The stock market drops 50 percent and comes up 50 percent, so you are back where you started, right? Not so right. After a moment of thinking about it, you probably realized the real math does not add up that way, but consumers see it that way in their “mental accounting,” a phenomenon that affects how people spend, save and invest their money.
The faulty stock market perception can be illustrated with the following equations.

If you were to ask people what the average of 3 and 5 is, they typically respond as follows: (3 + 5 = 8)/2=4. The average is 4.

If you were then to ask them for the average of a negative 50 and a positive 50 they would do the equation the same way. So the typical investors assume that if they are getting positive returns and negative returns that they are still doing fine.

So what if you were then to ask them, “What is the impact of losing 50 percent one year and gaining 50 percent the following year? Back to your starting amount, right?” Actually, that would work out like this:
• $10,000 down 50 percent is $5,000
• Then up 50 percent is $7,500
• This is a 25 percent loss (13 percent annualized) after “offsetting” years.
Let’s look at an example in which the gaining percentage is greater than the losing one. A return of +66 percent followed by -50 percent would seem to add up to an 8 percent return. But actually:
• $10,000 up 66 percent is $16,600
• Then down 50 percent is $8,300
• +66 percent followed by -50 percent produces a negative 9 percent annualized return.
But look at the compounding gain of two 8 percent years:
$10,000 x 1.08 = $10,800 x 1.08 = $11,664

So, many people wrongly think that if they are getting a greater return than a loss, then they are doing well. But obviously that’s not true. Another misperception is just how deep a hole is created by losses. A 100 percent return would be necessary to offset a 50 percent loss. But a 300 percent return is required to offset a 66 percent loss. And then 400 percent for a 75 percent loss.

So, the next time you’re thinking about taking a risk, make sure you are doing an accurate mental accounting.

If you are looking forward to retirement and tax-free Social Security income, you might be surprised when the IRS comes around for a bite. Yes, way back when Social Security was a young program, President Franklin D. Roosevelt promised no income taxes would be exacted, but that promise ran out in the 1980s for some people whose income exceeds certain levels.

Now the federal government considers the retirement entitlement as taxable income when your other income plus half of your Social Security exceed an amount based on your filing status ($32,000 if you filed jointly, $25,000 for single filers). First, only 50 percent of your benefit above a certain threshold is taxable. When you exceed the first threshold, up to a maximum of 85 percent of your benefit can be taxed.

You can continue to work and still receive retirement benefits. Your earnings in (or after) the month you reach your full retirement age will not reduce your Social Security benefits. But your benefits will be reduced if your earnings exceed certain limits for the months before you reach your full retirement age.

If you work for someone else, only your wages count toward Social Security’s earnings limits. If you are self-employed, the federal government counts only your net earnings from self-employment.
Income from other sources is not counted, such as other government benefits, investment earnings, interest, pensions, annuities and capital gains.

If you work for wages, income counts when it is earned, not when it is paid. If you have income that you earned in one year but the payment was made in the following year, it should not be counted as earnings for the year in which you received it. Some examples are accumulated sick or vacation pay and bonuses.

If you are self-employed, income counts when you receive it—not when you earn it—unless it is paid in a year after you become entitled to Social Security and earned before you became entitled.

Health care reform is beginning to take effect, but little attention has been paid to the effect on prescription drugs. The law spells out new benefits and regulations affecting the whole pharmacy arena. Prescription drug changes will be phased in between now and 2020, many starting within the next 12 months.
Some of the more significant changes, such as in Medicaid and Medicare, may shift costs to patients, employers and health plans. Many of the significant changes in the prescription drug field will be starting in this year:
• Medicare Part D coverage gap rebate checks go out. One of the first steps to gradually eliminating the coverage gap, or the doughnut hole, in Medicare Part D benefits will be to give Medicare patients whose drug costs reach the coverage gap in 2010 a one-time $250 rebate check from the Centers for Medicare & Medicaid Services (CMS).
• Retiree drug tax exemption will be eliminated. The tax exemption to employers that receive the Retiree Drug Subsidy for providing prescription drug coverage for retirees eligible for Medicare has been eliminated. The actual change does not occur until 2013, but many companies are accounting for the liability now. Many large companies have already indicated they anticipate taking an earnings hit as a result of this change. As a result, companies may consider other ways of providing benefits or could even cut benefits to lessen the impact.
• Lifetime limits will be disallowed. By the end of September, health plans will not be allowed to put lifetime limits on the dollar amount of coverage provided to their members. This provision extends to prescription drug benefits.
• Federal upper limit changes begin. The federal upper limit on pharmacy reimbursement for multiple-source drugs has changed from 250 percent of the average manufacturer price (AMP) for the least-expensive therapeutically equivalent drug to 175 percent of the weighted average, as determined by the most recently reported monthly AMPs of multiple-source drugs available at pharmacies.
• The Early Retiree Reinsurance Program starts. This $5 billion fund helps employers defray the cost of their retiree health insurance. This temporary reinsurance program will reimburse 80 percent of claims between $15,000 and $90,000 for employer-sponsored retiree coverage of individuals 55-64 years old who are not active workers or eligible for Medicare. For employers to take full advantage of the program, they will have to merge their pharmacy and medical claims data, which is typically handled by two different vendors.

The legal and tax information contained in these articles is merely a summary of our understanding and interpretation of some current provisions of tax law and is not exhaustive. Consult your legal or tax advisor for advice concerning your particular circumstances.