We are going on fraud patrol now. Sadly, the only indicator that reliably ticks upwards during economic slowdowns involves the incidence of fraud.

Today we tackle the subject of affinity fraud, and in our next post we will expose the practice involving advance loan fees.

I’ve been waiting for the mainstream business press to step up to the plate on this issue and was not surprised to see the Wall Street Journal article, “The Rabbi, the Do-Gooder, the Lost $100 Million” (page C1, 8/15/08 CI).

This is a wide-ranging, fully ecumenical practice targeting everything from co-religionists to fraternal and social organizations.

The methodology follows a drearily predictable routine:

With Friends Like These…

First and foremost is the presence of someone with membership in the group who is actively promoting an investment “opportunity” restricted to other members of the group.

This appeals on many levels, beginning with the desire for group members to conform to a norm and to bond with other members.

When offered a chance to participate, the individual’s guard is down, because, after all, this is not some stranger they are dealing with. It is one of us.

The skilled scam artist knows how to work the room. If someone is bold enough to ask for supporting documentation to justify the investment, the promoter will recoil with mock surprise and blandly assure the questioner by saying…

“Of course I have only the highest interest of my fellow members as my goal. I would never violate the trust of the group.”

This will make the reluctant party look like a spoil sport out to ruin a good thing for everyone else.

Be Careful Who You Trust

It’s not that different from the major advertising push of the dominant brokerage firms. An innocent who views these commercials would think that brokers place the client’s interest far and above their own.

But as the recent scandal involving auction rate securities has shown, Wall Street firms resisted making their clients whole, kicking and screaming all the way, until the threat of regulatory and civil litigation made their stance untenable.

Fifty Ways to Fleece an Investor

The fraud itself can manifest itself in various ways. It might be something as simple as a Ponzi scheme, with incoming new money used to repay some earlier investors, with the bulk being siphoned off by the promoter.

More sophisticated scams will exchange inflated paper assets for investor cash, and it may take years for the facts to unfold. Quite often, the participants get regular quarterly statements showing the value of their illiquid investments.

But no maturity or cash out date ever arrives. The account has long since been depleted and looted, leaving only an empty shell.

The pattern I’ve seen with the hedge funds that scammed their clients involved first finding a prominent “tent pole” client, who serves as a beacon and magnet for his affinity group. This might involve professional athletes, entertainers, or any other group with common traits.

The all to human trait of clustering and herding then kicks in, with no one wanting to be left out.

It’s no wonder this fraud is so flashy and widespread. It brings in money much faster than the dull and steady work of sifting and sorting among legitimate opportunities.

This pattern of bogus behavior resides at the very pinnacle of Wall Street’s promotional hierarchy. Investment becomes so abstracted and removed from reality, that people are ready to buy the hype, just so long as someone in their peer group has already blazed the trail.

Be Diligent, Be Vigilant

The purgative for this poison is readily available.

Don’t believe a word you hear. Don’t accept anything at face value.

Invest on your own, using no load funds and deep discount brokers.

And when consumed by the desire to invest in something new, exotic and illiquid that all your group is chasing….

Just lay down and take a nap until the urge passes.

Some day, many years from now, you can tell your progeny about the zero tax rate on capital gains.

Unlike most urban legends ungrounded in fact, this is the real deal.

How It Works

This little gem was inserted into the tax code when capital gains taxes were reduced overall to 15% early in George W’s administration.

Beginning in 2008, and extending through 2010 (assuming the next administration does not slam this door shut), those taxpayers who fall in the 15% marginal tax bracket are eligible for zero tax on long term capital gains.

What’s the Catch?

The net will only hold the small fry, and not the big fish who generate sizable capital gains.

This would be a couple, married filing jointly, with ordinary taxable income no greater than $65,100 or singles earning less than $32,500.

Let’s pay close attention to definitions here. We are not talking adjusted gross income (the figure found at the bottom of the first page of your two page form 1040). AGI only allows you to deduct so-called above the line deductions, like contributions to retirement accounts and health savings accounts.

We are dealing here with net taxable income, which is arrived at after claiming exemptions and either the standard or itemized deductions. Since every couple is eligible for personal exemptions of $3,500 each and at the minimum the standard deduction of $10,900, you get to subtract nearly $18,000 from your adjusted gross income to arrive at the final figure.

Itemized deductions that exceed the standard, as well as exemptions for dependents can bring the total down even further.

Clearly, the intent was to restrict this break to lower income households who do not normally generate much in the way of capital gains income.

You Might Have Some Options

Here are some options worth pursuing:

I. If Your Income Just Fell

One group that could benefit are those who acquired capital assets in prior, and more heavily compensated years, but now have downsized their income, either voluntarily or involuntarily.

This could include recent retirees, as well as those displaced from higher paying jobs due to the economic downturn.

They would be wise to sell appreciated assets this year and next, before Congress changes its mind.

Not much chance the rate is ever going to go lower than zero.

II. Give it to Your Kids or Parents

The other option is give highly appreciated assets to the adultlets in your household. In times past, you could have gifted your school age kids, but the threshold for the infamous “kiddie tax” has been raised.

As it now stands, any investment income over $1,800 is subject to the parental tax rate up to the age of 18, or 23 for dependent full time students.

But that still leaves the recent grad as a strong possibility, especially if they have taken a more altruistic and lower paying path such as teaching.

If your kids are earning above the cutoff, consider your retired parents as possible candidates.

Gifting is simplicity itself. A married couple can each use their $12,000 gift tax exemption to gift $24,000 to anybody. If both sets of grandparents still survive, that could be $96,000.

Throw in your non earning slacker graduates who are trying to get their garage band going, and we are talking big money…well into six figures that we can squirrel away.

And for those of you who are holding out for a better deal…

You must know something I don’t know.

Further proof that no trend lasts forever.

Our down-and-out dollar is starting to rebound. Earlier this year the Euro hit $1.60 and is now below $1.50. The dollar has also strengthened against the Yen and Pound.

Currency Monitoring

Just as you scan the stock indexes daily, you should also get in the habit of monitoring the dollar. A good place to start is page 4 of the daily Money and Investing section of the Wall Street Journal, under the heading “Commodities and Currencies”.

In fact, Morningstar has just recently broken out Currency Funds as a distinct asset class, and now tracks the category on its own. Within the ranks are funds that bet on both the strengthening and weakening dollar, as well as long currency positions in hard currencies such as the Swiss Franc.

Not to mention the avalanche of ETFs (exchange traded funds) that allow you bet for or against the major currencies.

I’ve always felt that you are in the mainstream of currency hedging by the simple expedient of having a globally diversified portfolio, and more to the point, I don’t have any confidence in my ability to project currency trends.

Reallocate that Portfolio

My sense of the recent turnaround is that it is not so much a vote of confidence in our tapped out economy as a recognition of how widespread the economic slowdown has become.

In the land of the blind, the one eyed man is indeed the king.

In retrospect, you can see that the strong dollar helped prop up our global dominance in the nineties, just as the tanking dollar helped to mark up the returns on foreign equities for most of this decade.

Which means that the relative return of foreign vs. domestic stocks has now reversed, and the allocation that worked for you in 2007 is now as unfashionable as your old bell bottoms and disco shirts from the seventies.

The practical implications are profound. We will not have so many foreign buyers of our overhanging real estate inventory if the dollar continues to outperform. Our export oriented companies will have to row against the current…a complete reversal from the boost they got from the declining dollar.

How Currency Flux Affects Oil Prices

For most of us in our day to day lives, the biggest change we will notice is in the cost of energy, a dollar denominated asset class for the most part.

Much of what we experienced in the rapid increase in energy prices was the doubly whammy that came from global demand and the weak dollar.

Which goes to prove that market excesses have a way of wringing themselves out if the market is allowed to sort out the winners and plunder the losers.

And the Political Fallout

Our brain-dead Congress has declared war on energy speculators…who have been guilty of the sin of price discovery and providing liquidity in a treacherous market.

While the traders who kept rolling over their positions and were long on energy have been decimated these past few weeks.

And so we come to the first theorem of political economy: After the battle, the first order of business is to go out on the battlefield and shoot the wounded.

Some of you may remember the late and gifted comedienne, Gilda Radner, who blazed to fame and glory on Saturday Night Live. Her classic catch phrase was…”Never Mind.”

About that earlier post on harvesting the maximum $500,000 in tax free capital gains on both your primary and secondary home…..never mind.

That’s the problem with writing a public blog. The Feds get around to reading it eventually. See the Wall Street Journal article, “House-Hoppers May Suffer Under New Tax Rules” (8/6/2008) by Tom Herman.

And so we end up with the housing stimulus package. Also known as…”I’m from the government, and I’m here to help you.”

Maybe the single scariest phrase ever uttered.

The Long and Short of It Is This

You and your spouse can still lop off a half million in capital gains on your primary residence.

And now you can do the same on the second/vacation home, but only on the pro-rata period which includes your occupancy.

For example, if you downsize to your second, smaller home after pocketing the gain from your first home, the clock starts ticking on your period of occupancy. If you occupy your second home for 30 months, but owned the home for a total of 90 months, you can exempt only 1/3 of the gain up to $500,000.

As tax shelters go, it’s still better than a poke in the eye with a sharp stick. Just not as good as it once was.

There are some other nuggets worth looking at in the stimulus package:

A Boosted Deduction in 2008

For example, all homeowners who do not itemize their deductions will get a one time only boost in 2008 of up to $1000 in the standard deduction, assuming your property tax bill is at least that large.

This won’t put you on easy street, but its a couple of hundred off your taxes, assuming you are at the marginal rate of 25% or more.

The Refundable Tax Credit for “First-Time” Home Buyers

The most talked about benefit is the refundable tax credit of up to $7,500 for so called first time home buyers. So called, because anyone who did not own a home in the three years prior to purchase is designated as a first time home buyer.

It’s like the miracle of modern medicine. Re-virginization.

But read the fine print. This tax credit is a bit of a “gotcha”….what you would like to think of as an outright gift comes with strings attached.

Because it must eventually be repaid at the rate of $500 per year over fifteen years, or upon the capital gains from the sale of the house, whichever comes first.

So it’s best to think of the credit as an interest-free loan, which is in and of itself a solid benefit for the strapped first time buyer trying to patch together a down payment.

Best of all, it’s what is known in the tax trade as a refundable tax credit. That means it is deducted from your tax obligation, and even refunded as a check to you if your taxes are less than the credit.

An Example:

Assume your payroll tax witholding totals $5,000 for the year, all of which is to be applied to your taxes. If you qualify for the maximum credit of $7,500, the government cuts you a check for that full amount. If your tax obligation was $10,000, it is whittled down to just $2,500.

Check out www.federalhousingtaxcredit.com for the full scoop.

I would not base the full decision on whether or not to buy based on this credit, but I would allow it to sway me in that direction. Prices are still declining in most markets, and we can expect to reach bottom by mid to late 2009.

The latest rallying cry on the street. Begin again….in 2010.

Watch out for the sell-by date…

This little gem expires July 1, 2009.

Now a treat for the overachievers among our readers.

We must first assume that you have punched every ticket suggested so far, and after maxing out the basics of home ownership, funding of your two core retirement accounts, and providing for future health and education funding, you still have room on your plate for more.

This could be a very long list, but I’d like to give you just another three solid side pockets to fill.

I. Build up Fixed Income

The first goal is to have you bulk up the fixed income side of your balance sheet. Two simple means are at your disposal, and are easily accessible on line.

1. Build a CD Ladder: Don’t expose yourself to long maturities. 12 months will do the trick. Don’t feel you are confined to what your local banks are offering. By using bankrate.com, you have access to the full panoply of banks nationwide.By constantly rolling over these 12 month maturities you have a hybrid instrument that functions almost as a money market account, but with rates that may yield twice as high a return, with the added feature of having a fixed income structure that is highly sensitive to changes in interest rates.This is especially important, now that rates are in the basement.
2. Buy I-Bonds: I’m in a funk about this option now, as the government has yanked the nominal rate down to zero before adding the inflation component.But this is both an ultra safe investment, and a tax shelter in that you can push all income off to the future when the bonds are redeemed, a period potentially as long as 30 years.

II. Consider Investment Real Estate

I offer this with caution, but you might have the temperament and skills to be a part time landlord, building a small portfolio of rental houses.

Be honest in doing your self-skill assessment. If you can handle the inevitable hassles of leasing, maintenance and repairs, this can be a very lucrative venture.

This is best for families that are more or less permanently rooted in their community…an important consideration as this cycle can take literally decades to completely unwind.

The model would be to use prudent leverage, so that rental income will pay off the mortgage balance. Cash flow may be nominal during the repayment period, but once the loan is paid off, you will have substantial monthly income to supplement your work or retirement income.

Ideally, you will have the talents of a handyman, bookkeeper, diplomat and psychologist so that you can deal with the full gamut of human behavior quirks that are in store for you.

III. Be Your Own Boss

This is the big Kahuna, so first take a long breath.

Most of us are destined to work for someone else during our working lives. And a strong minority of us are appalled at that prospect. If you have the moxie to launch your own business, you open up a wealth of opportunities to enhance your family’s wealth. Or maybe blow it all.

Surprisingly, our ham-handed government will come to your assistance, in allowing you to write off an incredible variety of expenses, and especially in opening up a whole new alphabet of retirement goodies, including the SEP-IRA and the Regular or Roth Solo 401-k.

For those of you who strike it rich relatively later in your career, and who wish to make up for lost time, there is the Solo Defined Benefit Plan, offered at a very competitive rate by Schwab, Fidelity and most other major discount brokers.

I can’t advise you what business to launch. But I can tell you that you are more likely to be successful if you can monetize a skill you already possess, and do so without adding major overhead.

And by major overhead I mean business rent and salaries.

If you could bill yourself out as an expert in your field, without violating your non-compete clause at the day job, you hedge against the possibility of failure, by holding on to your slave job while you build out your private practice.

Best of all, is the freedom that comes with this package. No downsizing. No forced moves. No age discrimination.

No more petty office politics.

No guarantees, but really, what have you got to lose?

It’s all indoor work…and no heavy lifting.

Let’s pause to mark our progress to date.

Our Basic Assumptions

• You have a time horizon of thirty years before your anticipated retirement.

• You don’t mind marching to a different drummer. You are prepared to make investing a priority, and consumption a residual pleasure. Rather than the other way around.

• By now, you are fully in harness, steadily paying off your home loan while diverting your income upstream to fund 401k and Roth IRA contributions, and your HSA and Education IRAs when appropriate.

Where will this get you? Let’s run some hypotheticals.

If You Bought Your Home

Start with a $200,000 home purchase…very close to the national median price. Finance it with an 80% loan at 7% for 15 years. The monthly payment will be just a shade under $1,440.

This is not a heroic sacrifice. You would have paid something similar for rent anyway.

After thirty years, two pleasant results will emerge:

1. Your cash flow has gone up $1,440 per month after 15 years. Just as if you got a $17,000 annual raise at work.And just in the nick of time, as you are now most likely in the “sandwich” generation, concerned both about your aging parents your college bound kids.
2. And now after 30 years, assuming just 3.7% average annual inflation, your home is worth $750,000. Free and Clear.

Easy to see why everyone says your home is your best single investment.

But a money market account funded at the same initial level will produce the same result at the same stipulated rate of growth. Time and compounding and reinvesting did all the heavy lifting.

If You Funded Your 401k

Assume a $75,000 average salary, with 4% contribution both from the boss and your salary. That totals $6,000 combined per year, compounding at 10% for thirty years, that will grow to $987,000.

Look at the disproportion. Your never missed salary reduction is just a small fraction of what you paid on your mortgage. But look at the results.

Right away you have to admit, that the equity portfolio has bested the real estate.

If You Funded an HSA

And your HSA at $3,000 per year for thirty years also growing at 10%….mushrooms to $493,000—-less any draw-downs for medical care.

Don’t Forget the Kids

And the Coverdell (Education) IRAs? $2,000 at 10% for 18 years….$91,000.

Times however many kids you funded.

I know. Not enough for the entire tab, but it helps to put a dent in it.

Totally…

Take away all the Coverdell money, long since spent, and assume half the HSA fund was used to pay out of pocket medical costs during your working years, and that leaves a net worth of just a shade under $2 million.

This does not include a spousal 401k. Or spousal HSA contributions.

It’s almost impossible not to become financially independent by sticking to the straight and narrow path of savings and investment first, consumption later.

In Part IV, we let ourselves dream a little larger, painting the canvas with even more vivid colors.

Our extreme makeover continues.

The ultimate reality show: “The Unconscious Millionaire.” Transitioning from wage slave to millionaire…by diverting your income upstream before you can see it and spend it.

Four Essential Accounts

We introduced in part one the four essential, tax advantaged and asset protected accounts that a family with children should fund. These are…

1. Your 401k at work with employer matching funds. (If the boss is stingy, and does not offer a match, you can easily pass on this one and focus on the others. The only feature that make the 401k truly distinctive and valuable is the free money match.)
2. You and your spouse’s Roth IRA. If you make too much to qualify, just do the shuffle…open non deductible IRAs, which have no income limitations, and roll them over in 2010, when you have the extra bonus of stretching the tax over the next two years.
3. You and your spouse’s Health Savings Account. You may not have the option now, but be patient. This is the future of health care once employers retreat from their costly legacy indemnity plans, while herding their employees into high deductible, consumer driven health plans.
   Don’t think it will happen to you?
   Remember your old defined benefit pension plan, which is now your defined contribution 401k? If they can pull the rug out from under you once, what’s to stop them from doing it again?
4. The Coverdell (Education) IRA is available for each of your kids. It’s capped at $2000 per year per child under age 18. Of course it won’t cover all the costs of college. For that, you will need to tap your kid’s part time earning power (they need skin in this game too) and both sets of grandparents. It’s just too much for any one couple to shoulder on their own.
   And if you still fall short, let the kids take out loans. Their lifetime earnings boost will make this a positive leveraged investment.

Now Add Home Ownership

Contrary to the accepted wisdom, your home is not the single best investment you will ever make. That hoary myth got started because most families never systematically invested in anything else.

Residential real estate appreciates at or near the rate of inflation. A globally diversified equity portfolio will produce better results.

If someone held a gun to your head and forced you to contribute $1,000 to fund the first four accounts listed, for a period of your most productive thirty years, then you would say equities are the best investment ever.

Your home equity looms large on the horizon because you did not have the option of skipping your monthly payment, and you forgot to tap your equity balance while paying off the loan.

Nothing magical there. It was the systematic debt repayment, combined with steady, non-spectacular appreciation, that did the trick.

I still view home ownership as the big pole in your tent, because it habituates you to the necessary patterns of savings and investment that carry over to the other side pocket funds.

In part III, we’ll kick around some hypothetical results from following this path. I promise this will be an eye-opener.

And in the concluding segment, Part IV, we’ll talk about investing any slack that remains after you have covered the essentials.

It’s high time we idiot-proofed the process of saving and investments.

I just finished reading “Automatic Millionaire” by David Bach, and I would recommend it especially to those you know who lack the discipline to save and invest on their own volition. Which is just about everybody I know…except for you and me, of course.

Bach’s premise is born out of his watchful experience as an investment adviser.

Clients complain there is always too much month at the end of the money, and how can we therefore draw blood from a stone?

Bach’s solution is the one the IRS came up with several decades ago:

Automatic Payroll Deductions

One of the last industrial states to elect payroll deduction for taxes was California. When Reagan was governor, he said that “taxes should hurt”. And hurt they did, when they accumulated without any sinking fund to offset the burden.

There are two core retirement accounts everybody should pursue. A 401k at work, with matching employer funds and a Roth IRA you fund on your own.

If you are on top of your game, and you qualify, there are two more to add to the list. Your Health Savings Account, and a Coverdell Educational IRA for each of your children.

First, Fund Your 401k

The easiest one of the bunch is the 401k, many of which have opted for automatic enrollment, requiring a negative option on the part of the employee.

In plain English, they sign you up at a rate to qualify for the matching funds, unless you instruct your employer otherwise.

It comes right out of your check before you ever see money hit your checking account, just like your payroll and income tax withholdings. And you can never spend what you never received.

The others require a bit more gumption, but are easy enough to set in place. To fund your Roth IRA, HSA, and Education IRA….first see if your HR department at work will divert your payroll funds and siphon off the required amount.

Then, Fund These Discretionary Accounts

1. $5,000 for your Roth ($6,000 if over 50)
2. $2,900 for your HSA ($3,800 if over 55)
3. $2,000 per year, per child for the Educational IRA. Assume two children

Let’s also assume an employee under 50. The total to fund all three accounts would be $11,900 per year. Try to write a check like that without advance funding.

I double dog dare you.

But if you are paid twice a month as most employees are, that works out to just a shade under $500 deducted every pay period.

Of course you’ll miss it, but you’ll soon learn to budget around this constraint.

Don’t Let Logistics Stop You

And what if the HR department can’t be bothered? You set up your own automatic draw down. Have $500 transferred immediately upon each of your direct deposited paychecks into a money market account, then go online to arrange the individual transfers to these accounts.

It’s not as slick as never having the money, but it comes in at a close second.

And now you have two dedicated funds focused on your retirement, plus side pocket investments for your health care and your children’s educational needs.

In tomorrow’s post, we will do some projections based on the expected useful life of these four accounts.

And we will throw in home ownership for good measure.