September 27, 2023

Wealth Matters: Taxes Influence Investment Strategy, and Not Always for the Better

That may not be a good thing for their portfolios.

“Clients are definitely asking, because it’s a real issue in today’s environment,” Michael N. Bapis, a managing director and partner with the Bapis Group at HighTower Advisors, said. “We try to keep them focused on the goals — preserving what they have, capturing some of the upside, limiting the downside. At the end of the day, we can’t change the tax laws.”

When asked about how tax rates would affect an investment, he said his advice was almost always the same. “If it doesn’t make sense for your portfolio, then it doesn’t make sense,” he said, even if there is tax savings. “If it does make sense, regardless of the tax consequences, we’re going to put it in your portfolio.”

Last week, I looked at how the changes to the tax code were affecting how people thought about their estate plan. This week, I’m looking at how tax increases can influence people’s investing behavior.

The tax rates on investments have increased significantly from last year. Depending on a person’s income, taxes on long-term capital gains and dividends are now as high as 23.8 percent, an increase of 59 percent over last year’s rate. Taxes on investments that are held for less than a year that incur short-term capital gains tax or investments subject to income tax rates have increased for top earners by 24 percent, to 43.4 percent (with the Medicare surtax included) from 35 percent.

Those are substantial increases, but focusing on them alone can obscure a fuller analysis of risk. Investors can end up paying no taxes on an investment, but that may be because they lost money on it, or they may pay lots of taxes on a large gain that they might not have achieved otherwise. This is why advisers stress that taxes should not be the first concern when deciding whether to buy — or not buy — an investment.

If there is one investment that has been promoted as great for minimizing taxes and achieving a large gain, it is master limited partnerships. Most are involved in the transportation or storage of oil and natural gas. What makes them appealing, from a tax perspective, is that a large portion of the dividend they pay is treated as a return of principal and is not taxed.

But in the rush for one type of tax savings, investors can end up paying other taxes. Master limited partnerships with pipelines that run through several states can incur state tax bills for investors, though usually only when the income goes above a certain threshold.

The bigger tax concern generally comes when investors sell their partnerships, since the part of the dividend that was not taxed for years reduces the original price of the investment. Greg Reid, a managing director at Salient Partners and chief executive of the firm’s $18 billion master limited partnership business, said an investor who bought a partnership and sold it five to 10 years later could be faced with two types of taxes. The first is income tax, because the original purchase price would have been reduced by the amount of principal returned in the dividends. The second is capital gains tax on the increase in the value of the investment itself.

Another way to look at these partnerships is to consider the solid and increasing dividends they have paid over the last 25 years, often 6 to 7 percent.

“The baby boomers are going to need a lot of income to live,” Mr. Reid said. “M.L.P.’s are particularly great for older people who are retiring. They have a growing income stream.”

As for avoiding high taxes, the solution is to give the partnership to charity or die with it in your estate. Both may be viable options for investors in their 70s and 80s but are probably less attractive to people in their 30s.

Municipal bonds, which have long been attractive to wealthier investors because the interest they pay is not taxed by the federal government, pose a different sort of risk.

Mr. Bapis said he was concerned that investors who were not paying attention to the broader economic news were not aware of the current risks of buying an existing municipal bond. With yields on many municipal bonds extremely low — around 0.75 percent for five-year bonds and 1.74 percent for 10-year bonds, according to Bloomberg — even a small increase in their price, which would cause the yield to go down, would cause a loss of principal.

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David Leonhardt, Washington Bureau Chief, Answers Readers’ Questions

Mr. Leonhardt is the author of the e-book, “Here’s the Deal: How Washington Can Solve the Deficit and Spur Growth,” published by The Times and Byliner. Previously, he wrote the paper’s Economic Scene column.

Below are answers to selected questions.

So presidents make their State of the Union speech then hit the road to sell it. Wouldn’t it be more effective to just stay in D.C. and do the heavy lifting of pushing Congress off of square one?

— HLB Engineering, Mt. Lebanon, PA

A. My colleague Michael Shear writes from Georgia, where is he reporting on President Obama’s trip today:

Recent presidents have made a habit of getting out of Washington to pitch their State of the Union ideas in front of largely friendly crowds who can — the White House hopes — put some political pressure on the lawmakers in Washington. Bill Clinton did it after proposing health reform (with little success). George W. Bush did it, too, after proposing Social Security changes (also with little success).

For Mr. Obama, staying in Washington is exactly what he doesn’t want to do. He and his aides became frustrated in his first year by the endless health care negotiations that made him feel trapped in the weeds of a political process for which Americans don’t have good feelings. The White House staff and the president have concluded that more time outside Washington will actually help the gridlocked process of legislating, by potentially putting political pressure on legislators.

There is a downside, though. The visits have a decidedly campaign-like feel that can lend credence to the accusation that the president is more concerned about political appearances than the business of governing. Mr. Obama has concluded that risk is worth it. But it’s not clear from recent history that the trips have actually helped achieve a president’s goals.

When the debt was the largest in history as a percent of GDP, in 1946, we had 27 years of mostly deficit spending. The debt in dollars doubled. But we had prosperity. Why don’t we do that today?

— Len Charlap, Princeton, NJ

A. You’re right that a country can have deficits and still pay down its debt, so long as the deficits are small enough and economic growth fast enough. And you’re right that some government spending plays a crucial role in creating economic growth. The most important programs seem to be investments — in education, scientific research, roads, bridges and the like — that the private sector won’t do on its own.

The Internet, the radio, the jet engine, much of biotechnology and the technique for extracting a form of natural gas known as shale gas all owe their beginnings to federal spending. This history is a major theme in “Here’s the Deal.”

But government spending and debt most certainly do not ensure prosperity. Federal debt is already high. The projections showing that annual deficits will fall in the next few years depend on some assumptions that may prove rosy. And as more baby boomers retire and health costs keep rising, projected deficits are projected to rise again, sharply, in coming decades.

As heartening as the recent progress on the deficit may be, the country still faces substantial long-term fiscal problems. If we don’t deal with them, we are likely to have an economy that looks nothing like the prosperous economy after World War II.

Congressional Republicans recently decided against using the debt limit as a lever to force President Obama to enact spending cuts he wouldn’t otherwise go along with. Is there any indication that Republicans will agree to a longer-term extension once the current limit is reached?

— Eric, Washington, DC

A. It’s hard to know, but it’s possible that the debt-ceiling fights will not continue. In the past, the extension of the debt ceiling tended to be an opportunity for the party that didn’t hold the White House to grandstand about the deficit and debt. (President Obama, somewhat famously, did so in 2006.) In the end, though, the extension tended to pass without any concessions from the president.

In 2011, Congressional Republicans successfully negotiated such concessions from Mr. Obama. In recent months, he made clear that he would not negotiate over the debt ceiling again, citing the economic damage from the uncertainty over the last extension. Republicans have gone along, at least temporarily.

Polls suggest the last fight hurt Republicans more than Democrats, which suggests Republicans may ultimately agree to a long-term extension or simply a series of short-term extensions. On the other hand, they were indeed able to win some spending cuts in 2011, so some in the party continue to see the debt ceiling as a powerful tool.

The most cliched last line in journalism — the kicker, as we say — is: Time will tell. I can’t think of another kicker here.

Why has the administration given so much focus to gun control in the past few weeks? With a Republican majority in the House and the fact that many Democrats would also vote against advanced gun control measures, would this kind of legislation have a chance of passing the House or the Senate?

— Matthew, Athens, GA

A. Unlike past mass shootings, the killings in Newtown, Conn., shifted the national debate. Public opinion changed modestly, and Democrats who favor more gun control became more willing to push for it.

As you note, most Republicans and some Democrats oppose sweeping new measures, which is why an assault-weapons ban still seems unlikely. But some other measures may be able to win overwhelming support from Democrats and enough from Republicans to pass both the House and Senate. The two leading candidates are an expansion of criminal background checks on people buying guns and a new federal trafficking law to block criminal purchases.

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Deal Professor: The Risks of Tapping Your Retirement Fund for an Alternative Use

Deal Professor 401kHarry Campbell

Retirement funds are being used increasingly for anything but retirement. Instead, 401(k)’s and individual retirement accounts are becoming money pots used to invest in business start-ups, speculate in gold and buy private equity investments.

Such maneuvers come with big tax advantages. But they may also leave their users penniless in retirement, while their ability to evade taxes can cost the government.

My interest was piqued by a recent ad in an airline magazine. It called on people to leave their mind-numbing jobs and use their retirement funds to start a franchise business. Invest in yourself was the idea.

I was startled at the directness. I.R.A.’s and 401(k)’s were never meant to be used to start a business. After 15 minutes on the Internet — one of the few upsides to air travel these days — I discovered armies of advisers willing to charge a fee to help you use your 401(k) or I.R.A. to start a business.

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One of leaders in this nascent industry is Guidant Financial. You can get an idea of what this is about from its Web site, which asserts that “by rolling your existing retirement funds into an iFinance plan you can invest in a small business or franchise inside your retirement plan … without tax penalties!”

The strategies to do so and not run afoul of I.R.S. regulations are varied, but the main one is to start a business and have it adopt a 401(k) plan. The existing 401(k) plan is rolled into the new one, which is invested in the new business. Voilà — instant financing. The downside, however, is that there is no money for retirement if the business fails.

And there is evidence that most of these businesses do fail. The Internal Revenue Service terms one form of this scheme as a Rollovers as Business Start-Ups plan, or perhaps with some unintended irony, a ROBS plan. In 2009, the I.R.S. studied ROBS plans and found that most of these businesses had gone bankrupt, losing the person’s retirement savings. In most cases the money was lost before the business even got off the ground. Nonetheless, the I.R.S. does not prohibit ROBS plans, but it has called for more scrutiny of the structure.

This has not diminished the ardor of franchisers and other investment advisers selling such plans. They aggressively market them to would-be entrepreneurs. Figures are hard to come by, but the chief executive and co-founder of Guidant, David Nilssen, recently told The New York Times that inquiries about these types of plans were up 196 percent in 2011 from 2009.

Yet this is not the only way use your retirement fund for something other than prudent retirement planning. A business even bigger than self-financing a start-up is the self-directed I.R.A. As of 2011, some $94 billion was invested in these plans, according to the Investment Company Institute.

Self-directed I.R.A.’s allow for speculation in much sexier investments, like gold bullion, oil and loans. But that is only the beginning. Want to own a rental home? You can do that through your I.R.A. How about cattle or llamas? You can do that, too. There’s even the case of someone who bought musical instruments using a retirement fund and rented them out for tax-free income.

Not surprisingly, the biggest growth area in alternative retirement fund investing is commodities. Gold I.R.A.’s are particularly popular, and one of the largest advisers in this area, the Entrust Group, recently stated that the value of these holdings at the firm had grown by more than five times in 2012.

This brings us to another oft-promoted feature of these funds, assuming the investments work out. Self-directed I.R.A.’s are great tax shelters because the money inside it, like money in a regular I.R.A. or 401(k), is untaxed until withdrawn. These plans offer tax savings that regular investors cannot get because they defer taxes for decades. And if the investments are made through a Roth I.R.A., the gains are completely tax-free.

Mitt Romney’s experience illustrates the effectiveness of this strategy. When he was at Bain, he funneled his private equity investments into a tax-sheltered retirement fund, investing an unknown amount, but likely about $450,000. That amount is now worth $20.7 million to $101.6 million. All of this gain has been tax-free, so far. Entrust, by the way, has an article on its Web site that promotes self-directed I.R.A.’s, citing Mr. Romney’s use of them to shelter up to $100 million in gains.

And if the tax on capital gains rises in coming years, and marketing by these alternative investment firms grows, expect more entrepreneurs and investors to turn to their retirement funds for this type of extreme investing.

Some of these investors will succeed, and these lucky few will pay fewer taxes because of the use of these retirement plans, costing the government money that could total billions. Originally, the idea was that the tax-free nature of this investment was justified to encourage saving for retirement. But that is not what is going on here. Buying mass quantities of gold? This is nothing but speculation. And as is the case with most speculation, the average investor is not likely to make money.

Mr. Romney, of course, as a top private equity executive, knew what he was doing and could afford the loss if things had gone wrong. But the average investor speculating with I.R.A. funds or concentrating them into one investment or a start-up is asking for trouble. There are no statistics on how self-directed I.R.A.’s have performed, but there is no reason to expect that investors in gold and cattle will do any better than those who have day-traded with their retirement funds.

Then there is the fraud issue. Self-directed I.R.A.’s have been a particular target of Ponzi schemes, causing the North American Securities Administration Association to issue a special alert. In the most prominent case of recent note, the Securities and Exchange Commission stopped a number of schemes trying to persuade retirees to buy promissory notes in Turkish investments — yes, Turkish promissory notes — through self-directed I.R.A.’s.

The fact that all of this activity is for anything but retirement is a case study in how legitimate tax policies can be distorted and rules bent to benefit the inventive. More sadly, though, is that a whole industry growing around these investments also shows how some Americans are willing to risk anything for a big jackpot in the markets. And how under the current system, if they succeed, they can do it tax-free, while the rest of us pay taxes.

A version of this article appeared in print on 10/31/2012, on page B10 of the NewYork edition with the headline: The Risks of Tapping Your Retirement Fund for Alternative Investments.

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After Huge Gains in Gold, Hedge Funds Sell

For the better part of the last two years, some of the world’s biggest hedge funds have been piling into gold, betting the precious metal would provide an effective hedge against inflation or be a safer place to park cash as equity markets around the world stumbled.

But to the surprise of many investors, when equity markets across the globe tumbled once again on Thursday, gold moved sharply lower as well.

Gold futures for September delivery fell $66.30, or 3.7 percent, to $1,739.20 an ounce in New York. It was quite a turnabout for the metal, which has been soaring in recent months amid the turbulent stock markets.

Hedge funds, which have been ratcheting down their positions in gold futures since early August, were quickly named as the culprits in the latest sell-off.

Some traders said that hedge funds were beginning to unwind, or close out, what has been a very popular and profitable trade for the last 18 months as they bet the dollar would fall and that gold would rise. In the last month alone, the euro has fallen nearly 4 percent against the dollar amid worries about the European debt crisis.

The sell-off in gold was part of a broader move in the markets that had investors shifting away from perceived riskier assets, like commodities, and into the dollar in reaction to the Federal Reserve’s announcement on Wednesday of its new stimulus program.

In addition, the Fed said that there were “significant downside risks” to the United States economy, which sent several commodities, including crude oil and copper, tumbling on Thursday on fears of a global slowdown in demand.

Other market participants said hedge funds were selling their positions in gold to raise cash to meet increased capital demands for their borrowings from Wall Street banks as the assets they have put up as collateral, like other commodities or stocks, have declined sharply in value.

“On the one hand you have a lot of strength in the U.S. dollar, historically gold and the dollar do trade inversely,” said Ryan Detrick, senior technical strategist at Schaeffer’s Investment Research. “The hedge funds are long gold and they need to raise cash and it looks like they are definitely selling some gold.”

Others say some hedge funds may be selling to meet redemption requests from investors who have been spooked by the recent market volatility and fear a repeat of the problems of late 2008.

“A lot of investors are waking up to the realization that something is off. We’ve seen Goldman Sachs close its flagship fund, legendary hedge funds are down sharply, and I suspect we’re going to see significant withdrawals from some hedge funds this year,” said Michael A. Gayed, the chief investment strategist of the investment advisory firm Pension Partners.

“The tendency for individual hedge funds or anybody is to sell winners before they sell losers. What’s been one of the few winners this year? It’s been gold,” Mr. Gayed added.

Still, some are not yet ready to call the end of the gold rush. Even with the pullback, gold remains one of the most profitable investments this year with a gain of 22 percent.

Some strategists have even predicted that gold will reach a record of above $2,300, which it hit during the early 1980s when adjusted for inflation and translated into current dollars. Likewise, the world’s largest exchange-traded gold fund, the SPDR Gold Shares, fell 2.6 percent on Thursday, but remains up 22 percent for the year.

Gold, whether through futures contracts or via exchange-traded funds, has been a popular investment among some of the world’s largest hedge funds. One of the best known “gold bugs” is John A. Paulson, whose firm, Paulson Company, is the biggest shareholder in the SPDR Gold Shares ETF. But many other hedge funds have embraced the metal as well.

After peaking in early August, hedge funds have been reducing their exposure in the gold futures market, according to Mary Ann Bartels, the head of United States technical analysis for Bank of America Merrill Lynch.

“A lot of speculators were very long in July,” Ms. Bartels said. “But they’ve been taking it down ever since.”

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Bucks Blog: Virgin America Subs for Continental in Membership Rewards Program

Hello, Virgin America. Goodbye, Continental.

Starting Oct. 5, Virgin America will join American Express’s Membership Rewards program. That means participants will be able to transfer points they have earned by spending with their Amex card into their Virgin America miles account. The airline’s loyalty program, Elevate, offers online-redemption with no blackout dates.

The arrival of Virgin at Membership Rewards helps, somewhat, to lessen the blow caused by the loss of Continental Airlines, which is leaving the Amex program at the end of September. American Express announced last year that Continental would exit the program, dashing the hopes of some Membership Rewards members that Continental’s merger with United would finally offer the chance to redeem their Amex points for United miles too.

Still, Virgin America is a decent redemption option for travelers aiming to redeem points for trans-continental flights, as the airline’s markets include New York, Los Angeles and San Francisco. (It also recently added Dallas and Chicago.)

Meanwhile, Membership Rewards participants have until Sept. 30 to transfer their Amex points into their Continental accounts one last time.

After Sept. 30, an Amex spokeswoman notes, Membership Rewards participants can still book seats on Continental – and any other airline — and pay with Membership Rewards points when they book through American Express’s travel Web site. The downside is that this option doesn’t allow you to combine your Membership Rewards points with airline miles you have already accumulated by flying on an airline. But, if you’re a Platinum cardholder, you earn a 20 percent Membership Rewards point bonus when you book travel in this way.

Does the addition of Virgin America to Membership Rewards help with your travel plans?

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Lacking Blockbuster, News Corp. Falls Short

That seemed to be Rupert Murdoch’s message on Wednesday as his sprawling media company, the News Corporation, reported earnings that largely fell short of most analysts’ expectations. The company’s total revenue for the quarter that ended in March, $8.26 billion, was down 6 percent from the same quarter last year, when ticket sales for the blockbuster film “Avatar” greatly increased revenue.

“Avatar” became the highest-grossing film in history (not adjusted for inflation), but with that title came one downside for the News Corporation: “challenging comparisons,” as Mr. Murdoch put it in a statement, between this year and last year’s earnings. The company’s net income for the quarter, $639 million, or 24 cents a share, was down 24 percent from the same quarter last year, when the net income was $839 million, or 32 cents a share.

Ticket sales for “Black Swan,” a film released last December that scored a best actress Oscar for Natalie Portman, led the film division’s revenue in the most recent quarter. Citing the new animated film “Rio,” which was released three weeks ago but has already earned more than “Black Swan,” Mr. Murdoch said the “difficult comparisons in this segment over the past nine months are now behind us.”

Cable channels like FX and the Fox News Channel remained by far the biggest contributors to the News Corporation’s bottom line, accounting for more than 60 percent of profit. Like other major media companies, the News Corporation enjoyed significant gains in cable advertising revenue over the same time last year — in its case, up 14 percent in the United States and up an average of 18 percent in other countries.

Fox News, which is the most-watched cable news channel in the United States, continues to be a profit center for the company. In the most recent quarter, Fox News recorded its highest-ever operating profit margin, David DeVoe, the company’s chief financial officer, said in a conference call with analysts Wednesday.

The company’s local and national broadcast television division also showed strong results, having mounted a recovery from the recession. It helped that Fox had the rights to the Super Bowl this year and that the eight-year-old “American Idol” franchise has, as Mr. DeVoe asserted, found a “second life” with new, nicer judges.

But attention lately has been focused not on the News Corporation’s television assets, but on underperforming digital pieces of the company. Since last year, it has been attempting to sell Myspace, the ghost of a social network that suffered increased losses in the most recent quarter. Chase Carey, the News Corporation chief operating officer, said Wednesday that an unspecified Myspace transaction is “on course.”

The company is also trying to spin off, a portfolio of video game news Web sites, according to AllThingsD, which reported the plan earlier this week.

In its publishing division, the News Corporation is trying to market the tablet newspaper, The Daily, that it introduced on the iPad in February. Mr. Carey said that the company lost about $10 million on The Daily in the quarter and emphasized that “it’s very early days.” He did not share any data about the number of subscribers to the newspaper, but a News Corporation employee was overheard on the conference call saying that the app that delivers the newspaper has been downloaded 800,000 times.

The publishing division posted a steep decline in net income in the quarter because of a $125 million charge related to a legal settlement at News America Marketing, its coupons and consumer marketing outfit. Excluding that charge, the company over all posted earnings of 26 cents a share.

Analysts pressed News Corporation executives on Wednesday on the status of its attempted acquisition of the 61 percent of British Sky Broadcasting, or BSkyB, that it does not yet own. The company is awaiting final approval of the deal by the British government.

If the approval comes — and by most accounts it will come soon — the News Corporation may have to pay more than the $12.4 billion it has already committed. Mr. Carey had little new to say about it, but he reiterated his hope for a “reasonable deal.”

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