Derivatives

When you buy stock, you’re purchasing a slice of a company — you are actually buying something for your money.  Derivatives are a bet.  They can wager that a company’s stock price will go up or down (options), or that a foreign currency will go up or down (currency options), or they can be more exotic (credit default swaps).  They are a contract for a specified length of time, during which, if the terms of the contact are met, one party owes the other some money.  After the contact expires, the contact has no value.

Derivatives are not all bad

Like a gun, there are good and bad uses for derivatives.

Let’s say you’re in the business of selling large robots, and you just sold one to a customer in Japan for one million yen (roughly one hundred thousand dollars).  It will take you six months to deliver the robot.  In the meantime you need to buy all the components and start the assembly.  All of your expenses are in dollars, but you will be paid six months from now in yen.  You have an estimate today of what your profit will be, but you want to guard against currency fluctuations, so you might purchase an option on the dollar/yen exchange rate.  You’ll pay something for the option, but it’s insurance on your profit.

An appropriate use of a derivative is when you are protecting an asset.  Buying or selling derivatives without risking anything is pure speculation.  There’s nothing wrong with speculation, but it is different than investing.

Derivatives in mutual funds

Mutual funds traditionally invest in a diversified portfolio of stocks.  According to the semiannual report, Janus Worldwide is holding options on Jupiter Telecommunication.  Specifically they sold put options on the stock.

“We believe that these options either will expire worthless, netting us a profit from the trade, or compel us to buy more shares at a lower price. At the time of the trade, with the stock trading below our estimate of intrinsic value, we were willing to buy additional shares at a lower price.” (p. 75)

In the Notes to Financial Statements, Janus states their position on the use of derivatives in their mutual funds:

“The Funds may use derivative instruments for hedging (to offset risks associated with an investment, currency exposure, or market conditions) or for speculative (to seek to enhance returns) purposes.” (p. 124)

How exposed is Janus Worldwide?

Jupiter Telecommunications is a Japanese company offering tv, internet, phone and mobile communications to the home market.  Janus sold $4.5 M worth of options on the stock price.  As of the time of writing the semiannual report, the options were valued at -$3.9 M, for a net gain of $0.6 M.  The net assets of the fund total $2.5 B, so the $4.5 M is 0.2% of the total fund value.

Are the options a hedge or speculation? Janus Worldwide owns 31,000 shares of Jupiter.  The option is also a bet that the price will rise, so it is not a hedge against falling share prices.  The options are speculation, not hedging.

How much could the fund gain/lose? If the options expire worthless, Janus will keep the net gain from the sale, $0.6 M.  A loss would occur if the share price falls below the strike price (90,000 yen).  Janus sold options on 46,500 shares, so the maximum potential loss would be approximately $4M (which is the current valuation of the option).

Options are leveraged instruments  — a $0.6 M investment exposes you to a $4 M loss (leverage ratio = 6.5).  Of course, the probability of Jupiter collapsing during the period of the contract is extremely small.  Nevertheless, the annual report does not provide guidance regarding how the option impacts the risk level of the mutual fund.

Summary

Most mutual funds allow the use of derivatives for hedging and/or for speculation.  Digging through the details in a fund’s annual report can be a lot of work — more work than the average investor should have to put in.  The SEC could simplify the standardized reporting format and help improve investors’ understanding of their investments.

Disclosure: I am long in JAWWX, which has a position in J:COM.

Image Credit: Dougww on Flickr.

Answer: the best use of whole life insurance is to avoid estate taxes.

Whole vs. term life insurance

Term life insurance is a contract that, if you die during a specified period of time, your beneficiary will receive a sum of money (the death benefit).  After the term expires, the contract is worth nothing.

Whole life insurance will also pay your beneficiary a sum of money, in the event of your death, but in addition, the policy accumulates a value.  Part of your monthly (or quarterly or annual) payment goes towards the actual term life insurance portion of the contract.  The rest of the payment goes into an investment, depending upon the type of policy.  The investment builds up value over time.

If a policyholder terminates the contract, he can receive the “surrender” value of the policy.  In the early years of the contract the surrender value can be negligible, but the value rises in later years.

Irrevocable life insurance trust (ILIT)

To avoid estate taxes, you can create an irrevocable life insurance trust (ILIT) to own the policy.  This transfer the funds out of your estate and into the trust’s.  It lowers the value of your estate, and should you die, it reduces your potential estate tax bill.

Estate taxes

In 2009, estate taxes were as high as 45%; however, the exclusion was $3.5 million.  If your net worth was less than $3.5 million (which includes >99% of Americans), you did not owe any estate tax.  That is why whole life insurance (and ILIT’s) are only useful for the rich.

2010 is kind of a crazy year for estate taxes, because this year you get an unlimited exclusion — there essentially is no estate tax this year.  All bets are off for 2011.  Unless Congress acts, the estate tax will be reinstituted and the exclusion will drop to $1 million, subjecting a much larger percentage of Americans to estate taxes.

Boy, that sounds a lot like how the Alternative Minimum Tax (AMT) crept from the wealthy into the middle class.

Why does whole life insurance exist?

That is a mighty good question.  Why would a special exemption from estate tax exist?

But the special tax treatment might explain why whole life insurance is so expensive.

Buy term and invest the rest

Whole life insurance is significantly more expensive than term.  It’s simple to find online quotes for term life — not so for whole.  The cost of whole life insurance varies depending what options you select:  investment type, joint life insurance, survivorship, flexible payment plans, waiver of premium in the event of disability, and so forth.

For a $250,000 policy, you might pay $30 a month for term life insurance, but $250 a month for whole life insurance.  I’m only estimating these numbers, but I’m not willing to go through getting a whole life quote, and I suspect my estimates are at least in the ballpark.

Should you be considering whole life, you need to figure out whether it’s better to buy the whole life policy or by the term policy and invest the extra $220/month.  At an 8% return on investment, you’d have to invest $220/month for 27 years to accumulate $250,000.  So, at first blush, it might seem like a good deal.  But remember that the cash value of the policy is only the surrender value — a number calculated by the insurance company.

Because it is difficult to calculate the future value of your investment in a whole life policy (due to the opacity of the insurance policies), it is much more straightforward to buy the term policy and invest the difference.  At least with a brokerage account, you can look up the cash value anytime you want.

Disclaimer: The information in this article is presented for educational purposes only.  If you have questions about your particular financial situation, please see a financial professional.

Image Credit: Jiří Mašek on Flickr.

There’s no mistaking it.  It’s the fire alarm. 

Honk! Honk! Honk! …………..  Honk! Honk! Honk! …………..

I’m in a hotel in Portland, Oregon.  I’m on the third floor.  What do I do? 

Fire in the Hotel

On a recent business trip, my sleep was interrupted by a blaring fire alarm.  I managed to get my bearings, get dressed, and get down the stairs. 

There was no smoke outside my door, so I assumed it was a flase alarm.  Then I saw several families tumbling out of the building coughing and holding wet towels over their mouths.  They collapsed on the grass, and I overheard them describing their ordeal.  When they opened the doors of their rooms, they could barely see the other side of the hallway. 

I walked around the other side of the building.  Every room, imcluding mine, had the alarm horns activated, but only one also had flashing lights.  It was this room that seemed to have the most activity surrounding it.

We would learn later that a small fire had indeed broken out in this room.  I still don’t know what caused it.  Someone grabbed a fire extinguisher to put out the flame.  The extinguisher sprayed a dry chemical everywhere, which put out the flame but created a cloud of irritating dust.  It was the dust that the families had mistaken for smoke particles.  They were probably smart / lucky to have thought of using the wet towels. 

What I wish I had done

Obviously, in the event of a real fire, get out of the building as quickly as possible.  Take the stairs (not the elevator).  Follow directions from the fire department.

However, if you don’t actually see flames or smoke, you might:

• Get dressed.  I did, but there were a few folks wandering around with only towels wrapped around them, and it was a might nippy.
• Grab your roomkey.  Not essential, but it will make it easier to get back in.
• Grab a sweater.  It’s the middle of the night.  It’s colder than it was during the day.  Wearing what you were wearing at 5pm probably won’t cut it.
• Grab your car keys (if you have a car).  It would have been great to be able to curl up and sleep in the back of my car until they sorted things out.  There were no stores open at midnight in suburbia, so I walked around like a zombie until they cleared us to go back in.
• Don’t take big stuff with you — suitcases or computers or whatnot.  It’ s not worth it.  It can likely be replaced (you do have insurance, don’t you?).

Three engines came from the local fire department.  They had good communication between themselves.  Once the hotel managmeent got over their deer-in-the-headlights look, they did what they could, handing out extra towels to help folks stay warm and bottles of water.  Thankfully, no one was hurt.

We laughed, we cried, we shared a moment…

The hotel was packed.  There was a huge group there after a wedding.  The bride, groom and wedding party were still all gussied up.  A good story to tell future grandkids, I guess. 

I felt worst for the families with small children.  Clearly they had to yank the kids out of sleep and now they were sitting outside on the cold concrete or grass.  Somehow, like kids tend to do, they were all coping.

In about an hour from the initial alarm, the fire captain explained what had happened.  It took another 30 minutes for them to clean up the dry chemical enough to let most folks back into their rooms.  After another hour, everyone could go back in.

The next day things were back to normal, except for a little residual white powder on the third-floor carpet.  I hope I never go through another fire — whether real or false alarm, but if I do, I hope to be a little more prepared.

Image credit: Fellowship of the Rich on Flickr.

That’s a horrible way to begin a post.  I hate to read the daily drivel of the typical blog writer (worse yet, my own).  Today, I don’t care.  I had a practically perfect day.

I’m in Portland, again.  I live near Boston, but I’ve been in Portland about half-time since April.  I’ve spent a few weekends here.  But this time it’s different.   It’s not raining. 

Portland’s Farmers’ Market

I start my day at the Farmers’ Market at Portland State University.  I have a high standard for these outdoor events, since I did grad school in Madison, Wisconsin which has, IMHO, the best Farmers’ Market in the World. 

Although it is about one-half the size of Madison’s massive market, I am not disappointed by Portland’s offering.  It has a fantastic array of high-quality produce, baked goods, coffee, and more.  All arranged around a pedestrian-only park with live music in two venues. 

A splendid retinue of slightly eccentric Portlanders wanders by to amuse me as I sit on the steps of higher learning, munching an anise-and-fig brioche from the Pearl Bakery and sipping coffee from the Spunky Monkey.  Life is good.

Wahkeena and Multnomah Falls

Fueled for the day, I drive west on I-84 into the Columbia River Gorge. 

I start a hike to Wahkeena Falls.  The sign says it’s 0.2 miles.  Too short, I think dismissively.  What I am forgetting is this:  There is no such thing as a level trail in Oregon. 

The switchbacks begin.  I pass the falls.  They are beautiful.  Check. 

I keep on going.  Four miles later, I’ve made the #420 loop.  I climbed up Wahkeena Falls and down Multnomah Falls. 

A four mile loop means two miles up and two miles down.  The altitude gain is about 2,000′.  Two miles is approximately 10,500′.  That’s a 20% grade up.  And a 20% grade down.  My calves still twinge.

McMenamins’ Kennedy School

Back in the car, I realize that the Pearl Bakery brioche powered me up the hill, but gravity brought me down.  Now I am running on empty.  Luckily, I planned ahead and mapped out the nearest McMenamins pubs. 

When I’m in Portland I eat almost exclusively at this local chain.  If they ever find out that Hammerhead Ale is carcinogenic, I’m a goner. 

The food is good.  The beer is better.  The service is terrific.  I no longer care what the online reviews say.  Absolutely every time I’ve been at one of their restaurants, I’ve had really good service by genuinely nice folks. 

McMenamins takes old odd buildings and breathes new life into them.  They fill them with hippie art of stars and moons.  They create really interesting places that I want to explore. 

One of their more ambitious projects renovated an old elementary school slated for demolition.  They converted the school into several restaurants and bars — each with its own atmosphere – and a 35-room hotel.  Ever want to sleep in a classroom (without worrying how the nun will wake you up)?  Here’s your chance!

My favorite bar is in the old boiler room, pictured to the right.  It is the funkiest creation of recycled plumbing ever assembled into one very functional room.  The bar is down below one level.  Great place for a meal.  I even shot a bit of pool.

Portland

Portland has a lot to offer.  I had a fantastic day.  What made it not-quite-perfect?  I wish I could have shared it with my family, but they are back in Boston.  “Aw shucks,” you say.   Yes, “shucks,” I say.

Full disclosure:  No financial interest in any of the businesses mentioned. 

Image credits:  All images were taken by the author.

Author’s note:  The title is inspired by Mary Poppins.  After she – literally — measures up her new charges, Jane and Michael Banks, she turns the measuring tape to herself, only to proclaim that it reads that she is “practically perfect in every way.”

I travel for work more frequently these days, and I spend more of my precious limited memory on things like “what color is my rental car this week” and “where the heck did I park it?

This week I found a new weapon in my war on aging.  The digital camera.

Now when I park the car, I take a quick photo of the street sign.  If I need to, I can refer back to it or show it to a helpful native who might point me in the right direction.

In Portland (and in other cities, I imagine) you pay for parking using centralized PayPark stations.  They print out a time-stamped receipt you stick on your window.  With a quick click, I no longer have to worry “does the meter expire at 2:30 or 2:45.”

I went for a hike without a map (ok, not a good idea in general).  The trailhead had a map carved into steel.  The photo of the entire map was too small to be useful on the camera’s build in screen, but with the zoom and steering functions on image replay, I managed my way around quite well.  Better than a Polaroid.

Now if I could just remember where I left my keys….

Are we talking term or whole life insurance?

Term life insurance is a straightforward contract:  “If you die during the period that the contact is in effect, your designated beneficiary will be paid the death benefit”.  Whole life insurance is a completely different ball of wax.  Whole life insurance is an investment vehicle to help the rich avoid estate tax.  (Yes, really).

So, we’re talking term.

A term policy has level payments, meaning that the premium (what you pay each month) is predetermined and never rises for the term of the policy.  In addition, most term policies can be extended (converted), albeit at a much higher premium.  This might make sense if you are stricken with terminal cancer in the 19th year of your 20-year term policy.  With cancer, you would not pass a medical exam for a new life insurance policy, but you might choose to convert your existing term policy.

Who needs life insurance?

Do I need life insurance?  Easy answer:  No.  You don’t need life insurance — it’s the people you leave behind that do.  The purpose of life insurance is to help your dependents cope financially should you die prematurely.

If you’re single and have no children, who would be affected by your death?  Unless you’re the primary support for a disabled sibling or a parent, then you probably don’t need life insurance.

If you’re married, your spouse works full time, and you have no children, you still may not need life insurance.  If you and your spouse agree that you could each maintain your standard of living without the other’s financial support, then you probably do not need life insurance.

If you have a child (or children), then you need to plan how these dependents will be financially supported.  You might plan to support a child until able to provide for him/herself, perhaps at age 18, 21, or 25.

If you have a special needs child who may need support for his/her entire life, then you should strongly consider life insurance, and you should see a specialist to discuss your particular situation.

How much life insurance do I need?

There are several ways of computing your life insurance need:

You can simply estimate your need at 1x, 2x or 5x your current salary.

You might decide to provide a lump sum to, for example, pay off the mortgage.

If you have a stay-at-home-spouse, you might instead estimate the total need by multiplying your total household expenses (minus yours) by the number of years until your youngest child can fend for him/herself.  You could factor in inflation, too, if you want to get fancy.  Or you might decide that your spouse would go back to work, reducing the need for life insurance.

How much do I need to buy?

Read the fine print of your employment agreement and understand how much insurance your employer provides.  Subtract that amount from your estimated need.  (While you’re at it, make sure your beneficiary form is up to date and doesn’t inadvertently divert your dollars to your ex.) Voila.  Now you have the amount of life insurance you need to purchase.  Let’s go shoppin’.

Buying insurance through your employer

If you work for a relatively large company, you can often purchase life insurance through your employer.  This kind of policy is usually a one-year term policy, and the price is based upon your age.  The advantages of this approach is that it is easy to sign up and typically, it does not require a medical exam.   One big disadvantage is that if you change jobs (your choice or theirs) you may lose your insurance.  If you purchase the insurance one year at a time, the rate will rise with your age and with inflation, so this approach can be considerably more expensive.

Getting other bids

If you’re considering getting long-term term insurance (e.g. a 20-year policy), you should get several bids.  It’s a relatively large expense, and you’ll be locked in for many years.  It’s worth making a few calls.  You should get a quote from your insurance company.  In addition, many professional and social organizations offer term life policies through their group life policies.  Check out the organizations you already belong to and see if they offer discount life insurance.

Comparing offers

The best rate I found for a 20-year term policy was through my current insurance company.  For the same amount of insurance through my employer, over 20 years, I would have paid more than five times as much as through my insurance company.  If you include a 3% annual increase in the premiums, I would end up paying 7.5 times as much, purchasing the insurance through my employer.  So with a little bit of homework, I saved about 87%.

Another important factor when choosing life insurance, is that you want that company to be around for at for least the term of your policy.  Check out the financial solidity of the insurance company through A. M. Best or Standard & Poor’s; they rate all major insurance companies.

According to the actuarial data at the Social Security website, the probability of my death sometime in the next 20 years is about 13.7%.  You might, therefore, expect that the total of the premiums to be paid over the term would be about 13.7% of the death benefit, plus a little bit for profit for the life insurance company.   In the quote from my insurance company, the premium is only 3.2% of the death benefit.  That low rate is only available for the “Ultra Premium” low-risk category.  To qualify, I’ll have to pass their lengthy interview about my habits and family history and a blood test.  I’m a healthy non-smoker with a good family history, so if I don’t qualify, I don’t know who would.  But we’ll see how smoothly the process goes.

Summary

For life insurance, the first step is to decide whether you need it, and if so, how much.  Shop around to find the best rate, checking insurance companies and organizations you belong to that offer discounted group life.  Compare it to what your employer offers, and don’t be surprised if you can get a much better deal elsewhere.

About the Author: Helen Maynard writes about her favorite topics at ScienceAndMoney.com.  By profession she is a scientist/engineer working with semiconductors.  She is peculiarly interested in personal finance and is studying to become a Certified Financial Planner.

Disclaimer: The information in this article is presented for educational purposes only.  If you have questions about your particular financial situation, please see a financial professional.

Image Credit: Laineys Repertoire at Flickr.

Carnival: This post was included in the 266th edition of the Carnival of Personal Finance hosted at Nerdwallet.

• Obtain a Preparer Taxpayer Identification Number (PTIN).
• Pass a basic tax competency test.  Attorneys, enrolled agents, and CPA’s are exempt from the test.
• Pass a suitability test including a credit check, criminal records check, and an audit to make sure they have paid their own taxes.
• Pay a fee of $75 to $300 which covers three years of registration (final amount TBD).
• Complete 15 hours of continuing education annually.

The requirements will be phased in over the next three years.  PTIN’s will be available beginning in September.  If you obtain a PTIN before the exam is ready, you have three years to take the exam.  If you apply for a PTIN after the exam is ready, you won’t be issued a PTIN until you pass the exam.

All returns prepared by a professional after 31 December 2010 will need to include a PTIN.

What does this mean to consumers?

If you have your return prepared by a professional, beginning next year it will need to include his/her PTIN.

Next year, you won’t know whether the preparer has met all of the other requirements of registration, since they may have obtained the PTIN early to delay the other requirements for up to three years.  You can, of course, ask a potential preparer and make your selection on the basis of whether or not they are fully registered.

Three years from now, you can be confident that anyone signing with a PTIN has passed the above criteria and is a registered tax preparer.  There will also be a federal public database listing registered preparers, just in case you want to check.

Who benefits from the new rules?

H&R Block, and other large firms, win because the additional paperwork and expense is bound to close down some of the smaller Mom and Pop seasonal shops.

Other winners will include companies that deliver continuing education classes and those that will be chosen to provide the testing services.

Consumers will benefit from an improved overall quality of tax preparers, weeding out the few who are corrupt or incompetent.  However, consumers will also, ultimately, be footing the bill, as the expenses will ultimately be passed on in higher fees.

References: IRS Announcement and Return Preparer Review

Image credit: Dennis Wong at Flickr.

Deal or no deal?

What is the underlying investment?

It is not a 529 or otherwise tax-advantaged account.  It is simply a savings account.  The bad news is that you don’t receive any tax benefit (unlike a 529 account).  The good news is that you don’t actually have to spend it on Jane’s schooling — you can actually use this money for any purpose.

The current annual yield on the savings account is a whopping 0.4% for account values between $1,000 and $10,000.

Is the $1,000 bonus a good deal?

The spreadsheet snippet below shows your earnings if you open the account just before your child’s sixth birthday (the minimum) and invest $25 per month (also the minimum).  In twelve years, you will have invested $3,600 and earned $87 in interest.  With the addition of the $1,000 bonus, you will have $4,687.

The annual rate of return on that investment over the twelve years is 4.3%.  If you consider the effect of income tax on your interest earnings, the rate of return drops a bit to 4.2%.

If you contribute more than the minimum, the “kick” from the $1,000 bonus is reduced.  The spreadsheet snippet below shows that if you invest $250 per month, the effective annual rate falls towards the savings rate.

Compare this offer to a 529

The annual rate of return from the Utah Education Savings Program’s Vanguard Total Bond Market Investment option is 5.66% over the life of the fund (1999).  Better yet, your 5.66% return is tax-free (if used for educational purposes).  If you’re in the 28% tax bracket, that’s equivalent to a taxable 7.86% return.

The Good, the Bad, and the Completely Indifferent

You can view the deal at Citizens Bank as a way to 10x the 0.4% offered, but you must adhere to a fairly strict set of requirements for at least 12 years.   I can think of easier ways to earn $1,000 — most of them legal.

I can’t imagine being locked in to a twelve-year investment for such a meager return, especially when tax-advantaged options exist.

Nevertheless, Citizens Bank is proud that it has signed up 15,000 new CollegeSaver accounts.  Did it tell the applicants about 529 programs?  Fifteen thousand suckers? Or fifteen thousand people who needed help savings for college.  Or maybe fifteen thousand people who plan to take a nice vacation in twelve years.

Full disclosure: No investment in Citizens Bank.  Citizens Bank is part of the Citizens Financial Company (Providence, RI) which is owned by the Royal Bank of Scotland (NYSE:RBS).

Disclaimer: This information is for educational purposes only.  This investment may or may not be appropriate for you.  If you have questions about your particular situation, please see a financial professional.

Carnivals: This post was included in this week’s Carnival of Personal Finance hosted at Personal Finance Journey.

When a photocopier is replaced, the used one can be resold.  The used copier still has the hard drive with all the document images intact.  The hard drive can be removed and the images retrieved.

Think of all the sensitive information that gets copied:  employment records, medical records, tax returns, and financial account information.   It’s all stored and available to those who would desire to retrieve it.

CBS News recently purchased four used copiers, removed the hard drives, and recovered documents about sex offenders, financial statements, and documents with Social Security numbers.

It’s not a new story.  Computerworld interviewed the president of Sharp Document Solutions in 2007, where he expressed concern about identity theft through copiers and intelligent printers.

A better way

It’s a great opportunity for a manufacturer of copier machines to redesign the device so that it uses random-access memory (RAM) instead of a hard drive.  Data stored in RAM is lost when power is removed.  RAM is the main memory in computers and is <$100 for 1GB, which would seem to be plenty for the typical office copier.  The copier maker could charge a premium for a RAM-based data-safe copier.  (Are you listening Sharp? Xerox? Ricoh?).

Other storage devices

Hard drives are difficult to fully erase.  The “delete” function in Windows, merely moves a file to the “Recycle” bin.  “Emptying” the Recycle bin merely deletes the file name from the directory list.  The file can still be recovered with a DOS-level function.  Fully wiping a drive requires writing to every itty bitty bit on the drive.

Hard drives are one form of information storage, but there are others.

Flash memory — like the kind found in “memory sticks” — is now embedded in virtually everything you plug into the wall or has batteries: cameras, cell phones, MP3 players, voice recorders, pagers, game boxes — just to name a few.  I’m convinced that one day even my toaster will have an IP address.  iPhones now have banking and financial apps for mobile transactions.  It’s safe to bet that the transactions are secure, but what about the data stored on the device.  When the device gets recycled, can that information be cleared?  Do people bother to delete it? Does “deleting” a file really make it unreadable?

CD’s and DVD’s are a common way to back up computer hard drives.  Do you know where your back up disks are?  I’ve moved a few times over the years, and I’m sure I’ve lost some along the way.  I’ve probably also lost some 3 1/2″ disks (and even some 5 1/4′s — but that tells you how old I am).

Information protection will become more important as we move further into the information age.  We need to consider the “cradle-to-grave” of our digital bits.  We need to be careful how we create, distribute, store, and ultimately destroy our digital records.

Tip o’ the green shade to Bill Winterberg at FP Pad, who brought the issue to my attention.

Image credit: jzawodn of Flickr.

Carnivals: This post was included in this week’s Carnival of Personal Finance hosted at PopEconomics.

According to an article by the WSJ, Eric Rey of Berkeley, CA asked the IRS for clarification on how he and his same-sex domestic partner should report their income for tax purposes.  California is a community property state, and domestic partners must each report half of their combined income.  Until now, income could only be split by the 5% of California’s domestic partnerships that are heterosexual.  Since My. Rey earns much more than his partner, it would significantly lower their overall tax burden, if he could shift half of his income to his partner.  This week, the IRS ruled that all domestic partnerships in Calfornia must report half of their combined income on each partner’s individual tax return.  

The IRS is considering whether the new ruling will apply to other community-property states.

The WSJ article is titled: “Gay Couples Get Equal Tax Treatment,” but in truth it is a favorable treatment.  Splitting income is even better than filing as a married couple, which has the potential of the marriage penalty.  This new ruling should lower the tax burden for many gay couples in California.  Most gay couples in which one partner earns significantly more than the other will likely get a bump down in tax bracket.  The tax brackets for gay couples in which each partner earns approximately the same should stay the same, so those couples will pay no more (or less) tax.

Frankly, the new ruling is disadvantageous (and potentially discriminatory) to California heterosexual couples because they cannot register as domestic partners, unless one partner is older than 65.  For example, a married couple in which the sole breadwinner earns $250k will be in the 33% tax bracket.  Their gay domestic partner neighbors who have the same income situation will be able to split the income, each reporting $125k, putting each into the 25% tax bracket.  That’s an 8% savings, or $20,000.

At the risk of repeating myself, each family ought to be able to choose how to file their tax forms.  Families that are currently hit by the marriage penalty could choose to file as two singles (or one single and one head-of-household, if there are children).  Gay married couples (like myself) should be allowed to file as married if that would lower their overall tax burden.

Image Credit: Thom Watson at Flickr.