There’s a popular metaphor referred to as “the boiled frog.” Simply put, it says if you drop a frog in boiling water it will quickly try to escape. But if you place a frog in tepid water that’s slowly heated to a boil, the frog will “unresistingly allow itself to be boiled to death.”
With the 2013 tax changes, this metaphor may apply to taxpayers, married and filing jointly, with wages of taxable income of $223,000 to $450,000, says Geoffrey M. Zimmerman, CFP®, Senior Client Advisor at Mosaic Financial Partners, Inc. These households could see their federal marginal tax rate go from 28 to 45.5 percent.
“Executives in this income range may soon find that they are in hot water with the heat on as the marginal tax rates ramp up fairly quickly,” Zimmerman says.
Smart Business spoke with Zimmerman about key tax changes as well as possible planning and investment strategies.
Why are $223,000 to $450,000 income earners unaware of the danger?
The increases come from moving up tax brackets, new Medicare taxes of 0.9 percent on payroll and 3.8 percent on unearned income, and the phase-out of itemized deductions. People earning more than $450,000 have a good idea of what’s coming, but others aren’t as prepared for 1 to 2 percent increases that can add up. For example, if each spouse earns less than $200,000, their employers aren’t required to withhold additional taxes from their paychecks for the 0.9 percent increase in Medicare. But, if their combined income pushes them over the $250,000 threshold in household wages, they may be surprised by an unexpected tax bill.
Additionally, if you live in a state like California where state income taxes have gone up, combined federal and state income tax rates can exceed 50 percent, with capital gains rates reaching 33 percent or more.
What should these taxpayers be doing?
First and foremost, don’t let the tax tail wag the dog. Tax strategies that look great in a silo may actually be detrimental to the big picture. If your strategy puts you in a concentrated position or triggers undue risk, then a sudden bad market movement can be worse than paying the taxes.
This is an opportunity for people to update their financial plan and review how the tax changes affect their goals. Make sure your advisers are talking with one another and coordinating their work and advice.
How can some key planning strategies mitigate these increases?
Look for opportunities related to the timing of cash flows. If you have a big income year where up to 80 percent of your itemized deductions might be lost, defer some itemized deductions to the following year where the income might be lower. In a low income year, look at doing IRA to Roth conversions, realizing capital gains and/or accelerating income.
Take the initiative to engage in tax loss harvesting in taxable accounts, which means you sell a security, harvest the loss and then use that loss to offset a gain in either the current year or carry forward for use in future years. This can be attractive, particularly for investing styles that offer similar but not identical alternatives. One example might be to sell an S&P 500-index fund and reinvesting with a Russell 1000-index exchange traded fund to capture the loss while remaining invested.
Review the use of asset location strategies to improve tax efficiency. Strategically place securities that produce ordinary income or that generally don’t receive favorable tax treatment into a tax-deferred account, while putting tax-efficient investments that generate long-term capital gains or qualified dividends in taxable accounts.
Municipal bonds/bond funds in taxable accounts now may be more attractive, and you also can review opportunities to take advantage of ‘above the bar’ deductions, such as contributions to qualified plans like your pension, 401(k), etc. For senior executives, contribution to nonqualified deferred compensation arrangements may be more attractive, particularly if a transition, such as retirement, is on the horizon.
With the help of good advisers who understand these moving parts and how they fit together, executives can use these strategies and others to make better decisions to move toward the things that are really important to them.
Geoffrey M. Zimmerman, CFP®, is a senior client advisor at Mosaic Financial Partners, Inc. Reach him at (415) 788-1952 or Geoff@MosaicFP.com.
Insights Wealth Management & Finance is brought to you by Mosaic Financial Partners Inc.
Many investors avoid microcap stocks, thinking that companies in that category are too small or too risky.
However, the term “microcap” is misleading and stocks in that sector can provide a good return on investment, says Denis Amato, CFA, chief investment officer at Ancora Advisors LLC.
“There is a misperception of microcap stocks being this crazy, wild area, so a lot of people shy away because they think this is a terribly risky area,” says Amato. “But by focusing on the value component, you will normally get good results over time, and if you put a microcap mutual fund in your portfolio, as opposed to buying individual companies, your risk is not as great as people’s perception of the area.”
Smart Business spoke with Amato about how to invest in microcap stocks.
What are microcap stocks?
Microcap stocks are generally those with market capitalization of $500 million and below, generally corresponding to the smallest 20 percent of the stock universe.
Many times, when people think of microcaps, they think of a new IPO or a penny stock. But that is not always the case.
There are two categories of microcaps. First is growth oriented microcap stocks, which may only have a few million dollars in revenues but market caps in excess of several hundred million dollars. Not always a good combination from a risk perspective. The better area to focus on, in our opinion, is microcap value stocks. These are stocks that often have several hundred million or even $1 billion plus in revenue, but market caps of just a couple hundred million dollars. This represents much better risk-reward to us than a company with low sales and high market cap. The price could be down because of the sector the business is in; it could have stumbled in some way or it may have had an earnings problem and the stock has been driven down because of it. And sometimes it is just a matter of the market ignoring the stock or the industry, or that the company is being followed by so few analysts that the stock is inefficiently priced. So the opportunities are real.
In fact, studies have shown that over a 50-year period, returns for microcap value stocks have exceeded the microcap growth category by a factor of almost four to one. That is why it is better to focus on microcap value stocks.
For what kinds of investors can microcaps be a good investment?
Microcap stocks make sense for a lot of people, but because it is a more volatile area, it makes the most sense for investors willing to take some risk and who have a large enough portfolio to make this a component.
How can an investor get involved in microcaps?
You can invest in microcaps through individual ownership of stocks, but to do that, you have to have a pretty broad portfolio because you need diversification to lessen the single company risk factor. Because they are smaller, they are riskier, so you need to have more than a handful of companies so you do not get stuck with the one or two that run into trouble.
Microcap index funds and exchange traded funds are also options, but studies have shown that the lack of Wall Street research devoted to these companies, makes microcaps an area where an actively managed fund has a good chance of outperforming passively managed strategies over time.
What timeframe should investors in microcaps be looking at?
Two to four years is reasonable because it can take several quarters to turn a company around and change the fundamentals that might be hindering the stock. Even after a company changes its fundamentals, sometimes it takes longer for the market’s perception of it to change. If you are going to get a really good return on a stock, it takes not only earnings going back up but also price earnings multiples to start reflecting that better result. The combination of those things generally takes two to four years.
What criteria should an investor look for in microcap stocks?
First, because microcap value stocks are where the better returns are, we always look for stocks that are undervalued in this sector. The financial condition of the company and its balance sheet also must meet strict criteria.
Finally, look for insider buying which is especially significant with small companies. With a large company, there may be 100 vice presidents, and five are buying and three are selling, so what does that really mean? With smaller cap companies, there are fewer insiders, and they tend to know what the real value of the company is. Management in small companies can be more aware of positive catalysts and this frequently gets reflected in insider buying.
A good microcap fund manager will take note of this and incorporate it into their decision-making process, especially with regard to the timing of the fund’s purchases. It is easy to find microcap stocks, but finding those stocks that are a good value and have other characteristics that will enable them to provide a good return are best left to professional managers.
What percentage of a portfolio, in your opinion, should be invested in microcap value stocks?
Studies have shown that 5 to 10 percent of an equity portfolio can be put into this sector. These stocks have a diversifying effect relative to an all S&P 500 oriented portfolio so investors can actually increase their returns without significantly increasing risk.
Denis Amato, CFA, is chief investment officer as well as an Investment Advisor Representative of Ancora Advisors LLC (an SEC Registered Investment Advisor). In addition, he is also a Registered Representative of Ancora Securities, Inc. (Member FINRA/SIPC). Reach him at (216) 825-4000 or email@example.com.
Insights Wealth Management & Investments is brought to you by Ancora.