Business & Investing

Innocent Spouse Relief for Income Tax Filings

Innocent Spouse Relief for Income Tax Filings

Once a married couple files a joint tax return, each partner is by law accountable for the full tax liability, regardless if just one of the spouses is accountable for the failure to pay. Referred to as a joint and several liability, this particular legal principle still is applicable following a divorce as well as in cases of misrepresentation or fraud. In past times, the IRS provided Innocent Spouse Relief as a way to protect a spouse who didn’t know or have reason to know that an understated tax existed. Just last year, the IRS introduced a revision of the Innocent Spouse Relief program so that knowledge that the tax return was incorrect is no longer fatal to a claim for relief.

Once taxpayers sign their tax returns, they’re expressing to the IRS their particular return is correct. With a joint tax return filed from a married couple, both spouses are accountable for the entire amount owed, which means that if the IRS in the future decides that a joint return was inaccurate, they can go after either spouse for the complete amount of any additional tax, interest and penalties. The IRS isn’t even bound by a divorce decree proclaiming that just one of the spouses is entirely accountable for back taxes.

Realizing this conceivable injustice, the IRS has provided several forms of Innocent Spouse Relief since 1971. Even so, the program has several restrictions. For example, relief was denied for spouses that knew or had reason to believe that they signed an inaccurate return, whether or not the signature was made under duress. Additionally, to apply for relief, the IRS imposed a two-year statute of limitations from the date with which the IRS first contacted the innocent spouse to collect the tax. Due to these restrictions, many otherwise-qualified innocent spouses were found liable for taxes in which the other spouse should’ve been held accountable; 85 % to 90 % of these were women.

This past year, the IRS revamped the Innocent Spouse Relief program. Located in Florence, Ky., the Innocent Spouse unit was given increased staff and agents were provided training on domestic abuse and how to interview petitioners. The IRS also increased the statute of limitations to apply for relief to 10 years and relaxed the requirement that the innocent spouse didn’t know the return was incorrect once it was signed. Now the IRS is much more likely to grant relief in cases of abuse or when one spouse had financial control over money matters throughout the marriage. Cases can also be evaluated to ascertain whether or not the innocent spouse signed the joint return while afflicted with physical, psychological, sexual or emotional abuse.

To obtain Innocent Spouse Relief taxpayers need to file Form 8857, which the IRS uses to start its evaluation under a facts and circumstances test. Form 8857 contains questions relating to how involved the spouse was in the household’s finances, whether he or she have helped to prepare the joint tax return, and whether or not the spouse suffered from abuse.

Innocent Spouse Relief is one way to prevent joint and several liability, but the most straightforward technique is to not file a joint tax return to begin with. All married couples have the choice to file under the Married Filing Separately designation. In reality, the benefits of joint returns are not as abundant as is commonly believed, particularly for two-income households where each spouse earns a similar amount.

A joint return will really only lower the overall tax bill when one salary is responsible for the majority of the income. Even so, those filing taxes under the Married Filing Separately designation are ineligible for specific tax breaks, such as the Earned Income Credit, child and dependent care credits and the student loan interest deduction.
We can provide assistance in deciding whether a joint tax return or a Married Filing Separately return is right for your specific situation. Additionally, with so many more people now eligible under the Innocent Spouse Relief Program, seasoned tax professionals are suggested for the often long and complex application process.

The Fed is Optimistic While the Markets Dither

After a great deal of speculation at the beginning of June regarding when the Federal Reserve might let up on its quantitative easing policy, Federal Reserve Chairman Bernanke finally spoke….and the markets overreacted with both stocks and bonds taking a hit in the face of indiscriminate selling.


Chairman Bernanke carefully couched his announcement on June 19, stating that the pull-back is predicted to begin later on this year, and that the Fed will reduce monthly purchases of Treasury securities and mortgage-backed bonds gradually beginning later in 2013 and finishing once the unemployment rate reaches Seven percent (which the Fed projects to be around mid-2014 ). He stressed the fact that the timing of the pull-back will be contingent upon the economy, understanding that if development falters, the central bank would probably slow or even reverse its retreat.


Even with a host of provisos and disclaimers, traders responded like Bernanke had pulled the rug out from under them.  Keep in mind that all this reaction was to a speech; the Fed has not created any modifications or established any plan to do so. The market’s dive demonstrates the capability that the Federal Reserve exerts over the mindsets of investors, traders and economists.


When they established the central reserve system A hundred years ago in 1913, the lawmakers that set it up could have hardly imagined the capability the Fed yields today. Up until the Fed’s latest policy meeting, the stock market had been performing very well.  The Dow Jones Industrial Average was up 20 percent since the beginning of the year, and had established a new record high. Bernanke’s comments, which came after a two day policy conference in Washington, evidently rattled Wall Street gurus that favored that any QE let-up be pushed back into a more nebulous time frame.


A review of what Chairman Bernanke really said throughout the press conference should reassure the most anxious investor that the Fed intends to proceed very cautiously in order not to disturb the economic progress that has recently been made. Unwinding the stimulus campaign slowly is anticipated to take several years. The Fed expects to carry on for the time being to buy $85 billion of bonds each month in Treasury securities and mortgage-backed bonds, as well as hold short-term interest rates to near zero.


Following a couple of jittery days, investors began to settle down. After taking a serious hammering in the wake of Bernanke’s comments, both the DJIA and the Standard & Poor’s 500 recovered near the end of June.


Job Creation


In another news release, the Fed declared that it is expecting unemployment rates to decrease quicker than they had expected – reaching between 6.5 percent and 6.8 percent by the end of 2014. The Federal Reserve has noted, in another statement, that the economy was expanding at a moderate pace and that risks to growth had diminished – an important observation because the Fed had been trying to protect the economy from the effects of government spending cut-backs.


With better news on the housing front and polls showing consumer confidence growing, investors have a lot to celebrate. As the knee jerk reactions over Bernanke’s speech subside, perhaps we shall cruise into smoother waters in July.

The Future of Bonds

In the second quarter of this year, the yield on the 10-year Treasury bond rose 54 basis points to 2.24 percent in the span of one month. Economists have been predicting the eventual rise in interest rates, but a jump this big over such a short time frame was not expected.


If you own a substantial bond allocation in your portfolio, it’s a good time to reassess what you own – and why. Earlier this year, private industry regulator FINRA (the Financial Industry Regulatory Authority) issued a warning to investors regarding the adverse relationship between bonds and rising interest rates. Since bond prices typically drop when interest rates rise, an outstanding bond – particularly one with a low interest rate and high duration – might experience a significant price drop. This means that bond funds invested primarily in long-term bonds will decline in value.


Currently, there are about $1.2 trillion of fixed income assets invested in defined contribution plans such as 401(k)s, according to a study by Casey Quirk published in May. If interest rates increase to even half of their historical average, these plans will likely lose up to $180 billion in value.  However, just because interest rates might rise and bond prices subsequently fall, you may not need to be concerned. It depends on the reason why you own bonds in the first place. Are they part of an overall asset allocation? Do you use them for regular income, or to help diversify a stock-laden portfolio? Your bond allocation depends on many factors, such as your objectives for income and future goals, your investment timeline and how well you tolerate risk in the markets.


Perhaps you own individual bonds to secure a predictable income stream and a known schedule for the return of your principal. If this is your objective, then you needn’t be too concerned with rising interest rates. You will continue to receive income regardless of the direction of interest rates, and your original principal will be returned upon maturity.

However, if your bond holdings are designed to help minimize the overall volatility of your portfolio, rising interest rates might present a risk you hadn’t considered. If the value of your bonds slips at the same time that your equity holdings experience volatility, your portfolio’s market value could drop substantially.


The market value of bonds tends to be inversely affected by movements in interest rates because:


• When rates rise, market prices of existing debt securities fall as these securities become less attractive to investors when compared to new issues with higher coupon rates.

• When interest rates fall, market prices on existing fixed income securities tend to rise because these bonds become more attractive when compared to newly issued bonds priced at lower rates.


Note, too, that government and other investment grade bonds tend to be more sensitive to changes in interest rates.

Overview of the Tax Provisions in the 2012 American Taxpayer Relief Act



Dear Clients and Friends,

The recently enacted 2012 American Taxpayer Relief Act is a sweeping tax package that includes, among many other items, permanent extension of the Bush-era tax cuts for most taxpayers, revised tax rates on ordinary and capital gain income for high-income individuals, modification of the estate tax, permanent relief from the AMT for individual taxpayers, limits on the deductions and exemptions of high-income individuals, and a host of retroactively resuscitated and extended tax breaks for individual and businesses. Here’s a look at the key elements of the package:

Tax rates. For tax years beginning after 2012, the 10%, 15%, 25%, 28%, 33% and 35% tax brackets from the Bush tax cuts will remain in place and are made permanent. This means that, for most Americans, the tax rates will stay the same. However, there will be a new 39.6% rate, which will begin at the following thresholds: $400,000 (single), $425,000 (head of household), $450,000 (joint filers and qualifying widow(er)s), and $225,000 (married filing separately). These dollar amounts will be inflation-adjusted for tax years after 2013.

Estate tax. The new law prevents steep increases in estate, gift and generation-skipping transfer (GST) tax that were slated to occur for individuals dying and gifts made after 2012 by permanently keeping the exemption level at $5,000,000 (as indexed for inflation). However, the new law also permanently increases the top estate, gift, and GST rate from 35% to 40% It also continues the portability feature that allows the estate of the first spouse to die to transfer his or her unused exclusion to the surviving spouse. All changes are effective fore individuals dying and gifts made after 2012.

Capital gains and qualified dividends rates. The new law retains the 0% tax rate on long-term capital gains and qualified dividends, modifies the 15% rate, and establishes a new 20% rate. Beginning in 2013, the rate will be 0% if income falls below the 25% tax bracket; 15% if income falls at or above the 25% tax bracket but below the new 39.6% rate; and 20% if income falls in the 39.6% tax bracket. It should be noted that the 20% top rate does not include the new 3.8% surtax on investment-type income and gains for tax years beginning after 2012, which applies on investment income above $200,000 (single) and $250,000 (joint filers) in adjusted gross income. So actually, the top rate for capital gains and dividends beginning in 2013 will be 23.8% if income falls in the 39.6% tax bracket. For lower income levels, the tax will be 0%, 15%, or 18.8%.

Personal exemption phase out. Beginning in 2013, personal exemptions will be phased out (i.e., reduced) for adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers). Taxpayers claim exemptions for themselves, their spouses and their dependents. Last year, each exemption was worth $3,800.

Itemized deduction limitation.Beginning in 2013, itemized deductions will be limited for adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers).


AMT relief. The new law provides permanent alternative minimum tax (AMT) relief. Prior to the Act, the individual AMT exemption amounts for 2012 were to have been $33,750 for unmarried taxpayers, $45,000 for joint filers and $22,500 for married persons filing separately. Retroactively effective for tax years beginning after 2011, the new law permanently increases these exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers and $39,375 for married persons filing separately. In addition, for tax years beginning after 2012, it indexes these exemption amounts for inflation.


Tax credits for low to middle wage earners. The new law extends for five years the following items that were originally enacted as part of the 2009 stimulus package and were slated to expire at the end of 2012: (1) the American Opportunity tax credit, which provides up to $2,500 in refundable tax credits for undergraduate college education; (2) eased rules for qualifying for the refundable child credit; and (3) various earned income tax credit (EITC) changes.


Cost recovery. The new law extends increased expensing limitations and treatment of certain real property as Code Section 179 property. It also extends and modifies the bonus depreciation provisions with respect to property placed in service after Dec. 31, 2012, in tax years ending after that date.


Tax break extenders. Many of the “traditional” tax extenders are extended for two years, retroactively to 2012 and through the end of 2013. Among many others, the extended provisions include the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes, the $250 above-the-line deduction for certain expenses of elementary and secondary school teachers, and the research credit.


Pension provision. For transfers after Dec. 31, 2012, in tax years ending after that date, plan provision in an applicable retirement plan (which includes a qualified Roth contribution program) can allow participants to elect to transfer amounts to designated Roth accounts with the transfer being treated as a taxable qualified rollover contribution.


Payroll tax cut is no more. The 2% payroll tax cut was allowed to expire at the end of 2012.


Business extenders in the 2012 American Taxpayer Relief Act

Business tax breaks extended. The following business credits and special rules are also extended:


            … The research credit is modified and retroactively extended for two years through 2013.

… The employer wage credit for employees who are active duty members of the uniformed services is retroactively extended for two years through 2013.

… The work opportunity tax credit is retroactively extended for two years through 2013.

… Exclusion from a tax-exempt organization’s unrelated business taxable income (UBTI) of interest, rent, royalties, and annuities paid to it from a controlled entity is extended through Dec. 31, 2013.

… Exclusion of 100% of the gain on certain small business stock acquired before Jan. 1, 2014.

… Basis adjustment to stock of S corporations making charitable contributions of property in tax years beginning before Dec. 31, 2013.

… The reduction in S corporation recognition period for built-in gains tax is extended through 2013, with a 10-year period instead of a 5-year period.

Depreciation provisions modified and extended. The following depreciation provisions are retroactively extended by the Act:

… 15-year straight line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements;

… 7-year recovery period for motorsports entertainment complexes;

… accelerated depreciation for business property on an Indian reservation;

… increased expensing limitations and treatment of certain real property as Section 179 property;

… special expensing rules for certain film and television productions; and

… the election to expense mine safety equipment.


Enhanced small business expensing (Section 179 expensing). Generally, the cost of property placed in service in a trade or business can’t be deducted in the year it’s placed in service if the property will be useful beyond the year. Instead, the cost is “capitalized” and depreciation deductions are allowed for most property (other than land), but are spread out over a period of years. However, to help small businesses quickly recover the cost of capital outlays, small business taxpayers can elect to write off these expenditures in the year they are made instead of recovering them through depreciation. The expense election is made available, on a tax year by tax year basis, under Section 179 of the Internal Revenue Code, and is often referred to as the “Section 179 election” or the “Code Section 179 election.” The new law makes three important changes to the Code Section 179 expense election

First, the new law provides that for tax years beginning in 2012 or 2013, a small business taxpayer will be allowed to write off up to $500,000 of capital expenditures subject to a phase out (i.e., gradual reduction) once capital expenditures exceed $2,000,000. For tax years beginning after 2013, the maximum expensing amount will drop to $25,000 and the phase out level will drop to $200,000.

Second, the new law extends the rule which treats off-the-shelf computer software as qualifying property through 2013.

Finally, the new law extends through 2013 the provision permitting a taxpayer to amend or irrevocably revoke an election for a tax year under Section 179 without IRS’s consent.

Extension of additional first-year depreciation. Businesses are allowed to deduct the cost of capital expenditures over time according to depreciation schedules. In previous legislation, Congress allowed businesses to more rapidly deduct capital expenditures of most new tangible personal property, and certain other new property, by permitting an additional fist-year write-off of the cost. For qualified property acquired and placed in service after Dec. 31, 2011 and before Jan. 1, 2013 (before Jan. 1, 2014 for certain longer-lived and transportation property), the additional first-year depreciation was 50% of the cost. The new law extends this additional first-year depreciation for investments placed in service before Jan. 1, 2014 (before Jan. 1, 2015 for certain longer-lived and transportation property).

The new law also extends for one year the election to accelerate the AMT credit instead of claiming additional first-year depreciation.

The new law leaves in place the existing rules as to what kinds of property qualify for additional first-year depreciation. Generally, the property must be (1) depreciable property with a recovery period of 20 years or less; (2) water utility property; (3) computer software; or (4) qualified leasehold improvements. Also the original use of the property must commence with the taxpayer – used machinery doesn’t qualify. 


Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years.  Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning.  Information contained above is not intended to be a recommendation to buy or sell any specific investments, or take specific tax actions and individuals should consult with their advisors for appropriate advice relating to their individual circumstances.

Year End Fiscal Cliff Tax Strategies


Depending on what, if any, tax legislation Congress is able to enact in the next several weeks, we will likely experience a tax increase for 2013 and later years.  That said, the following are some key strategies that should be considered.


Business Expense Strategies

If you are a cash-basis taxpayer and business owner operating as an S corporation, partnership or sole-proprietorship, you pay tax on the business’s net income on your individual federal income tax return. The business itself does not pay the tax. Therefore, an increase in tax rates is going to affect you.  Now is the time to plan for these tax rate hikes. Specifically, pay close attention to when you incur deductible business expenses. You may postpone some of these expenses to a future year when tax rates may be higher.  On the other hand, businesses with carry-forward losses may benefit more by accelerating income (to the extent possible based on tax law) into 2012 and deferring expenses to 2013 or later.


State and Local Tax Payment Strategies

Taxpayers often have some flexibility in determining when to make state and local tax payments. Such payments include income tax, real estate and personal property taxes. All of these items may be deductible for you depending on your tax situation. Review your situation to determine whether you have flexibility to delay these payments into next year. The delayed payment, and subsequent increase in tax deductions, may provide greater tax savings next year if tax rates increase.


Timing Charitable Contributions Strategies

As you consider additional 2012 charitable contributions, you should project forward to 2013. It might be advantageous to split your charitable giving budget between the two years. A charitable deduction (as long as it is not subject to limitation based on your income) could potentially be more valuable in 2013 than in 2012. After some analysis, you may find it more beneficial to lower your remaining 2012 charitable contributions and allocate more assets (cash or securities) to your 2013 charitable budget.  If you choose to wait for 2013 to make charitable gifts, you should consider making them with appreciated long-term assets rather than cash. Given the potential for rising tax rates, this strategy deserves a second look.   When the strategy is appropriate, the benefits are twofold:


When gifting appreciated stock to charity you avoid incurring capital gains taxes on the stock


A gift to a qualified charity provides a tax deduction, to the extent it is not limited based on your income.


Make sure to discuss this option to insure expenditures are fully deductible.


Timing Income

With respect to payments from your employer, consider whether you anticipate receiving a bonus or a lump sum payment due to retirement or a job transition, and talk with your employer about your flexibility in the timing of receiving the payment. Some employees are offered transition payment schedules that stretch over more than one year. This may not be ideal when tax rates are expected to increase as in 2013. A review of the payment amount, date(s) of receipt and your expected income tax bracket in 2012 and future years will be important in deciding or negotiating when to receive this income.


With respect to IRA or annuity distributions, taxable distributions from IRAs or annuities are a concern in a rising-tax-rate environment. If you are required to take minimum distributions from a retirement plan, IRA or inherited IRA, you’ll want to factor that into future-tax-year projections. Taking mandatory distributions boosts your taxable income and may require either an increase in your withholding or, perhaps, paying estimated taxes quarterly to avoid an underpayment penalty.  If you’re considering taking an elective distribution in the next few years, taking that distribution in 2012 when income tax rates are lower may be beneficial. This strategy is particularly timely when it comes to potential distributions and recognition of taxable income attributable to a Roth IRA conversion.


IRA to a Roth IRA Conversion Strategies

Anyone, regardless of income, now can convert a traditional IRA to a Roth IRA.  The benefits of converting are the potential for tax-free income in retirement and the ability to pass on assets that your heirs can withdraw tax-free after your death. However, you may incur income taxes in the year you make the conversion.  Because rates are scheduled to increase on January 1, 2013, if you’re considering converting, you may be better off doing it this year rather than in 2013.


Accelerating Long-Term Capital Gains Strategies

January 1, 2013, may see the end of historically low long-term capital gains rates. How much these rates will increase depends on your ordinary income tax rate bracket. Various Congressional proposals have been made that included alternative schedules, with some affecting only higher-bracket taxpayers; however, at this point they remain just that — proposals. As it stands now, you may find it beneficial to sell appreciated securities or assets that you’ve held for the long term in 2012 to take advantage of this year’s lower capital gains tax rates. This strategy may be particularly appropriate in certain situations: You can take advantage of the current 0% long-term capital gains rate. If your net taxable income, including your long-term capital gains, is less than $70,700 (joint filers) or $35,350 (single filers) in 2012, you will be in the 10% or 15% ordinary income tax bracket, which means you may be able to realize some tax-free long-term capital gains. If your capital gains push you over your threshold, or you are in a higher tax bracket, then some or all of the gains will be taxed at the 15% long-term capital gains rate.


If you hold a concentrated equity position, meaning a substantial position in one stock that has appreciated over time, selling a portion of the shares and purchasing other investments with the proceeds can help you diversify and reduce the market risk in your portfolio. If you have other goals that involve recognizing the gain, then you should evaluate the various strategies to help manage the risk of a concentrated position and the tax liability that may occur upon selling the investment.  However, given the limited window of opportunity for 2012’s historically low long-term capital gains tax rates, you may want to seriously consider selling a portion this year. Doing so can help you avoid the potential tax rate increase that is scheduled for long-term capital gains recognized in 2013 and thereafter.


If you own real estate or business assets, the upcoming tax rate changes should prompt you to consider how you are managing those assets. In some cases, the buyer and seller of such assets can structure the sale so that proceeds are paid over more than one tax year. Typically, this strategy helps the seller manage his or her tax liability. However, given that both ordinary income tax rates and long-term capital gains tax rates are scheduled to rise in 2013, you may want to attempt to complete a sale, and receive its proceeds, in 2012. If that is not possible, then perhaps electing out of an installment sale treatment and accelerating the income recognition all to 2012 may be an option.


Think ahead before selling if you decide to sell appreciated securities in 2012 to take advantage of the lower long-term capital gains rates, but be strategic in how you do it. For the portion of your portfolio you have designated for long-term goals, review and rebalance your allocation so that you are in a better investment management position going forward.  Doing so will let you benefit from 2012’s lower long-term capital gains tax rates, and in future years you may need less rebalancing, which should help reduce the gains that you realize when the tax rates are higher.


 Accelerating Capital Losses Strategies

Typically, investors consider selling investments near year-end to realize losses to offset capital gains or up to $3,000 in ordinary income.  However, if you have modest unrealized losses in 2012, and do not anticipate generating sizable capital gains, you might consider waiting to realize those losses until 2013.


Offsetting long-term capital gains that are taxed at 20% (the 2013 rate) will provide more tax savings than using the losses to offset gains taxed at 15% (the 2012 rate). You’ll need to look closely to project any potential capital gains (and don’t forget about long-term capital gains distributions from mutual funds). For investors whose income (including long-term capital gains) is within the 10% or 15% income tax bracket, harvesting losses will not provide a tax benefit if it only reduces long-term capital gains. Losses in excess of gains will offer a nominal tax savings at best and may provide more value if left for future years.


If, on the other hand, you have substantial capital losses or capital loss carry-forwards, it can sometimes be difficult to use up all of those losses.  In this case, it probably does not make sense to postpone offsetting capital gains or waiting to recognize gains.


Rebalancing Your Portfolio Strategies

In general, a qualified dividend is one paid by a U.S. corporation or an international corporation that trades on a U.S. stock exchange. You may also receive a qualified dividend if you hold shares in a mutual fund that invests in these types of corporations.


Currently, qualified dividends are taxed at a maximum 15% rate — like long-term capital gains; however, in 2013, they are scheduled to be taxed at ordinary income tax rates, which could be a maximum 39.6% rate (and quite possibly an additional 3.8% Obamacare surtax on high income taxpayers).  Given this anticipated change, you may want to consider reallocating the portion your portfolio held in taxable accounts using the following strategies.


Consider adding growth-stock holdings. If you don’t need current income, you may want to consider the advantages of shifting some of your equity allocation to growth stocks. Or you might reposition a portion of your tax-deferred account allocation to dividend-paying stocks, where the dividends will be shielded from current taxation. With a dividend-paying stock, your total return is based on both growth and income, and the income portion may be taxed as ordinary income starting in 2013.


If you hold a growth stock for the long term, any appreciation in the stock’s price will not be taxed until you sell it. At that point, you would owe long-term capital gains taxes (as long as you held the stock more than one year), which will still be lower than ordinary income rates even after 2012.  Because this strategy involves issues surrounding both your long-term asset allocation and taxation, careful analysis must be done to help determine the right strategy for your situation.


Reassess your tax-exempt bond holdings. If you need income, carefully weigh the pros and cons of tax-exempt bonds versus dividend-paying stocks. With rising tax rates, tax-exempt income may be more appealing. Dividend-paying stocks run the risk of having their dividend reduced or eliminated altogether.  Also, tax-exempt bonds are usually less volatile than stocks.


However, tax-exempt investments have inherent risks. For example, bond investments may not be as well equipped to protect against inflation as stocks.  In addition, keep in mind that some municipal bond interest may trigger the AMT tax.  Also, bond prices will fluctuate and move inversely to interest rates.  If interest rates increase, your bond investments’ principal value will fall.  We recommend continual portfolio monitoring and the outlook for the economy and the markets, so any proactive changes can be made when necessary.


You’ll also want to evaluate the investment’s yield. At 2012 income tax rates, a tax-exempt bond with a 4% yield would be comparable to a taxable investment with a 5.3% yield for someone in the 25% federal income tax bracket.  If income tax rates increase, this same taxpayer would need to find a taxable investment with a 5.6% yield to generate the same after-tax income as the 4% tax-exempt bond.


If you choose to alter your portfolio’s investment mix, remember that overall asset allocation remains appropriate for your investment goals, time horizon and risk tolerance.


Medicare Tax on Investment Income Strategies

Starting in 2013, married filing joint taxpayers with incomes over $250,000 and single taxpayers with incomes over $200,000 will be subject to a new (Obamacare) Medicare tax.  If you’re in either group, an additional 3.8% tax will be applied to some or all of your investment income, including capital gains. This will be in addition to ordinary and capital gains taxes that you already pay!  


Exercise Employer-Granted Stock Options

If your company has granted you stock options as part of your compensation package, you may have either (or both) nonqualified stock options (NSOs) or incentive stock options (ISOs). You will want to understand the choices you have and the tax consequences of exercising each type of stock option. NSOs give you the choice to exercise the options sometime between the vesting date and the expiration date. (See your stock option plan document or your employee benefits representative if you do not know these dates.) When you exercise an NSO, the difference between the stock’s fair market value and the exercise price will be taxable compensation that’s reported on your W-2. If you have vested options and the opportunity to exercise them in 2012 or 2013, you’ll need to determine in which year it might be more beneficial to exercise the options and recognize the income. You may want to project your taxable income for 2012 and a later year and then decide at which time it may be less taxing to exercise your options and realize the additional income. You’ll also want to consider the stock’s market outlook, its valuation and the options’ expiration date, in your decision-making process.


ISOs are somewhat more complex because your holding period determines whether the exercise proceeds are taxed as ordinary income (similar to NSOs) or long-term capital gains. To benefit from the potential long-term capital gains tax treatment (with its 15% top rate in 2012 and 20% top rate in 2013) versus ordinary income tax rates (which range up to 35% in 2012 and 39.6% in 2013), you must hold the stock you receive more than one year from the exercise date and more than two years from the grant date.  Because of the holding period requirement, it’s obviously too late to lock in the 15% capital gains tax rate on options you have not yet exercised. However, if you exercised options in 2011 or earlier and still hold the shares, you’ll want to weigh the pros and cons of selling them and recognizing gains in 2012 versus later years.


You should also be aware that if you exercise and hold shares from your ISO exercise, the taxable spread (the difference between the stock price on the exercise date and your option cost) will be taxable income for AMT purposes in the year in which the exercise occurs.


If you exercise your ISOs and sell without meeting this holding period, you will recognize taxable W-2 compensation similar to NSOs. Due to the lower capital gains rates, you may find it more attractive to hold ISO shares instead of selling them soon after your exercise.  Just be sure to consider any ATM tax potential.


If, instead, you decide to exercise ISOs and sell the stock, you may want to consider selling by year-end to take advantage of 2012’s lower ordinary income tax rates. As with NSOs, you’ll want to the market outlook for the stock, in your decision-making process.


Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years.  Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning.  Information contained above is not intended to be a recommendation to buy or sell any specific investments, or take specific tax actions and individuals should consult with their advisors for appropriate advice relating to their individual circumstances.

The Fiscal Cliff


What Exactly Is the Fiscal Cliff?

The fiscal cliff refers to a number of tax hikes and spending cuts that will go into effect on Jan. 1, 2013. If Congress and President Obama do not agree to act on averting this perfect storm of financial disaster, then America will, as the term has been coined, "fall off the cliff."  The tax increase alone will be more significant than any in the last half century.

According to a recent report from the Congressional Budget Office (CBO) the fiscal cliff (by virtue of taking billions of dollars out of the economy) would drive the U.S. into a recession next year and increase the jobless rate to 9.1% by the end of 2013.  In addition, the CBO said economic output would drop by about one half of one percent in 2013 if Congress fails to act to reverse the tax increases and spending cuts put in motion by an earlier deficit agreement.  It starts to take effect in January and includes $7 trillion worth of tax increases and spending cuts over a decade.  In addition, the debt ceiling — the legal limit on federal borrowing — will need to be raised by early next year from its current level of $16.394 trillion.

So what tax hikes and spending cuts exactly make up the fiscal cliff? Let’s take a look.

Automatic spending cuts

Since Congress failed last year to reach a debt deal, Budget Control Act provides for automatic spending cuts to begin on January 2, 2013 that will amount to $1.2 trillion in deficit reduction over 10 years.  Frankly, that only amounts to about $120 billion per year which is a drop in the deficit bucket.

Defense spending would be cut about $55 billion in 2013, which translates to at least a 10% cut to every program, project and activity that's not explicitly exempt.

Another $55 billion will be cut from projected levels of nondefense spending, which would include things like education, food inspections and air travel safety.  That amounts to about an 8% cut to programs, projects and activities.


The Bush tax cuts

The current rates we have enjoyed for over the last decade are set to expire December 31 as follows:

Income tax rates / brackets: Rise to 15%, 28%, 31%, 36% and 39.6%, up from 10%, 15%, 25%, 28%, 33% and 35%.

Capital gains rate: Rises to 20% from 15% for most filers.

Qualified dividend rate: Rises to one's top income tax rate, up from 15% for most filers.

Increased itemized deduction limitations: High-income taxpayers may not be able to take some itemized deductions and personal exemptions in full.

Child tax credit: Falls to $500 per child from $1,000. The refundable portion also reduced.

American Opportunity Tax Credit: This credit expires. The smaller value HOPE tax credit for college tuition is reinstated. Several smaller education tax benefits also expire.

Earned Income Tax Credit: Expanded eligibility for the credit expires.

Marriage penalty relief: This means that a low or middle income two-earner couple will owe more to the IRS than they would if they were single making the same income.

Estate tax: The estate tax exemption and credit levels revert to prior levels. The exemption level falls to $1 million from $5 million; and the top tax rate on taxable estates increases to 55%, up from 35%.

Payroll tax holiday

The Social Security tax rate reverts to 6.2%, up from 4.2%, on the first $110,100 in wages. Effectively, someone making $50,000 will pay another $1,000 in payroll taxes next year.  Given the bankrupt state of the social security system as a whole, this was an incredibly misguided provision in the first place.

Unemployment benefits extension

The federal benefit extension period expires. For workers who lose their jobs after July 1, 2012, only 26 weeks of benefit payments are available, down from 99 weeks of benefits that had been available.  This means that an estimated 2 million claimants will lose their benefits by January.

AMT patch

The Alternative Minimum Tax thresholds fall to $33,750 for individuals and $45,000 for married couples. That's down from $50,600 and $78,750, respectively, if the exemption amounts had been adjusted for inflation.   As a result, more than 30 million more people will now be hit by this tax, up from 4 million to date.


As part of Obamacare, which is now the law of the land, several new additional taxes will be added on top of the tax increases above.

A surtax of .9% will apply to wages or earned income over $200,000 ($250,000 if married). That's on top of the 1.45% Medicare currently owed on all wages.

An additional 3.8% Medicare surtax will also apply to investment income for taxpayers earning incomes in excess of $250,000.

What to do now

Tax, estate and financial planning are key right now.  A thorough review of your tax and financial situation should be taken to determine if it makes sense to sell any long term capital gain investments and pay the 15% tax today, rather than 20% or more after the first of the year. 

A review of portfolio holdings should also be conducted to determine any possible exposure to adverse selling pressure to dividend paying stocks or funds.  Likewise, the renewed favorability of municipal bonds should be considered, given the higher tax rates that are upon us, not to mention the additional 3.8% Medicare tax on investment income for high income earners under Obamacare.

Accelerating any ordinary income into 2012 from 2013 is also a possible strategy, depending on your individual circumstances.

Finally, for anyone with assets exposed to the new estate tax thresholds (currently $5 million per person, going down to 1 million per person) an immediate review of wills, trusts and estate planning options could save millions in death taxes.


Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years.  Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning.  Information contained above is not intended to be a recommendation to buy or sell any specific investments, or take specific tax actions and individuals should consult with their advisors for appropriate advice relating to their individual circumstances.

Are Bond Investments Dangerous Right Now?

By Anthony Caruso, CPA, PFS

September 18, 2012


The short answer is “probably”.  But then again, stock investments are dangerous right now too.  In fact at any given time, there is some level of risk associated with any investment.  It’s the nature of investing.  The trick of course, is to balance that risk with reward and still sleep at night.  That is my job as an investment advisor.  It is also my job to help my clients determine what their level of risk really is.  Risk is a funny thing.  When the stock market is rip roaring, most everyone is willing to take a little more risk than they really should, and when the market is depressed, most are so fearful that little to no level of risk can be tolerated.  Neither of these extremes makes for good investing and my job is to guide clients past the emotional responses to make better decisions.

There has been a lot of talk about the bond market, how risky it is, and how it is ready to implode.  That conversation has been going on for several years now.  The culprits for the bond bubble are the Federal Reverse holding rates unrealistically low (QE 1, QE2, the twist and now QE3), money printing, dollar devaluation, inflation, etc.  These are all good points, all true, and all inevitable.  The real question is, when bonds will be crushed, not if.

To recap, there was a massive shift from stocks to bonds because of the financial meltdown and bear market of 2008- 2009. Scores of investors moved from “risky” stocks to “safe” bonds.   Now when I say “bonds” here, I am talking about everything from individual bonds, to bond funds and bond ETFs.

US interest rates are at historical lows. The 10-year Treasury note currently trades at about 1.8%, which is up since the announcement of QE3.  The 30-Year Treasury bond now yields around 3%, which is the lowest rate in over 50 years. Can interest rates still go lower?  Remember, bond yields have to go lower for bond prices to go up from here.  Realistically, how much more room can there possibly be?  Then again, Japan has been in this kind of funk for twenty years so anything is possible.  Now if and when interest rates go up however, then the principal value of bonds will go down, and bond investors who do not take evasive measures, will lose a great deal of money.

There are many reasons why interest rates may move higherThe national debt is now 16 trillion dollars and will soon exceed our annual GDP.   Think about that for a moment.  The US government owes more than the total value of all goods and services produced in the USA in a year!  It is only a matter of time before China (our largest creditor) and other foreign creditors start demanding higher rates to purchase our debt?  When there is more risk, those who lend us money want more interest to compensate for a greater chance of not being repaid.  Even the US government can go bankrupt.  That is the reality.  Can you say Greece (or Spain, or Italy, or Portugal for that matter)?  We are not immune to insolvency just because we are the USA.  The laws of economics and math are blind to borders.

Now on the flip side, the economy is still a disaster.  Unemployment remains high, corporate earnings are starting to stall, the manufacturing and purchasing indexes are heading down and housing remains depressed.  Europe remains a mess despite recent ECB actions to copy our Federal Reserve playbook on bond purchases, and China is slowing down.    The mere fact that the Fed has rolled out QE3, in a panic mode of unlimited duration, confirms just how serious things really are.  That said, there is a case to be made for interest rates and bond prices not to move significantly any time soon. 

Of course, since the Fed is now moving to print money to buy mortgage backed securities, and will slow or end the buying treasuries come January, interest rates could spike for that reason alone, let alone for the reasons stated above.  That could put us back to the Jimmy Carter era of “stagflation” with higher interest rates and inflation, and a recessionary economy at the same time.  Time will tell.

It is obvious that the low interest rate Fed policy has promoted investors who rely on investment income (such as the elderly and retirees) to move to more risky stock investments to generate dividends and appreciation in order to make ends meet.  This is why the stock market looks so good at the moment, and gives the impression that the economy is in great shape.  It is not, and the stock market poses just as much risk of loss as do bonds, in my opinion, and maybe more.

So, stocks and bonds have had a nice run, but there also seems to be some scary concerns.  It’s quite the conundrum.  Is it time to just go to cash?

In the world of investing, gut feelings and opinions mean nothing and investing on emotions is financial suicide.  If nothing else, always remember that sage Wall Street saying “the trend is your friend – until it ends.”  John Bogle, the founder of the Vanguard Group, once said “The genius of investing is recognizing the direction of a trend – not catching the highs and lows.”  Too many people try to time and pick the top and bottom of a position which is impossible.  Riding along with the general trend is much more important the picking the exact high or low.  Peter Lynch, the great Fidelity Magellan Fund manager noted that “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections, than has been lost in the corrections themselves.”  I don’t doubt that.

So what is the answer?  I can only tell you what I do with my money, and what I do for my clients.  First of all, every client portfolio has customized proportions of equities and fixed income (stocks and bonds) based on their unique needs, age, goals, and tolerance for risk. But the proportions do not matter here, for purposes of the point I am about to make.  When good advisors talk about the equities portion of a portfolio they usually speak in terms of Modern Portfolio Theory.  That is, asset allocation and diversification (having different asset classes such as large companies, small companies, domestic and international companies, and alternative investments that may be appropriate at the time).    There is often much less effort put in to the fixed income portion of the portfolio however.  The easy way out might be to have a couple of different short to intermediate term funds, with perhaps some corporate bonds, some treasuries, or some TIPS, then call it a day. 

By my way of thinking however, the fixed income investments must be equally diversified and spread among many different classes to balance risk (loss of principal) and reward (income earned).  There are many types of fixed income options and doing the work to mix the right ingredients in the right proportions, will make the kind of cake grandma would serve, rather than the three day old mass produced variety from the supermarket.  My approach has been to spread the fixed income money over a dozen or more funds, each with a different, yet specific purpose.  Some contain government and agency bonds, some corporate bonds, some municipal bonds, some high yield bonds, some global bonds denominated in dollars, and some denominated in the local currencies.  Further, there are mixed maturities and durations.  On any given day, some go up in value with the stock market, and some go up when stocks are down and money flows in a “flight to quality.”  Bonds with different or inverse correlations we in the biz might say.  The result is to keep the overall principal invested in bonds stable (isn’t that what bonds are supposed to be for anyway), and yet collect much higher rates of interest than CDs or treasuries are currently paying (nearly nothing).  While I don’t expect bonds to appreciate much from here, I am more concerned with minimizing any principal loss (to balance out the volatility of stocks), and earning income.  That’s the way we do it anyway.  I think it is worth the extra work. 

Well that all sounds well and good you might say, but what do you do when the inevitable bond bubble finally does burst?  Remember our motto – the trend is your friend.  When the trend of this investment or that one starts to decline, then get out.  We have predetermined rules on when to enter and when to exit, and we follow those rules.  This does not mean we pick the tops and bottoms.  We don’t and no one can.  But we can catch the general trend and limit our downside risk.  This applies to both stocks and bonds, on an investment by investment basis. 

So rather than get off the bond bus too early, stay for the ride.  Just be sure you pay attention and have a pre-determined plan as to where your stop is, or find an advisor that can guide you.  You might just sleep a little better, after all.

Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years.  Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning.  Information contained above is not intended to be a recommendation to buy or sell any specific investments, or take specific tax actions and individuals should consult with their advisors for appropriate advice relating to their individual circumstances.  Find us at



The Richest Man in Babylon

"Divide your portion to seven, or even eight, for you do not know what misfortune may occur on the earth." – Ecclesiastes 11:2

One of the biggest challenges I’ve faced with tax clients over the years, is that so many just live beyond their means.  These are bright, well educated people with successful professions or businesses that make very good livings.  The problem is, they always seem to have inadequate savings, and no cushion for a rainy day.  And certainly, as Ecclesiastes teaches us, no diversification.  Most would tell me they will start putting something more away for retirement “one of these days”.  It’s one of the reasons I added investment advisory services to my practice.  I knew I could help them with some basic rules and near painless financial discipline.

The Richest Man in Babylon is a classic tale, and the principles of the story are not unlike the more contemporary book “The Millionaire Next Door.”  The wisdom is simple. The value is priceless.

The parable told in this very old book is not only timeless, but perhaps even more relevant today.  The story takes place in the ancient city of Babylon.  Babylon was a city of wealth and splendor with treasures of gold and jewels.   It was located beside the Euphrates River in a flat and arid valley.  It had no forests, no mines, and no stones for building.  It was not located on a natural trade route. The rainfall was insufficient to raise crops.  Babylon was a prime example of man’s ability to achieve greatness by using whatever means was at his disposal. All of the resources supporting this large city were man made, as were all of its riches.  Babylon possessed only two natural resources consisting of fertile soil and water in the river. With one of the greatest engineering accomplishments of the day, Babylonian engineers diverted the waters from the river by means of dams and irrigation canals to provide water to the land allowing the growth of abundant crops. The Babylonians were also artists, inventors, philosophers, manufacturers, financiers and traders, well ahead of their time.  It was a civilization to behold. 

The story begins with friends Bansir, a chariot builder, and Kobbi, a musician, discussing their poverty despite being in lucrative professions.  They come upon childhood friend Arkad, who has since become one of the richest men in Babylon.  They ask him how he came to acquire such riches while they have worked so hard, yet are penniless.  Arkad explains that he himself was once a hard working but penniless scribe, who made a deal with a very rich man named Algamish.  Arkad would complete a job for Algamish and in return, Algamish would teach him the secret of acquiring wealth.   

The agreement was honored and when Arkad completed the job the wealthy man shared his secret. “I found the road to wealth, when I decided that a part of all I earned was mine to keep.”  Bansir and Kobbi then ask, "Isn't all that I make mine to keep?" Arkad then said no, that a man had to pay for his clothes, for his food, his shelter, etc., but that if he regularly saved at least a tenth of his income (and as much more as he could afford to save) and put that money to work earning interest, he would become wealthy.  Arkad then began to share his wisdom with his friends, explaining his basic principles he called “Seven Cures for a Lean Purse”.

Start Thy Purse to Fattening

Arkad instructs the men to begin by continuing to work hard at their current occupations, but for every ten coins placed in their purse to take out for use but nine. "Deride not what I say because of its simplicity," Arkad says, "Truth is always simple."

Control Thy Expenditures

"How can a man keep one-tenth of all he earns in his purse when all the coins he earns are not enough for his necessary expenditures?"  "How many of you have lean purses," Arkad asks. All of the men say that they have lean purses, that they have no money. "Yet," Arkad responds, "Thou do not all earn the same. Some earn much more than others. Some have much larger families to support. Yet, all purses are equally lean.” Now, I will tell thee an unusual truth about men and the sons of men. It is this: “That what each of us calls our necessary expenses will always grow to equal our incomes unless we protest to the contrary." Arkad tells the men not to confuse necessary expenses with their desires, that all men are burdened with more desires than they can gratify. "Budget thy expenses that thou mayest have coins to pay for thy necessities, to pay for thy enjoyments and to gratify thy worthwhile desires without spending more than nine-tenths of thy earnings."

Make Thy Gold Multiply

Once you've started saving at least one-tenth of what you earn, you must put that money to work earning interest. "Put each coin to laboring that it may reproduce its kind even as the flocks of the field and help bring to thee income, a stream of wealth that shall flow constantly into thy purse."

Guard Thy Treasures from Loss

Arkad explains “Everyone is tempted by opportunities, whereby it would seem that a man could make large sums by investing his money in most plausible projects. Often friends and relatives are eagerly entering such investment and urge him to follow." The first sound principle of investment is security—what is a person who wants a loan from you offering as collateral? "Guard thy treasure from loss by investing only where thy principle is safe, where it may be reclaimed if desirable, and where thou will not fail to collect a fair rental. Consult with wise men. Secure the advice of those experienced in the profitable handling of gold. Let their wisdom protect thy treasure from unsafe investments."

Make of Thy Dwelling a Profitable Investment

If you pay rent to a landlord all your life, at the end of your life you'll have nothing to show for it. If you can instead pay a mortgage on a house, at the end of your life you'll have a house to show for it. "Own thy own home."

Insure a Future Income

It behooves a man to make preparation for a suitable income in the days to come, when he is no longer young, and to make preparations for his family should he be no longer with them to comfort and support them.  "The man, who, because of his understanding of the laws of wealth, acquireth a growing surplus, should give thought to those future days. He should plan certain investments or provision that may endure safely for many years, yet will be available when the time arrives which he has so wisely anticipated.

Increase Thy Ability to Earn

A man must set goals and work to achieve them. These goals should not only be to advance in one's career or one's position, but also to become wiser and more knowledgeable. Further, if a man respects himself, he must do the following:

  • Pay his debts with all promptness in his power not purchasing that for which he is unable to pay.
  • He must take care of his family that they may think and speak well of him.
  • He must make a will in case God calls him, so a proper and honorable division of his property is accomplished.
  • He must have compassion upon those who are injured and smitten by misfortune and aid them within reasonable limits; do deeds of thoughtfulness to those dear to him.

"Cultivate thy own powers, to study and become wiser, to become more skillful, to so act as to respect thyself. Thereby shalt thou acquire confidence in thyself to achieve thy carefully considered desires."

And there you have it.  Isn’t this really what modern day financial planning is all about?  A little common sense, a little wisdom, and a little more discipline – that’s the hard part for most, and it really does not need to be.  Having a good plan and a good advisor to show you the way is most of the battle.  The rest, as true of most things in life, is up to you.  

Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years.  Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning.  Information contained above is not intended to be a recommendation to buy or sell any specific investments, or take specific tax actions and individuals should consult with their advisors for appropriate advice relating to their individual circumstances.

The Truth About Diversification

Diversification is a method that reduces risk by allocating money in a portfolio among various types of investment categories.  Those categories are known as “asset classes”, and deciding how much to put in to each asset class is known as “asset allocation”.  The rationale behind diversification is that a portfolio of different kinds of investments will generate higher returns with lower risk than one with only a few investments.

Why You Should Diversify
Let's say you have a portfolio of only one investment, all in a large insurance company.  It grows nicely and pays a handsome dividend for years, but then, a series of tornados in the Midwest devastate thousands of homes.  A short time later, two major hurricanes hit Florida then the gulf region.  Potential claims are so substantial that the insurance company could go bankrupt, and its stock plummets.  Your portfolio is crushed.  But now let’s say that instead of putting all of your money in to owning one insurance company, you had split your money equally putting half in to the insurance company and the other half in to a home improvement and building materials company.  In this instance, while the storm damages would cause your insurance stock to lose value, at the same time, homes would have to be rebuilt or repaired and the demand for building materials would skyrocket, as would your investment in the building materials company.  A statistician would say that because these two stocks seem to counterbalance each other, they do not have a strong “correlation”, meaning that they do not act the same way.  In building a diversified portfolio then, we want to have asset classes that not only do not act the same way, but actually have some degree of “inverse correlation”, meaning that if some investments go down, others will go up to offset losses (stocks and bonds often move in opposite directions).  This is why diversification keeps your risk of losses in check.  Now as you might imagine, the more you diversify your portfolio with inversely correlated asset classes, the better chance you have to lower risk.

Diversification or Diworsification?
Diworsification is a play on the word diversification, coined by the famed fund manager Peter Lynch.   While diversification involves a selection of assets with inverse correlations, which reduces risk and can increase potential returns, “diworsification” occurs by investing in too many assets that may appear to be different, but in fact act the same way.  A common mistake for example, would be for an investor to split his money over the top five performing U.S. large company mutual funds, with the assumption that five different mutual funds would be five totally different “diversified” investments.  On closer inspection however, by drilling down and looking at the top 25 stocks that each of these different mutual funds owned, one would be surprised to see that they all owned almost the exact same individual stocks.   

Two Kinds of Risk
When we talk about managing risk in the investing process, it’s important to note that there are actually several types of risk we need to be concerned with.

Systematic Risk – These are risks that affect the entire market and cannot be completely diversified away. Interest rate increases, recessions, political instability, exchange rates and wars are examples of systematic risks.

Unsystematic Risk – These are risks that are specific to individual stocks or investments, and can be diversified away as you increase the number of stocks or investments in your portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the advantages of diversification will exist only if the securities in the portfolio are not perfectly correlated

What is Asset Allocation?
Asset allocation is the strategy of dividing your total investment portfolio among various asset classes (that are not perfectly correlated), such as equities (stocks), fixed income (bonds), real estate, commodities, precious metals, etc. Asset allocation is the method we use to achieve effective diversification.
Some common asset classes are as follows:

  • Large-cap stock – These are shares issued by large companies with a market capitalization generally greater than $10 billion.
  • Mid-cap stock – These are issued by mid-sized companies with a market cap generally between $2 billion and $10 billion.
  • Small-cap stocks – These represent smaller-sized companies with a market cap of less than $2 billion. These types of equities tend to have the highest risk due to lower liquidity.
  • International securities – These types of assets are issued by foreign companies in developed nations, and are listed on a foreign exchange.  International securities allow an investor to diversify outside of his or her country, but they also have exposure to country specific economic or political risk.
  • Emerging markets – This category represents securities from the financial markets of a developing country. While investments in emerging markets can offer a higher potential return, there is also higher risk, often due to political instability, country risk and lower liquidity.
  • Fixed income securities – The fixed-income asset class comprises bonds or other debt obligations that pay the owner a set amount of interest, periodically or at maturity, as well as the return of principal when the security matures.  Maturities can range from short term to intermediate or long term.  These securities are intended to have lower risk because of the steady income they provide.  In reality, bonds can fluctuate in value and be worth more or less than the price you originally paid, if you seek to sell them before maturity.  In addition, there is always a risk of default if the issuer cannot repay the principal when due. Fixed-income securities include corporate and government bonds.
  • Money market – Money market securities are debt securities that are extremely liquid investments with maturities of less than one year. Treasury bills (T-bills) and short term commercial paper make up the majority of these types of securities.
  • Real-estate investment trusts (REITs) – Real estate investment trusts (REITs) trade similarly to equities, except the underlying asset is a share of a pool of mortgages or properties, rather than ownership of a company.

There is no standard formula that can find the right asset allocation for every person.  A customized asset allocation plan should only come after a professional assessment of an investor’s age, level of risk tolerance (how much can he lose in the short term and still sleep at night), anticipated future additions to the portfolio during working years, investment objectives (such as how big does the portfolio need to be at retirement age to meet expected living expenses) and other pertinent financial planning issues.  Only then can his specific investment goals be properly understood, and a roadmap to get there be designed.

Strategic and Tactical Asset Allocation 
After an assessment is made and a suitable asset allocation plan is determined, a portfolio is divided in to various percentages of each asset class.  Over time, some classes will grow in value, and others will lose in value.  Using a strategic asset allocation method, those asset classes are periodically “rebalanced” back to their original starting percentages to keep risk management and diversification on track.  For example, an investor with a $200,000 portfolio may start with an asset allocation of 50% in stocks and 50% in fixed income.  After a year, when stocks have outperformed bonds, the portfolio now holds $130,000 in stocks and $110,000 in bonds.  Rebalancing would result in the sale of $10,000 worth of stocks from the portfolio, and the proceeds would be used to buy bonds, to get back to the original 50%/50% allocation.

On the other hand, if a tactical asset allocation method is used, a portfolio manager seeks to create extra value by modifying the percentages in each asset class to take advantage of certain economic or market conditions.  This is a more active strategy where a portfolio manager only returns to the portfolio's original strategic asset mix after desired short-term profits are achieved.

Diversification via asset allocation is a fundamental investing principle, because it helps investors maximize profits while minimizing risk. Choosing an appropriate asset allocation strategy and conducting periodic reviews will ensure you maintain your long-term investment goals and reach your desired return at the lowest amount of risk possible.

How to Evaluate and Choose Mutual Funds

By Anthony Caruso, CPA, PFS 

Many investors today utilize mutual funds as part of their overall investment plan.  Whether you must make your own mutual fund selections for your 401(K) or employer sponsored retirement plan, or use a professional investment advisor for other types of investment accounts, mutual funds can be an effective way to own baskets of stocks or bonds, with a small amount of investment dollars.

Understanding Mutual Funds

To successfully invest in mutual funds, you should understand what they are and how they work, so let’s start with some basics.

A mutual fund is a company that gathers money from many investors, and allocates that money by buying stocks, bonds or other assets.  A mutual fund is like a big basket which holds a number of investments like stocks or bonds.  When you buy a mutual fund, you actually buy a piece of the basket.  In this way, you can own a small percentage of many different assets that you might not otherwise be able to afford on an individual basis. 

The value of the fund is based on the value of the assets it holds. As the stocks or bonds within the fund increase in value, the fund increases in value. Conversely, as the stocks or bonds within the fund decrease in value, the fund also decreases in value.   Mutual funds only trade at the end of the day based on their net asset value (NAV). To determine the NAV at the end of the trading day, the mutual fund company looks at all of the assets that are in the basket, determines their value and divides that number by the total number of outstanding shares in the fund.

Types of Mutual Funds

Mutual funds are divided into two categories: closed-end funds and open-end funds.

Closed-end funds have a fixed number of shares issued to the public.  If you want to purchase a piece of the fund, you have to purchase an existing share from a shareholder that is selling.

Open-end funds have an unlimited number of shares. If you want to purchase a piece of the fund, the fund creates a new share and sells it to you. There are significantly more open-end funds than there are closed-end funds.  Closed end funds can trade at values that are above or below their NAV, while open end funds only trade at their end of day NAV.

Mutual Fund Research – Do Your Homework


All mutual funds have expenses. Some funds’ expenses are low while other funds’ have very high expenses.  These include everything from the advisory fee paid the fund manager to administrative costs like printing and postage.

With a little bit of homework, you can determine a fund’s expenses before you invest.  This is important because those expenses can have a dramatic effect on your investment returns. The three expenses you should be aware of are loads, redemption fees and operating expenses.

Loads are commissions or fees that can be charged either when you buy or sell a mutual fund.  A front-end load (usually associated with class “A” shares) can be up to 8.5% of your investment.  A back-end load (usually called redemption fees, are associated with class “B” shares) can also be quite high, but reduces over the years, the longer you keep your investment in the fund.  Class “C” shares do not have a front or back end load, but have extremely high operating expenses deducted each and every year.  These loads are usually used to pay a commission to the agent who sold you the fund. No-load funds, on the other hand, do not charge any commission at the front or back end.

Operating expenses are generally stated as an annual percentage called the operating expense ratio. These fees cover the operating and trading costs for the fund, as well as management fees that go to pay the fund manager for his expertise and time.

12(b)-1 are fees that cover advertising and distribution expenses for the fund.  These fees are charged in addition to a front- or back-end load.

When doing your homework, look for no load funds that do not charge 12(b)-1 fees, and have a low operating expense ratio.  Studies have shown that load funds with high expense ratios perform no better than comparable no-load funds.

Another point to consider when investing in mutual funds is taxes.  When a fund manager sells a stock or bond within the basket for a gain, IRS regulations provide that this gain be taxed to the shareholders of the fund.  This means that a fund with a high “turnover” (a fund that buys and sells a lot within the basket each year) could have a great deal of gains that will be taxable to the shareholders.  The tax gains are passed through to the shareholders who own the fund as of a specific date each year.  This means that someone buying the fund just before the taxable distribution date, will pay the tax on the gain for the entire year, even though they did not own the fund all year.  For more tax efficient funds, look for funds that have a low turnover rate.


By law, a mutual fund company must outline all of the above expense information, and a great deal more, in their prospectus.  A fund’s prospectus will specify a fund’s objectives and its past performance, information about the fund manager and the fees associated with the fund.

Past Performance

A common mistake for novice investors is to select a mutual based solely on its past performance record.  Past performance may not be a food indicator of future performance, given possible changes in the global or domestic economy, the markets, or specific sectors the fund invests in.  While past performance is a useful tool and one item to consider, it should not be the sole criteria.  In many cases last year’s winners are next year’s underperformers.


A fund that has been in existence five to ten years or more has a much better track record to assess than a relatively new fund that have not necessarily had performance measured during various economic or market periods.  The longer the period of history you have to review, the higher the quality of historical performance data.

Portfolio Holdings

When investing in mutual funds (or any investments), it is important to be diversified (see my blog titled “The Truth About Diversification”).  Sometimes, owning a few different mutual funds may give the appearance of being well diversified, but on closer inspection, if the funds you own, each have major holdings in the same stocks, you may not be diversified at all.  One test is to check the fund's ten largest holdings. In the more concentrated funds, the ten largest holdings may comprise a significant percentage of the portfolio; in the less concentrated funds, they may hold a much lower percentage.  Always know what specific investments your fund or funds own to remain diversified.

Portfolio Manager

Mutual funds are managed by a portfolio manager, or in some cases, by a team of portfolio managers.  The success of a fund by an individual fund manager may be largely dictated by his performance.  That is important to know, because a fund with a good track record historically, may perform differently in the future if the fund manager changes.  It is always prudent to review the tenure of the fund manager in concert with past performance.


There are several key statistical numbers that provide valuable information about a mutual fund.  Fortunately, we do not have to calculate those statistical numbers ourselves as they are readily available.

Alpha – measures the performance of a fund on a risk-adjusted basis. Alpha calculates a risk factor relative to a fund, and then compares that risk-adjusted performance to a benchmark (such as the S&P 500).  A number is then assigned that reflects how that fund performs, relative to the amount of risk the investment is exposed to.  For example, a positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%, or a negative alpha of -1.0 would indicate an underperformance compared to the benchmark  of 1%. 

Beta – measures how a mutual fund performs in relation to the market as a whole.  A beta of 1 for example, means that a mutual fund will move up or down in value in tandem with the market.  A beta of 2.0 would mean a mutual fund would go up twice as much as the market when it the market increases, but it will also go down twice as much when the market decreases.  That means this would be a much more volatile fund.  A conservative investor would look for investments with a lower beta, rather than a higher one. 

Standard Deviation – measures the risk, or volatility of a mutual fund or investment.  For example, a mutual fund might have a ten year average annual return of 8%.  At first blush, that might look very good.  But let’s say that this fund had a standard deviation of  20.  This would tell us that although the fund had on average returned 8% over ten years, it did not earn 8% each and every year.  Some years may have been up and some may have been down, but the average was 8% overall.  The standard deviation number tells us that we should expect that this fund “could” return 20% more or 20% less than 8% in any given year, most, but not all of the time.  There are certain times, more rare but possible, that a fund might move two or three standard deviations above or below the average 8% (60% more or 60% less).  In a down market, that could be painful.  The lower the standard deviation, the less risk or volatility a fund has.         

In conclusion, doing a little homework on mutual funds can really pay off later on not only in terms of performance, but also in terms of understanding risk and diversification.  You will find that all of the information discussed above is easily available on a number of internet sites, including Yahoo, MSN, and Morningstar to name a few.