turn 76 in 2016, your distribution period under the Uniform Lifetime Table is 22 years. You divide your account balance as of December 31, 2015, by 22 to arrive at your RMD for 2016.

The only exception is if you’re married and your spouse is more than 10 years younger than you. If this special situation applies, use IRS Table II (also found in Publication 590-B) instead of the Uniform Lifetime Table. Table II provides a distribution period that’s based on the joint life expectancy of you and your spouse.

If you have multiple IRAs, an RMD is calculated separately for each IRA. However, you can withdraw the required amount from any of your IRAs. Inherited IRAs aren’t included with your own for this purpose. (Similar rules apply to Section 403(b) accounts.) If you participate in more than one employer retirement plan, your RMD is calculated separately for each plan and must be paid from that plan.

Remember, you can always withdraw more than the required amount, but if you withdraw less you will be hit with a penalty tax equal to 50% of the amount you failed to withdraw.