Hey Kids, money is important

April 16, 2014

Three reasons for liking money: The best is that it buys things you want at today’s prices. Another reason is that it will buy things in the future. And the third reason is that it represents the trading value of goods and services (1).

Risk

Most people aren’t given a lot of money. They have to earn it and invest it to get rich. They also have to protect it against ‘risk’. Think of risk as your chances of losing money. Here are some easy ways of losing money:

  1. Theft. People may steal your money unless you put it in the bank and keep your bank account’s password a secret.
  2. Overspending. Save money for things that you will need in the future. Otherwise, you are spending too much money. Another way of overspending is to borrow money to buy things that you don’t really need. The best way to avoid overspending is to plan a budget.
  3. Debt. Using a credit card or taking a loan are two different ways of borrowing money from somebody called a lender. Before borrowing the money, you must sign a contract that requires you to repay the lender on time with an extra amount of money called interest. All of the money that you owe is called debt and refusal to repay the lender may eventually prevent you from buying things. Don’t borrow money unless you need it for an important reason (such as education) and use a budget to manage your debt.
  4. Unemployment. Unemployment occurs when people can’t work for money. Avoid unemployment by getting a good education and learning good skills. Don’t drop out of high school before graduation.
  5. Disasters. Accidents, illnesses, wars, and severe weather conditions are disasters that require a lot of money to survive the damage. Adults can buy insurance that will help pay for illness, injuries, and property damage.
  6. Inflation reduces the purchasing power of money.
  7. Citizens are required to pay taxes on the money they earn.

Inflation

Money’s ability to pay for things is called purchasing power. It’s no secret that the purchasing power of money changes over time. Today the price of a Big Mac™ hamburger is nearly five dollars. But 50 years ago, the price of a Big Mac™ hamburger was only 45 cents. What happened over 50 years? The prices of most things went up, including the price of hamburgers. The increase in prices over time is called ‘inflation’.

You can be sure that today’s money will buy less in the future due to inflation. The best way to protect against the effects of inflation is to start investing money as soon as possible.

Investing money

Think of  ‘investing’ as a good way of using money to earn more money. The money that you earn is called a profit or a return. Investing is a lifetime skill worth learning now.

The risk of investing is that you will lose money. If you don’t want to risk losing money, invest in U.S. Government Bonds. The government always repays your money plus a type of return called interest.

Stocks are risky investments that often pay a higher return than U.S. Government Bonds. When you buy shares of a good stock, you must sell them at a higher price to earn the type of return called a capital gain. Try to avoid losing money by selling the shares at a lower price than you paid; that kind of loss is called a capital loss. The longer you wait to sell shares, the better your chance of selling them at a higher price. Some good stocks also pay small amounts of cash called dividends.

Investors who don’t have the time or interest in selecting a good stock can earn the average return from a large group of stocks by purchasing shares of a stock index fund. Investing in a good stock index fund is less risky than investing in a good stock.

Taxes

Investors must pay part of their returns to the Government by paying taxes. Employees are able to pay lower taxes on their returns by investing in tax-deferred and tax-free retirement accounts. If you earn wages as an employee, you may be able to invest in tax-deferred accounts known as the traditional individual retirement account [IRA] and the employer sponsored 401(k) account. Tax-deferred accounts protect you from paying taxes on returns until you start withdrawing money after retirement. You may also be able to invest in tax-free accounts known as the Roth IRA and the Roth 401(k). After you pay regular taxes on your wages, you never pay taxes on money that you withdraw after retirement. Employers, tax advisers, and librarians can provide information that you need to know before using these important retirement accounts.

Making the most of your money

Click into this money management website to get good advice on managing and growing your money.

Copyright © 2014 Douglas R. Knight

References

1. Free exchange. Money from nothing. The Economist, 3/15/2014.


ETF risk, Tax burden

September 24, 2011

ETFs are taxed on earnings from the underlying assets of the investment portfolio. But it’s the shareholders, not the ETF, that pay all U.S. Federal and State taxes on the portfolio income.  The shareholder’s tax burden is the total cost of a tax accountant’s fees combined with tax payments.  The warning signs of increased tax preparer’s fees are Schedule K-1s and trust letters.  The cost of tax preparation may increase by an obligation to prepare tax reports for state governments where a grantor trust or partnership earns income.  I exclude regulated investment companies (RICs) from incurring extra costs of tax preparation (most index ETFs are registered by the U.S. Securities and Exchange Commission as RICs).   The tax rates are higher for precious metals than for long term capital gains.  Portfolio turnover rates above 100% tend to increase the tax burden by generating higher capital gains and ordinary income1,2,3,4,5,6.

U.S. Tax forms4,7,8  The federal tax structures of Grantor Trusts and Partnerships are complex and may require many reporting forms.

  • RICs. Most open-end investment companies and unit investment trusts qualify as RICs.  Brokers provide tax form 1099 to RICs shareholders.
  • Grantor trusts.  Shareholders must report distributions in a trust letter.
  • Limited partnerships.  Returns must be reported on Schedule K-1, which is more complex than tax form 1099.  Shareholders must report their share of the partnership’s income, gains, losses, and deductions on federal income tax returns even if cash distributions are not made.
  • Limited partnerships OR tax-deferred accounts (e.g., IRAs). Shareholders must pay tax at the corporate rate if they incur an “unrelated business taxable income (UBTI)” above $1,000, in which case they must file form 990-T 9.

Tax rates.  Tax rates for income and capital gains are published annually by the Internal Revenue Service.

  • RICs.  The “portfolio turnover rate” reveals a hidden expense of investment operations10,11Turnover rate is the annual replacement rate of portfolio assets.  A 100% turnover rate means that all assets were replaced during the year with two consequences: 1) trading fees decreased the portfolio’s net assets, and 2) the portfolio’s capital gains are taxed at a higher rate when holding periods are below one year.  RICs with higher turnover rates typically invest in high-yield bonds, taxable bonds, REITs, and short-term stocks as sources of frequent taxable distributions in contrast to RICs with lower turnover rates that hold stocks for the long-term and distribute fewer taxable capital gains to shareholders.  Unit investment trusts offer a shelter from the federal unrealized capital gains tax by operating at a low turnover rate.12
  • Grantor trusts.  Long-term capital gains from precious metals are taxed as short-term capital gains (currently 28%) because precious metals are considered ‘collectibles’.
  • Limited partnerships.  Capital gains from futures are subject to taxation by the 60/40 allocation rule (60% at long-term tax rate of 15% and 40% at the short-term tax rate of 28%).

Tax preparation time7

  • Routine.  The tax preparation of RIC-returns involves collection of form 1099, confirmation of the broker-supplied cost basis, computation of income & capital gains taxes, and filing the tax return.
  • Additional.   Additional time is needed for collection of trust letters or K-1 schedules, unusual tax calculations, and complex tax laws.  Brokers are not required to provide the cost basis of investments in open-end investment companies until 2012; nor are they required to provide the cost basis of UITs, grantor trusts, and partnerships until 2013.  Limited-partnership shareholders are liable to file income tax returns in other states when sufficient income is generated from those states.  Out-of-state taxes raise the total income tax and extend the routine tax-preparation time.

Tax efficiency10,11,12.  Passively managed funds are more tax efficient than actively managed funds due to the lower portfolio turnover of passive management.

A tax advantage of ETFsover mutual funds is the ‘erasure’ of unrealized capital gains during share redemption.

  • Mutual funds distribute unrealized capital gains to the retail investor, who is left paying a tax on imaginary gains.
  • ETFs distribute unrealized gains to the authorized participant, not the retail investor.

The ‘erasure’ of unrealized gains by authorized participants is augmented by preferential redemption of security lots with lowest cost basis.  The latter strategy works better for ETFs with lower turnover rates (e.g., passively managed versus actively managed ETFs).

copyright © 2011 Douglas R. Knight, updated June, 2012

References

1.  Partnerships. http://www.irs.gov/businesses/small/article/0,,id=98214,00.html

2.  Abusive Trust Tax Evasion Schemes – Facts (Section II). http://www.irs.gov/businesses/small/article/0,,id=106538,00.html .

3.  Sales and Trades of Investment Property. http://www.irs.gov/publications/p550/ch04.html

4.  U.S. Income Tax Return for Regulated Investment Companies. http://www.irs.gov/pub/irs-pdf/i1120ric.pdf

5.  Internal Revenue Bulletin No. 2003-32, August 11, 2003. Section 851. Definition of Regulated Investment Company.

6.  Little, Pat.  Is that an ETF? Research Note, Hammond Associates, September, 2010.

7.  Laura Saunders, Jason Zweig. Extreme Tax Frustration. Wall Street Journal, June 25-26, 2011.

8.  ETF Education Center, The history of exchange-traded funds.  ©2011 ETFguide.com.

9.  Publication 598 (03/2010), Tax on Unrelated Business Income of Exempt Organizations, revised: March 2010.

10.  Ferri, Richard A., CFA.  All About Index Funds, second edition.  McGraw Hill, 2007.

11.  The “tax efficiency of fund is tied to turnover ratio”, Motley Fool, The Columbus Dispatch, page D4, 3/20/2011.

12.  Investment Company Factbook, 50th Edition, A Review of Trends and Activity in the Investment Company Industry. Investment Company Institute, 2010.


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