Client Letter – Q2 2005

Did you get a big surprise when preparing your federal income tax return this year? If you were lucky and did not, just wait until next year: your time may be coming. The dreaded alternative minimum tax took a larger bite out of taxpayers’ wallets this year, costing an estimated $6,000 apiece for more than 2.9 million taxpayers.

Next year, unless something is done, it is estimated that the tax—AMT for short—will hit 18 million households, including much of the middle class living in states like New York and California that have high state income taxes. How could this happen after the major income tax cuts fostered by President Bush in 2001 and 2003? Aren’t we supposed to be paying less federal tax, not more?

Paradoxically, the Bush tax cuts contributed to the increase in the AMT’s reach. To understand how, one must delve into the arcane world of AMT. This formerly obscure tax is really an alternative tax system adopted in 1969 to make sure the very rich did not abuse deductions and avoid paying their fair share of tax. It requires taxpayers to calculate their tax two ways: first, using the regular tax rules, and then using the AMT rules. They pay whichever produces the higher amount.

Under the AMT, taxpayers lose personal exemptions, deductions for state income taxes, medical expenses, home-equity loan interest, and employee business expenses. Then a flat tax of either 26% or 28%, depending on the taxpayer’s income level, is applied. The AMT allows a taxpayer to exclude $58,000 of income from tax. But that number hasn’t gone up over the years while incomes have. The Bush tax cuts also have pushed more taxpayers into AMT because it reduced regular tax rates while expanding deductions that are not allowed under AMT. Residents of high-tax states have been especially prone to AMT, and there is little they can do to avoid it, short of moving to another state or earning less income.

Although a Presidential commission is examining potential changes to the AMT, the tax raises so much money for the government—an estimated $34 billion next year—it will be hard to get rid of it without raising income taxes some other way or by cutting back on the Bush tax cuts. The President has told the commission to make any proposal “revenue neutral” and not to touch his tax cuts.

Now, let’s change gears and discuss the markets.  If you were an asset management client during the last quarter, your performance reports show that we’ve had an average quarter.  A typical 50/50 portfolio went up about 2% during the last 3 months.  The U.S. equity markets did better, on average, than the international markets.  Real estate was the star performer—with a 14.7% return in 3 months!  Ironically, all of the “talking heads” have been making predictions for years that the real estate market was going to crash, but I guess it hasn’t yet.  Even though the real estate market might “appear” overpriced, I’m glad that I don’t make investment decisions based on my “intuition.”  The strong performance of real estate investment trusts (REITs) is just one recent example of the wisdom behind my disciplined approach to asset class investing.  There is no harm in having opinions as long as we avoid making important investment decisions based on them.

Finally, I sent out an email in May announcing some important updates to my website.  In case you did not have a chance to read the email, here it is again:

I am very excited to announce several important updates to the Keystone Financial Planning website.  First, there is a new menu item called “Refer A Friend,” which provides an easy way for you to tell your friends about the website.  Second, the “In The News” section has been completely redesigned and 8 new articles have been added.  Finally, the “Valuable Web Sites” page (in the “Educational Resources” section) has been updated to include some new links.

In addition, Keystone Financial Planning maintains an archive of its “Electronic Newsletter” going back to November 2001.  So, make sure you take a few moments to stop by and visit the site!

I appreciate your business and your friendship.  Please let me know what I can do to improve the quality and value of my services to you.


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About Christopher Jones

Christopher Jones is the Founder and President of Sparrow Wealth Management, a fee-only financial planning and investment management firm. Before entering the investment field, Chris was a management consultant for Deloitte Monitor. He graduated summa cum laude from Brigham Young University with a B.S. in Economics and a minor in Business Management.