David Crosetti's  Instablog

Introduction:

I have to admit that I am somewhat of a news junkie. I spend a lot of time on various websites checking out what's going on in the world.

Recently, Tim Cook, the CEO of Apple (AAPL) was called to appear before a Congressional committee to explain why his company is not paying all of the Federal income tax that it should be paying.

Senator Rand Paul was a little vexed by having Cook appear before Congress and he issued the following statement:

'I'm offended by a $4 trillion government bullying, berating and badgering one America's greatest success stories,' the Kentucky Republican told the committee. 'Tell me what Apple has done that is illegal?'

'If anyone should be on trial here, it should be Congress,' he insisted. 'I frankly think the committee should apologize to Apple. I think that the Congress should be on trial here for creating a bizarre and Byzantine tax code that runs into the tens of thousands of pages, for creating a tax code that simple doesn't compete with the rest of the world.'

What You Should Know:

There were a couple of very interesting articles that were published on Seeking Alpha that discussed this hearing and each author gave his own take on this event.

Felix Salmon wrote an article: "Tim Cook's Improbable Victory in Washington" http://seekingalpha.com/article/1453101-tim-cook-s-improbable-victory-in-washington

Califia Beach Pundit wrote: "Thoughts on Tim Cook's Testimony" http://seekingalpha.com/article/1458571-thoughts-on-tim-cook-s-testimony

The response to both articles was very lively and "spirited." I think you might enjoy both articles, if you haven't had the chance to read them.

What I Know:

In the article mentioned above, "Thought On Tim Cook's Testimony," Califia Beach Pundit says:

Apple has amply demonstrated the absurdity of our tax code by borrowing $17 billion to avoid paying taxes twice on money it has earned overseas. Apple is essentially engaging in an arbitrage in which it will pay less than 2% a year in order to avoid paying 35% on any overseas profits it might otherwise repatriate. When such a huge arbitrage exists (otherwise known as a "wedge" to economists) it is a sign of markets and regulatory structures that are seriously dysfunctional and inefficient. This is a compelling argument for reforming our tax code and sharply reducing the corporate tax rate. At the very least, the U.S. corporate tax rate should be no higher than it is in majority of the countries in which our businesses compete, and we should never impose a tax on money that has already been taxed in another jurisdiction.

I guess the question should be: "Did Apple (AAPL) do anything illegal in any of its tax strategies?" I mean, Apple is not unique in using this particular tax strategy to avoid Federal taxes. Many companies are doing exactly the same things that Apple is doing.

What Exactly Is Our Obligation When It Comes To Taxes?

The reality of the situation is summed up in a quote I came across by Judge Learned Hand who wrote in an opinion while he sat on the 2nd Court of Appeals:

"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one's taxes. Over and over again, the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike, and all do right, for nobody owes any public duty to pay more than the law demands."

Let's face it. We have one of the most complicated tax systems in the world. If you spend any time doing your own personal taxes you can understand just how complicated the system is.

The IRS itself acknowledges that Americans spend more than 7.6 billion hours preparing both business and personal taxes and things are so complicated for the average American that 80% of individual tax payers use professional tax preparers or tax software to complete their own taxes.

Our tax code is complicated, confusing, intimidating, and full of provisions that continue the process of making it even more so. Until Congress gets the "political will" to change our tax code, we are stuck with what we have--a real mess.

Conclusion and Summary:

I tend to side with the thoughts of Judge Learned Hand. I believe that each of us should pay the taxes that we owe and not a single penny more. In order to do that, some of us use a CPA, some use a tax preparation company such as Jackson Hewitt etc., others purchase tax software like Turbo Tax.

In doing any of these activities, our goal, if we are honest, is to minimize our taxes using every deduction, exemption, and credit that is available to us. In that way, we hopefully end up paying exactly what we owe and not a penny more.

Some of my favorite tax savings opportunities are:

1. Participating in my company's 401k plan. I can shelter from current taxes up to $17,500 of income if I am under age 50 and for those over 50 the new contibution can be $23000.

2. Participate in a Roth or Traditional IRA if you qualify for those. In either case, the contribution limits are $5500 for those under age 50 and $6000 for those 50 and above. Contributions to a Roth are made with after tax dollars, but earnings in the Roth accumulate tax free while IRA contributions are pre-tax dollars and are a deferral of current tax liability on that money.

3. If you like to trade stocks, it would be better to do it in a tax deferred account, in my opinion. Since withdrawals from the tax deferred accounts will be eventually taxed as "ordinary income" the gains you would have from trading would accelerate the value of the portfolio.

4. As a DG investor, I purchase dividend stocks and tend to hold them. I reinvest dividends and occassionally will pare a holding that becomes overbalanced. While collecting dividends in that account, I am avoiding taxes now, but will pay taxes on withdrawals as ordinary income.

5. For income earners who have a large income, perhaps Municipal bonds (tax free) would make sense. I do not own any municipal bonds as I do not have a large income from work.

While there are many other ways to reduce your current tax liabilities, this article is intended to open discussion with investment programs that are tax friendly.

Take the time to sit down with a good tax professional to see which programs will work for you and to find ways that your current situation might be helpful in reducing taxes in other ways. You could turn a hobby into a business, for example. I have with my cattle business. We started small, but are growing every year. There are many tax provisions that are very favorable to that particular business and many others. Check them out.

Introduction:

In the movie, Office Space, there is a scene where three characters are standing around the copy machine and having a conversation. It goes something like this:

Peter Gibbons: Our high school guidance counselor used to ask us what you'd do if you had a million dollars and you didn't have to work. And invariably what you'd say was supposed to be your career. So, if you wanted to fix old cars then you're supposed to be an auto mechanic.

Samir: So what did you say?

Peter Gibbons: I never had an answer. I guess that's why I'm working at Initech.

Michael Bolton: No, you're working at Initech because that question is b.s to begin with. If everyone listened to her, there'd be no janitors, because no one would clean crap up if they had a million dollars.

Samir: You know what I would do if I had a million dollars? I would invest half of it in low risk mutual funds and then take the other half over to my friend Asadulah who works in securities...

Michael Bolton: Samir, you're missing the point. The point of the exercise is that you're supposed to figure out what you would want to do if...

What I Know:

Office Space came out in 1999. Back then, a million dollars was a lot of money. I remember when I was a kid, thinking that a million dollars would probably be more money than anyone could ever need.

Now, make no mistake, a million dollars is a still a good deal of money today, but a million bucks just doesn't seem to go as far these days as it used to go.

Regardless, the question today is this. "If you had a million dollars, what would you do?"

Well, before you can do anything, you have to have a million dollars. Here's where things get tricky for most people. They look at a million dollars and they think that there is no way that they will ever reach that goal. But, they're wrong. It's actually not all that difficult. The hard part is actually getting started and putting aside all your rationalizations as to why you can't have a million dollars.

How To Have A Million Dollars:

Let's take a look at this project from the perspective of someone who is starting out at age 25. That individual would have a potential 40 years of investing before reaching what is today known as "retirement age."

While the best vehicle for putting aside the most money is the 401k plan that many of us have at work, sometimes the investment options available in the 401k are not all that great. When you compare other tax deferral investment options, perhaps the Roth IRA lends itself well to our goals. Regardless, I am not endorsing any particular investment vehicle, but will use the Roth and Traditional IRA as points of discussion, relative to the amount of money that can be invested.

This year, the Roth and Traditional IRA investment vehicles allow an individual who is younger than 50 to put aside $5500. The amount of earnings that can be put into the retirement plans has been growing over the years and should continue to grow as we move forward.

By committing to investing $5500 a year in a Roth or Traditional IRA, with a rate of return in the 8% range, and investor can expect the following results:

(click to enlarge)

Investing $5500 a year, with an 8% growth rate, will earn you $1,658,280.42 at the end of 40 years and our example reaching age 65.

Our example investor actually becomes a millionaire in 2047, which is 34 years from the starting point in 2013.

What You Should Know:

There are some people who would be unable to save $5500 a year in their initial work years. However, saving whatever you can is a key to having long term success. If you never save because you can't reach the $5500 number, today, you will fall farther behind when you decide to save nothing.

In this example, we never increased the amount of money being put aside in the retirement account. As our income grows and as the government increases the amount of money that we can save in a Roth or Traditional IRA, it makes sense to try and reach those increased savings amounts.

Starting early makes all the difference in the world. The longer you delay, the lower your end results are going to be. It's all about math.

Summary and Conclusion:

In our example, the individual is going to save $220,000 of his own money, ($5500 x 40 years), but he will have 1.6 million dollars put away.

Having a spouse who can do the same thing makes the exercise even better, in my opinion.

What I look for in investing this money is:

1. Stocks that are priced at a value to their intrinsic worth

2. Companies that have a long history of paying dividends

3. Companies that increase dividends annually

4. Companies that have DGR larger than inflation

5. Reinvest dividends for capture of compounding

Tap an IRA Early, Delay Social Security

This strategy could lower your lifetime tax bite, let you collect higher benefits and extend the longevity of your portfolio.

By Susan B. Garland, From Kiplinger's Retirement Report, April 2013

It's conventional wisdom that you should delay tapping your IRA as long as you can. There's also the tendency of most retirees to claim Social Security benefits as soon as possible. The unintended consequence: You're likely to shorten the life span of your nest egg.

A growing body of research shows that flipping the order may be wiser. You could lower the lifetime tax bite, collect years of higher benefits and extend your portfolio'slongevity if you delay Social Security and take larger IRA withdrawals in the early years of retirement.

Retirees who collect reduced Social Security benefits early often need to take some IRA money to meet spending goals. These retirees could be hit by what's known as the "tax torpedo." This occurs when IRA withdrawals trigger the taxation of Social Security benefits-and push taxpayers into a higher marginal rate. For these retirees, the tax torpedo can last a lifetime.

By holding off on Social Security and living on IRA income in those early years, you could receive a larger government benefit later, thus reducing the amount of taxable income you'll need from your IRA. The smaller IRA withdrawals could also increase the likelihood that Social Security benefits will remain tax free.

The biggest beneficiaries of this strategy are retirees with portfolios of between $200,000 and $600,000, according to research by William Reichenstein and William Meyer, principals of consulting firm Social Security Solutions. For these retirees, Social Security represents a larger share of retirement resources than wealthier retirees, so delaying could have a stronger impact on a portfolio's longevity.

To avoid the tax torpedo, retirees who are developing an income plan must understand how IRA income and Social Security benefits are taxed. Every dollar withdrawn from a traditional IRAis taxed at ordinary-income tax rates. But James Mahaney, vice-president for strategic initiatives at Prudential Financial, says that Uncle Sam "treats Social Security income at a preferred rate": At least 15% of benefits and as much as 100% is tax free-depending on your total income.

In addition, Mahaney says, the formula that determines whether Social Security benefits will be vulnerable treats those benefits more favorably than IRA income. While 100% of IRA distributions count as "provisional income" for deciding what percentage of benefits will be taxed, only 50% of benefits are cranked into the formula. (Provisional income is adjusted gross income plus any tax-free interest income and 50% of Social Security benefits.)

For a single retiree, up to 50% of benefits are taxable if provisional income exceeds $25,000. When provisional income exceeds $34,000, up to 85% of benefits are taxable. The thresholds for joint filers are $32,000 and $44,000.

As rising provisional income pushes more of your benefits into the taxable realm, your effective tax rate can soar. For higher-income beneficiaries, an extra $100 of income-or IRA distributions-can make $85 of benefits taxable. Taxing $185 at 25% costs you $46.25, the same as taxing your extra $100 at 46.25%.

You may be able to ease the pain by reducing the amount of provisional income that exceeds the thresholds. Because only 50% of Social Security benefits are included in the formula, you can pour twice as much Social Security income than IRA income into the formula before hitting the threshold.

Delaying benefits will get you a higher benefit amount later, and that can reduce the need for IRA income. By tipping provisional income toward Social Security income, you can reduce or eliminate the likelihood that your benefits will be taxed.

Consider this example from Mahaney. The Smiths and the Jacksons are 72-year-old couples who each have $69,000 in income. The Smiths, who claimed their Social Security early, take $45,000 from an IRA and collect $24,000 in benefits each year. The Jacksons, who delayed claiming, get $39,000 in benefits and take just $30,000 from their IRAs.

The Smiths' provisional income is $57,000 ($45,000 and $12,000); the Jacksons' is $49,500 ($30,000 and $19,500). Because the Smiths have more IRA income than the Jacksons, they have more income exceeding the tax triggers and a higher adjusted gross income. Assuming a 25% federal income tax rate, the Smiths will pay $6,060 in taxes each year, compared with $2,854 for the Jacksons.

Extend the Life of Your Portfolio

The extra tax tab could have a big impact on a portfolio's longevity, according to a study by Meyer and Reichenstein. Taking large withdrawals from an IRA in later years can significantly boost the tax bill-and shrink a portfolio. If you are in the 25% tax bracket, for instance, you will need to take $1,000 to raise $750 in income. (Kiplinger's has partnered with Social Security Solutions to help readers maximize lifetime benefits. Go to kiplinger.socialsecuritysolutions.com.)

The researchers offer this example of an individual who has $700,000 in an IRA when he retires at 62. Starting at that age, he needs after-tax income of $36,150, which is adjusted for inflation over a 30-year retirement. (His portfolio grows at an inflation-adjusted 1.2% a year.) He is due $18,000 a year in Social Security benefits if he collects at his full retirement age of 66.

If the retiree starts collecting at 62, he will receive a reduced lifetime benefit of $13,500 a year and he will need to make up the $22,650 balance with IRA withdrawals. His portfolio will barely last 30 years, the researchers note. If he delays until 66, his portfolio will last an extra four years. Delay until 70 and his portfolio will last an extra ten years. (If he doesn't believe he will live that long, he can instead boost his annual spending by $3,600.)

In this scenario, claiming early causes multiple costly problems. The reduced benefit means the retiree will have to withdraw more from his IRA, and since every dollar withdrawn is taxed, he'll have to withdraw even more to cover the tax bill. "It's a double whammy," Meyer says. "You are getting reduced Social Security benefits, and because you need to withdraw more from your tax-deferred account, it kicks up your provisional income and more of your benefits are taxable."

By delaying until 70, the retiree gets an extra $10,260 in benefits than if he had claimed at 62. He reduces his taxable IRA withdrawals. And by substituting Social Security income for IRA income, his provisional income is lower. The result: a smaller tax tab on his IRA withdrawals and benefits.