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 IHA Monthly   March 2011 
In This Issue
Market Commentary
March 2011 Asset Class Returns
Alternative Minimum Tax
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History Speaks
Nancy Sheperdson recounting the very first days of the modern U.S. taxation system:
On the evening of March 1, 1914, Americans all around the nation inaugurated what has become a spring ritual for millions of us. They raced to file the first Form 1040 at the last minute before the deadline, hurrying by motorcar or trolley or on foot......

.....In New York City stragglers braved a blizzard to reach the Customs House office of the Bureau of Internal Revenue, which, like district offices everywhere, stayed open until midnight. Their last minute scurrying was front-page news in the Times the next day, and it savedIncomeTax.Monopoly them from being the first Americans to pay penalties for late filing....

..... But amazingly, from today's perspective, most Americans actually welcomed the tax.....


.....The attitude made considerable sense. Nobody would owe any tax or even, usually, have to file a return if he or she earned less than three thousand dollars (four thousand if married)-and that was the equivalent of more than sixty-six thousand dollars (eighty-eight thousand if married) today. In fact, the tax was deliberately designed to affect only the wealthiest one percent of the population....

....One Missourian expressed joy in the tax in a note he attached to his return: "I have purposely left out some deductions I could claim, in order to have the privilege and the pleasure of paying at least a small income tax. ... And the New York Herald observed the emergence of "the young man who overstates his income in order to be among those who are obliged to pay an income tax." The paper predicted that "many a $12 to $20 a week clerk will be waving an income tax receipt from the stool of his favorite quick lunch to show his value and standing in the commercial world."....

Market Commentary

InnerHarbor Advisors, LLC is a Manhattan based financial planning firm catering to market professionals. If you would like to speak with a financial planning expert - or if you are currently working with someone and would like a fresh perspective, please contact John O'Meara or Michael Keating at 212.949.0494 ...or simply 'reply' to this email.


One of our favorite Wall Street adages is that bull markets climb a wall of worry. If that is true, March threw some Old Testament style worries at the market. War in the Middle East expanded as the U.N. approved a no fly-zone over Libya and government troops opened fire on protesters in Bahrain, Sudan and Syria. The massive earthquake and tsunami that struck Japan has morphed into a full blown nuclear disaster as the Fukushima nuclear power plant is leaking radiation and authorities do not seem confident about when they will have the situation under control. Despite this, U.S. markets remain very close to their post-financial crisis highs. The same can be said (in dollar terms) for most markets in Europe, South America and Asia. The biggest worry that markets may face in the next few months is not man-made conflict or natural disasters but a more traditional bull market nemesis: inflation

One of our themes for the year has been rising commodity costs, which have had a role in the relative weakness (until this month) in emerging markets as well as the unrest in the Middle-East and North Africa. We are now starting to see real inflationary pressures in the U.S. and developed markets. The February CPI report showed annual inflation has risen above 2% (that is sharply higher than just three months ago) and that most of the increases have been in energy and food, the items bought most often by consumers. While it is well known that the Fed tends to discount these two sectors (they are not part of Core CPI) as volatile and 'mean reverting' when making policy decisions, it is becoming hard not to see inflationary pressures building throughout the economy. The chart below shows the price paid by producers for their inputs.



This chart is from MIT's Billion Price Project which uses prices available over the Internet to develop a real time inflation gauge.


The Economic Cycle Research Institute, which has been better than most at forecasting the direction of U.S. economic developments, recently warned that they are seeing more signs of inflationary buildup in their forecasting models. The upshot of this is that the Federal Reserve will find it increasingly difficult to provide the easy money that the market has become accustomed to. In particular, they will find it very difficult to expand their quantitative easing program when the current version expires in June. When the Fed concluded the first round of quantitative easing around this time last year the market dropped nearly 20% before recovering on the news of QEII.

We continue to maintain a relative conservative outlook. In the beginning of the year we outlined three primary fears for 2011: structural problems in the U.S. recovery, sovereign debt problems and bank instability in Europe and rising commodity costs. In the U.S., we still see the structural issues in regards to housing prices. We think the employment reports of the last couple months have been the best since the recession began but that there is still a structural difference between the current skill set of the American worker and the requirements of potential employees (and means we are many years away from 5% unemployment). In the last month Portugal bowed to reality and accepted financial aid,a step which basically everyone on the planet could foresee. Now the question moves to whether Spain, Italy or Belgium will need a bailout. Any of those could ignite a banking crisis in Europe and probably worldwide. Up to this point however, markets are acting as if this possibility is minimal. Finally we are really seeing the affects of inflation hit the developed world now. This will act to limit the ability of Central Banks to provide easy monetary conditions, as demonstrated by the decision of the European Central Bank to raise rates last week.


Asset Class Returns

Through March 31, 2011
Monthly and 52 week returns for major asset classes. Performance information is for total return assuming reinvestment of interest and dividends. It excludes management fees, transaction costs and expenses.  



Commodities continue their recent strength and are now up over 25% in the last six months. That does not even begin tell the story in individual commodities; silver has more than doubled in the same period. While U.S. markets were positive for the month, international developed markets were down over 2%. This was primarily because of the earthquake and tsunami in Japan and that country's large weighting in that index. The real story was emerging markets which have lagged their developed counterparts for most of the year but rose 10% in the last two weeks of March and are at their highs of the year. March was very quiet on the fixed income front, with little movement among any of the bond classes despite growing fears of inflation.


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Financial Planning Highlight

Alternative Minimum Tax (AMT)

"Wolf in Sheep's Clothing"

Soft wording makes this tax sound, well... optional. Pay no attention to the wording, there is nothing "alternative" or "minimum" about AMT. Since it is that time of year, in this month's Financial Planning segment we use 3 1/2 paragraphs to take a stab at explaining what AMT is, why it affects you, and some advice to make it less painful. 


Demystifying AMT

The Alternative Minimum Tax (AMT) is a separate tax calculation upon your reported income. Your accountant will calculate two separate returns- one using the traditional US tax code and the other using the AMT code. AMT disallows some items that are deductible under the normal tax code, notably state and local property and income taxes. After both sets of 'tax due' computations are figured and the two numbers compared, you will owe the amount that is... higher. 

*While it can appear that the AMT is a separate tax on your return it is important to realize that it actually a separate calculation and you will always pay the higher amount of the two separate calculations.

Did you pay the Alternative Minimum Tax this year?

If line 45 on form 1040 has a number entered, you paid the tax determined by the AMT calculation. For your future reference, here is a link to the IRS AMT assistant page which will help you understand whether you will be subject to the AMT.

Why does this matter?

In states with a high personal income tax, once income reaches the level where AMT becomes the real tax rate, a significant change in income is required to get out from under AMT. Let's use a simplified example; assume that under the regular tax calculation you owe $165,000 in federal taxes but your AMT calculation shows $175,000 is due. Again, you have to pay the higher amount, but what happens if you had made significantly more money, say $250,000 more?  Take a look: 

Regular tax:     $165,000 +

                        $76,475 (approx fed tax due after deduction for high state taxes (eg, New York)


AMT:               $175,000 +

                        $70,000 (AMT rate due, with no state tax deduction allowed)

                        $245,000 due

Because New York state and local taxes are high, and deductible for regular tax only, and because any deduction that is allowable under AMT will also be allowable under the regular taxation, the AMT will be the de facto tax rate until income is significantly higher or lower and any tax planning done should focus on deductions allowable under AMT.  

Planning Tips for the AMT

The AMT disallows nearly all of the deductions that are available under the regular tax system. We will focus on the areas that affect people the most.

Local and State Taxes - Since these are not deductible for AMT, this puts many people in high tax states into the AMT. There is no avoiding these taxes so the best planning techniques involve timing these payments. If you are subject to AMT there is no advantage to prepaying local taxes in the current year, while there could be a benefit in waiting, particularly if you are not subject to the AMT in the following year. *Also, if you are calculating the costs of buying a home in an area with high property taxes, keep the AMT in mind as your after tax costs might be higher than expected due to the inability to deduct these levies.

Miscellaneous Itemized Deductions - For most people these are unreimbursed business expenses and are not deductible under the AMT. If you have a lot of these it would be a good idea to talk to your employer to either get reimbursed for these expenses or to establish what is known as an "accountable" business expense plan. It may even be worth negotiating a lower salary in order to have the employer pick up these business expenses.

Tax Exempt Bonds - Not all tax exempt bonds are equally tax exempt. Bonds issued by municipalities for "private activity" may not be deductible for AMT. If you want to buy a tax free bond fund and are subject to AMT, make sure that the fund specifically notes that it invests in AMT tax free securities. Nearly all the major mutual fund companies have a listing for such AMT tax-free bond funds.

Incentive Stock Options (ISO) - Under the AMT, if you exercise an ISO and don't sell the stock that year, you have to pay tax on the difference between the strike price and price of the stock on the day of exercise. This is radically different from the regular tax treatment where no tax would be owed until the stock was disposed (and the gain can be treated as a capital gain rather than ordinary income). This could cause you the most financial damage, particularly in the scenario where you exercise an option and the price of the stock subsequently declines significantly. For a vivid account of how devastating this can be, check out this article on the affect it had on a couple from Iowa. While Congress has addressed some of the problems in the ISO-AMT issue, please consult with your financial and tax advisers before you exercise any ISO's.

Capital Gains - While the capital gains rates are the same under AMT and the regular tax code, a large capital gain could push you into the AMT and thus make more of  your ordinary income subject to the AMT rate instead of the potentially lower rate of the regular tax code. This is particularly so if the capital gain is a significant percentage of your overall income or if you are right on the margin of falling in the AMT. If this is the case your best bet is to talk to a tax professional about the timing of the capital gain.

Qualified Retirement Plans(QRP) - Contributions to a QRP, such as a 401k plan, are one of the few deductions still permitted under the AMT. This makes it even more imperative that you maximize your contributions to these plans.

Unlike the examples of yesteryear, today there is little joy (or bragging rights) in ever paying taxes. But as with many financial decisions it often pays to have a plan prepared. This is definitely the case in regards to the AMT because innovative tools now will allow you to run "what if?" scenarios that can help you make the right decisions about the timing of key financial transactions throughout the year


As always we welcome your comments or suggestions. Stop in to see us at 420 Lexington Ave, Suite 2920, New York, NY... Call us at 212.949.0494 or simply 'reply' to this email.

Thank-you for reading,

John O'Meara, CFP
Michael Keating, CFP





Mike and John InnerHarbor Advisors

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