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Issue Twenty Eight | Winter 2013

News from 1st Portfolio Wealth advisors

owners, executives and families preserve and grow their wealth. Our firm draws on the financial acumen and entrepreneurial expertise of its advisors to provide comprehensive wealth management and business retirement plan services in a conflict‑free environment. Guided by our holistic, goals‑based planning process, 1st Portfolio Wealth Connect™, our clients achieve peace of mind and financial independence. 1st Portfolio’s proven investment approach combines long‑term growth strategies with timely asset allocation adjustments designed to enhance returns and provide downside protection in volatile markets.

The Year in Review: “Groundhog Day”

In This Issue:

> Year in Review: Groundhog Day > Our 2013 Forecast and Beyond > Finding Income in a 0% World

1st Portfolio’s wealth solutions are custom-built to address the unique needs of affluent individuals and families. Our investment approach and proprietary tools help our clients preserve and grow their wealth.

> The Tax Man Cometh

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> 10th Annual

Our proprietary six-step goals-based planning and implementation process keeps you informed, organized and confident about progressing toward your financial goals.

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We act as fiduciaries on behalf of our clients. Our clients, in turn, enjoy a feeling of openness and trust knowing our solutions are completely aligned with their interests.

W. Kirk Taylor, CFP®

As I look back on the events of 2012, it occurs to me that

2012 played out much like a scene from the movie Groundhog Day, where a news reporter played by Bill Murray finds himself repeating the exact same events of a specific day… over, and over, and over.

In a sense, the market-moving events of 2012 were the same events that repeated themselves in 2011, 2010 and 2009. The list includes: European sovereign default concerns; a break-up of the Euro; a dysfunctional U.S. Government; debt ceiling showdowns; the loss of our AAA credit rating; a Presidential election, and most recently, the Fiscal Cliff. The astonishing part of this repetitive cycle is that the markets somehow managed to pull

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growth, falling unemployment, continued improvement in housing and an accommodative Fed — strong economic forces that bode well for 2013.

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themselves up by their boot straps and post a gain at day’s end. They say “Bull markets climb a wall of worry”, and this bull market has been no exception.

Vienna, VA 22182 (703) 821-5554 firstportfolioinc.com

Although the November election and fiscal cliff concerns weighed on holiday sales, consumer confidence moved high-

er throughout the year, unemployment moved correspondingly lower and the nascent housing recovery gained steam — a good sign for an economy that likely grew a modest 2% or so in 2012. In the year ahead, we see steady, albeit modest economic growth, falling unemployment, continued improvement in housing and an accommodative Fed — strong economic forces that bode well for 2013. Coming soon to news headlines near you is “Fiscal Cliff Part II – The Debt Ceiling Showdown”. In true Groundhog Day fashion, look for another repeat; i.e. scary headlines followed by an 11th hour deal, followed by rising stock prices. We won’t get the “grand bargain” we need but another layer of uncertainty will be peeled back, edging us closer to the day when corporate America begins to invest its $1 trillion stash of cash. This milestone should slingshot the economy out of its subpar range, taking stock prices along with it. In our accompanying article, “Our 2013 Forecast & Beyond”, we discuss how we see 2013 shaping up for investors. n

Bearing the Bull | Winter 2013 1


Why Diversification Matters

Our 2013 Forecast and Beyond

Traditional asset allocation strategies are built on the notion that when one assets class falls in value, a complimentary asset class rises in value. For example, when stocks fall, bonds tend to rise, offsetting losses in stocks and reducing volatility, while generating smoother portfolio returns over time. Most investors know that asset class returns are random, making it difficult to consistently predict next year’s winner. Allocating

capital across multiple asset classes eliminates the guesswork, providing participation in all markets. The Asset Allocation portfolio depicted below is diversified across ten asset classes and rebalanced annually. While it’s never the best, neither is it the worst performer during any given year. Note that the diversified portfolio outperformed the S&P 500, with less volatility, especially in 2008.

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

4Q12

MSCI EME 56.3% Russell 2000 47.3% MSCI EAFE 39.2% REITs

REITs

MSCI EME 34.5% DJ UBS Cmdty 21.4% MSCI EAFE 14.0% REITs

REITs

Barclays Agg 5.2% Cash

MSCI EME 79.0% MSCI EAFE 32.5% REITs

REITs

REITs

REITs

35.1% MSCI EME 32.6% MSCI EAFE 26.9% Russell 2000 18.4%

MSCI EME 39.8% DJ UBS Cmdty 16.2% MSCI EAFE 11.6% Market Neutral 9.3%

27.9% Russell 2000 26.9% MSCI EME 19.2% DJ UBS Cmdty 16.8%

8.3% Barclays Agg 7.8% Market Neutral 4.5% S&P 500 2.1%

19.7% MSCI EME 18.6% MSCI EAFE 17.9% Russell 2000 16.3%

MSCI EAFE 6.6% MSCI EME 5.6% REITs

S&P 500 15.8% Asset Alloc. 15.2% Market Neutral 11.2% Cash

Asset Alloc. 7.4% Barclays Agg 7.0% S&P 500 5.5% Cash

Russell 2000 -33.8% DJ UBS Cmdty -35.6% S&P 500 -37.0% REITs

Cash

S&P 500 16.0% Asset Alloc. 11.2% Barclays Agg 4.2% Cash

4.8% Barclays Agg 4.3% DJ UBS Cmdty 2.1%

4.8% Russell 2000 -1.6% REITs

-37.7% MSCI EAFE -43.1% MSCI EME -53.2%

S&P 500 15.1% Asset Alloc. 12.5% MSCI EAFE 8.2% Barclays Agg 6.5% Cash

37.1%

31.6% MSCI EME 26.0% MSCI EAFE 20.7% Russell 2000 18.3%

S&P 500 28.7% Asset Alloc. 25.1% DJ UBS Cmdty 23.9% Market Neutral 7.1% Barclays Agg 4.1% Cash

Asset Alloc. 12.5% S&P 500 10.9% DJ UBS Cmdty 9.1% Market Neutral 6.5% Barclays Agg 4.3% Cash

1.0%

1.2%

12.2% Asset Alloc. 8.3% Market Neutral 6.1% S&P 500 4.9% Russell 2000 4.6% Cash 3.0% Barclays Agg 2.4%

-15.7%

1.8% Market Neutral 1.1% Asset Alloc. -24.0%

28.0% Russell 2000 27.2% S&P 500 26.5% Asset Alloc. 22.2% DJ UBS Cmdty 18.9% Barclays Agg 5.9% Market Neutral 4.1% Cash 0.1%

0.1% Market Neutral -0.8%

Emerging Markets

Large Cap U.S. Stocks

Real Estate

U.S. Bonds

Small Cap U.S. Stocks

Market Neutral Hedge Funds

Developed International Stocks

Commodities

Asset Allocation Portfolio

Cash

0.1% Asset Alloc. -0.6% Russell 2000 -4.2% MSCI EAFE -11.7% DJ UBS Cmdty -13.3% MSCI EME -18.2%

0.1% Market Neutral 0.0% DJ UBS Cmdty -1.1%

3.1% Russell 2000 1.9% Asset Alloc. 1.3% Barclays Agg 0.2% Cash 0.0% Market Neutral 0.0% S&P 500 -0.4% DJ UBS Cmdty -6.3%

10-yrs ’03 - ’12 Ann. Cum. MSCI EME 376.0% REITs

MSCI EME 16.9% REITs

204.6% Russell 2000 152.8% MSCI EAFE 130.3%

11.8% Russell 2000 9.7% MSCI EAFE 8.7%

Asset Alloc. 117.7% S&P 500 98.6% Barclays Agg 65.8% Market Neutral 60.2% DJ UBS Cmdty 49.3% Cash

Asset Alloc. 8.1% S&P 500 7.1% Barclays Agg 5.2% Market Neutral 4.8% DJ UBS Cmdty 4.1% Cash

18.2%

1.7%

The “Asset Allocation” portfolio assumes the following weights: 25% in the S&P 500, 10% in the Russell 2000, 15% in the MSCI EAFE, 5% in the MSCI EMI, 25% in the Barclays Capital Aggregate, 5% in the Barclays 1-3m Treasury, 5% in the CS/Tremony Equity Market Neutral Index, 5% in the DJ UBS Commodity Index, and 5% in the NAREIT Equity REIT Index.

Source: J.P. Morgan Asset Management, Russell, MSCI, Dow Jones, Standard & Poor’s, Credit Suisse, Barclays Capital, NAREIT, FactSet. 2

Michael J. Rebibo, CFP®

Bearing the Bull | Winter 2013

As I write this article, I am traveling with my son Jacques for a Colorado snowboarding trip. Our flight out of Washington, DC was delayed 12 hours, affording me plenty of time to read and write. I decided to pick up some of the financial magazines and see what the “experts” had to say about 2013. I grabbed The Economist, Barron’s, Bloomberg Markets, Kiplinger’s and For‑ tune magazines, and even the more pedestrian Money Magazine. All except one had basically the same title which was something along the lines of “What’s in Store for 2013”. The lone exception was The Economist which chose “A Rough Guide to Hell” as its title. Each magazine carried both gloomy and optimistic articles on the economy in 2013. In this way, they cover all bases and can point to being right at the end of the year. The usual Bulls, like Larry Fink, Chairman of BlackRock Inc., which manages hundreds of billions, were even more bullish than usual stating that the “system was in relatively good shape and a large supply of natural gas in the U.S. will create jobs”. At a recent BlackRock iShares conference, Fink said safely that, “In the long run, I am very bullish on the United States”. I think any U.S. money manager or U.S. financial company CEO could safely make that claim! Everyone was very bearish on bonds. Most were predicting a maximum return equal to the underlying yield (interest) on bonds for 2013. This is the same as saying interest rates will be unchanged in 2013, with investors earning only their coupon payment and no capital appreciation on their bonds — another very safe prediction. Some bond fund managers were even bearish on their own funds. Jeffery Gundlach, CEO of $50 bil-

lion dollar bond fund Doubleline Capital LP was extremely bearish. He references the 27-year build up of corporate, personal and sovereign debt, which will ultimately lead to a crisis in which these countries will default sometime after 2013. Gundlach is predicting runaway inflation while others in the same magazine were predicting deflation. He recommended putting everything in “hard assets” like gold, gems, art, natural gas and agriculture. Runaway inflation would be disastrous for bonds as runaway inflation would result in a sharp rise in bond yields and a corresponding drop in bond prices. If his predictions come true, his fund would likely suffer losses. The general consensus among fund managers is that the bull market for bonds is over and bond yields will increase, causing what many believe to be a bubble in bonds to burst. Despite the risks commonly accepted by most, 2012 marked another year of record inflows into bond funds. Data of fund flows continue to suggest retail investors are fleeing the stock market for the safety and yield provided by most fixed income investments.

2012 marked another year of record inflows into bond funds. Data of fund flows continue to suggest retail investors are fleeing the stock market for the safety and yield provided by most fixed income investments. Before we unveil our forecasts for 2013, let’s review what we said a year ago about 2012. We listed ten reasons to be bullish, which included the impact of fiscal and monetary stimulus, expected gains in unemployment, rising consumer confidence and a generally undervalued stock market trading at 13 times earnings. Additionally, we cited important technical indicators such as the January Barometer and the Presidential Election Cycle as providing important tailwinds to equity markets. When we summed it all up, we concluded that “If we apply a below-average price-to-earnings (P/E) multiple of 13 to the $110 in earnings, we arrive at a possible S&P level of 1430. If uncertainty dissipates and P/E multiples expand upward to the average of 15, then 1650 is not out of the question”. It turns out that we were both right and wrong; we were wrong in that earnings are expected to increase 5%-6% (not 13%) in 2012, but we were right in that P/E multiples would expand as continued on page 4 uncertainty dissipated during the year.

Bearing the Bull | Winter 2013 3


Our 2013 Forecast

Reasons for Optimism Low Interest Rates

interest rates to remain low this year, we’d be remiss if we didn’t

Beyond 2013

reiterate that it’s only a matter of time before inflation expec-

The Federal Reserve is keeping rates at zero allowing corporations and individuals to borrow for next to nothing. Cheap financing increases corporate profits as well as disposable income for consumers. The age old adage “Don’t fight the Fed” explains the connection between easy Fed monetary policy and bull markets, proving why investors who ignore this tenet have typically left valuable gains on the table.

tations creep into the bond market. In fact, we see the Barclays

As with weather forecasts, short-term market predictions (one year or less) are easy to make but hard to accurately pull off with any consistency. As long-term investors, we place more importance on our 3- to 5-year forecast and prevalent investment themes. Here is our longer-term outlook:

When we boil it all down, the economy will likely muddle through in the first half of the year, with a modest pickup in growth during the second half of the year.

Low Cost Energy So what do we expect to happen in 2013? As with each of the last four years, there are plenty of headwinds to keep investors out of the market. Chief among them, until recently, was the Fiscal Cliff, which with the 11th hour passage of the American Taxpayer Relief Act (ATRA), morphed into one or more mini fiscal cliffs. Please see our article on page 7, “The Tax Man Cometh”, for more on the implications of ATRA on taxpayers. While the next Congressional stand-off over the debt ceiling and the two-month postponement of sequestration shouldn’t have a significant long-term impact on the economy, fears of such will increase market volatility over the near-term. Europe still remains mired in debt and China is experiencing a Chinese-style recession; i.e., slower growth by their standards but faster growth than here at home. These fears are essentially priced into international markets, making them undervalued by historical standards and by comparison to U.S. stocks. Looking beyond Congress’ version of the street game “Kickthe–Can”, and assuming that China and Europe avoid a deep economic contraction, we see only two other risks to the current state of affairs: rising inflationary pressures and falling corporate profits. The potential impact of excessive monetary easing is widely debated but not likely priced into either the stock or bond market. There is a thin line, however, between “good” demand-driven inflation and hyper-inflation. Notably, the latter would give both stock and bond investor’s indigestion. Additionally, corporate profit margins, which are sitting at the highest level in four decades, have flat-lined recently leaving profits susceptible to even a modest decline in revenues, and an increase in input costs such as commodity prices or wages. None of these risks are currently front and center, but they bear watching nonetheless. 4

In 2008, oil prices peaked $150 per barrel as Peak Oil theories once again came in vogue. Over the past three years, oil prices have traded in a fairly reasonable band of $80 -$100 per barrel, with an occasional, but brief, trip to $110 per barrel. Today, we are on the verge of energy independence and according to the Energy Independence Administration, U.S. oil imports will hit a 25-year low by 2014. Never underestimate the power of U.S. free market enterprise.

Aggregate bond index generating a return of -1% to +1%. We

■■

■■

■■

expect stocks will outperform bonds again this year by a reasonably wide margin, with the S&P 500 gaining between 7% -10%, and closing between 1500-1575. We see bigger opportunities in emerging markets especially in China, India and Brazil.

■■

We expect domestic bonds, measured by the Barclays Aggregate Bond Market Index, to average between -1% to 3% annually. We expect domestic stocks, measured by the S&P 500, to average 6% to 8% annually. We expect developed international, measured by the MSCI EAFA, to average 4% to 6% annually. We expect emerging markets, measured by the MSCI EM, to be volatile but average 9% to 12% annually.

Best wishes to all for a prosperous New Year! n

Finding Income in a 0% World

Residential Real Estate We consider the continued rebound in real estate as one of the more important fundamental forces in 2013. According to the Case-Shiller 20-city index, prices are up nearly 5% from a year ago. Rising real estate values carries important implications for the economy. First, it means that the renters sitting on their hands will be motivated to consider buying over renting — the possibility of home appreciation motivates renters to become buyers. Rising demand for housing ultimately creates jobs, bringing unemployment down further.

Michael P. Duprey

Rising home prices also improve the balance sheets of banks, pension funds and the like holding presently underwater mortgage securities, in turn freeing up more capital to lend. Rising home prices create newfound equity for today’s underwater homeowners, creating a new pool of families that heretofore were unable to refinance at lower rates. Finally, rising home prices make consumers feel wealthier and more confident, leading to increased consumer spending, which in turn creates what is known as the “wealth effect”.

With each new year, more and more baby boomers retire and transition to the next stage of life, a.k.a. the “golden years”. Some may work part time, some will volunteer, and others will travel or take up that hobby they never found time for while working. The one constant amongst retirees though is that retirement marks the point in time when they transition from being wealth accumulators to wealth distributors.

When we boil it all down, the economy will likely muddle through in the first half of the year, with a modest pickup in growth during the second half of the year. We see inflation remaining subdued throughout 2013. And although we expect Bearing the Bull | Winter 2013

Now that we’re at the tail end of a 30-plus year bull market in bonds (and an all time low in yields), generating income is harder and certainly more dangerous than ever. Shrinking yields are forcing fixed income investors to “reach” for yield and take risks that may prove to be very costly when the Fed finally takes its foot off of the accelerator.

Back in the good ol’ days, when interest rates were much higher, the transition from accumulation to distribution was much easier; after all, CDs paid 10%-12%. If you had accumulated enough wealth, you could simply park all of your cash in CDs and other conservative fixed income investments and not think twice about the stock market.

To illustrate, the iShares IBOXX Investment Grade Corporate Bond exchange traded fund (symbol: LQD) currently yields 4%. This is an attractive yield when compared to the 10-year treasury yielding slightly less than 2% and money market accounts yielding zero. However, the duration for LQD, which measures interest sensitivity, is 7.96. The duration measure of 7.96 indicates that a 1% (100 bps) rise in interest rates will result in a 7.96% drop in price. When — and not “if” — that occurs, the LQD owner will lose two years of interest in the blink of an eye. There’s no getting around the risk of rising rates completely, but there are ways to mitigate the risk and find opportunities even in today’s 0% world. Our fixed income portfolios include a wide range of fixed income investments, which we continued on page 6 discuss below.

Bearing the Bull | Winter 2013 5


Fixed Income Opportunities Investment Grade Corporate Bonds Investment grade corporate bonds are a bit pricey at current levels but they are considerably more attractive than U.S. treasuries, which are extremely sensitive to rising interest rates. Generally speaking, investment grade corporate bonds and treasury securities are our least favorite fixed income investments, although there is room for them in broadly diversified portfolios.

High Yield Bonds High yield bonds are among our favorite fixed income segment as they have historically generated “equity-like” returns but with less risk than common stock, and because they tend to perform well in a rising interest rate environment due to their high coupon. After years of double digit returns there is risk in this segment, especially if the economy contracts, but we expect to see strong relative returns from high yield over the next year or more. “Buyer Beware” though; this risky asset class fell more than 20% in 2008.

Emerging Markets Bonds Many emerging market countries are relatively debt-free and experiencing strong economic growth. With yields of 6% or more, they are among our favorites. Although emerging markets are more stable than they used to be, like high yield bonds, there’s plenty of default risk and currency exchange risk in emerging market bonds.

Municipals Bonds Municipal bonds have been another strong performer and under the recently passed American Taxpayer Relief Act (ATRA), they became increasingly more attractive for those finding themselves in the new 39.6% tax bracket. We tend to favor general obligation bonds over revenue bonds as they will hold up better if the economy contracts.

Income & Growth Opportunities Many fixed income investors, fearful of the impact inflation can have on their “real” (after inflation) return have logically gravitated toward securities that offer income and growth. Our equity portfolios include a wide range of dividend paying investments, which we discuss below. 6

Dividend Stocks Since 1926, the S&P 500 has generated a total return of nearly 10% per annum, with dividends accounting for 40% of the return. Companies with sound balance sheets, strong cash flow and a history of consistent profitability make particularly attractive investments during prolonged periods of inflation, as they have the ability to pass along rising prices to their customers and still turn a profit. Dividend increases that exceed the rate of inflation are not uncommon for this group.

The Tax Man Cometh W. Kirk Taylor, CFP®

Preferred Stock Preferred stock sits above common stock in the corporate capital structure. They pay higher yields than common stock and are generally a safer bet, in the event of bankruptcy. Due to a unique combination of yield, safety and appreciation, preferred stocks are thought of as a hybrid security — part bond, part stock.

Real Estate Investment Trusts (REITs) REITs have been one of the best investments of the last decade returning nearly 12% per annum. Due to their tax structure, REITs pay out-sized dividend payouts, while offering the potential for capital appreciation. Because real estate is a hard asset class, it tends to perform well during inflationary times.

Master Limited Partnerships (MLPs) Master Limited Partnerships, which tend to be concentrated in the Energy sector, offer yields of 5% to 7%, and in select cases as high as 10%. They outperformed the S&P 500 12 out of the last 13 years; and after last year’s correction, they are particularly attractive at current levels. Given our growing domestic production, this sector has a bright future. Like dividend paying companies, MLP distributions typically grow over time, with MLP distributions expected to grow 7% this year. Tax Note: MLPs have complex tax structures; investors are partners and will receive a K-1. They are generally most appropriate for taxable accounts and should be avoided in tax-deferred accounts.

Strike the Right Balance In today’s low interest rate environment, income-oriented investors must be more diligent than ever, as reaching for higher yielding opportunities without fully understanding their risks can be costly. An intelligent balance of the investments discussed above should provide income oriented investors with income and growth, as needed. n Bearing the Bull | Winter 2013

As 2012 came to a close, Congress came up with an 11th hour — make that a 13th hour — deal, to avoid going over the socalled fiscal cliff. On January 1, 2013, after we had technically gone over the cliff, Congress passed H.R. 8, a.k.a. the American Taxpayer Relief Act. The Act has something for everyone but the milestone piece of the legislation is that the majority of the Bush era tax breaks, which were due to sunset at the end of 2012, were permanently preserved; something I view as constructive for the economy. For high-income earners though, that old military recruiting slogan “Uncle Sam Wants You!” has becomes the Treasury’s new battle cry, “Uncle Sam Wants Your Money!”

jointly with a taxable income of $450,000. The Social Security payroll tax reverts back to 6.2% from 4.2% for all filers and unemployment benefits for the long-term unemployed are extended one more year. Although this is a third-rail topic (there are pros and cons to extending these benefits), I believe extending unemployment benefits further removes some of the incentive to seek employment. Lastly, long-term capital gains rates and qualified dividend rates remain the same except for the highest income earners. For the aforementioned “almost wealthy”, the longstanding personal exemption is phased out for individuals earning over $250,000 and for married couples earning over $300,000. The real ‘gotcha’, though, is the “Pease” limitation (named after the former Democrat Representative Donald Pease from Ohio) on itemized deductions such as charitable donations and mortgage interest. It’s estimated that up to 80% of the deductions for individuals earning over $250,000 and married couples earning over $300,000 will be eliminated. While the calculation is complex, tax experts say the Pease limitation effectively adds one percentage point to the top tax rate. The Tax Policy Center, a non-partisan group in Washington, has an online calculator that may help you estimate the impact of the Act on your personal tax return. As always, you should consult with a qualified tax advisor or CPA for individualized advice. n

Who’s Paying More in 2013? Setting aside the debate over whether or not tax increases on the wealthiest Americans (the top 1%) is money well-spent or instead may push our slowly growing economy toward recession, there is some good, some bad and some surprise increases for those we might call the “almost wealthy”. After permanently preserving the Bush era cuts, next atop the list of good in the Act is that millions of Americans will avoid being caught in the Alternative Minimum Tax (AMT) trap, as a permanent inflation index was created for the tax. Finally, the estate and gift tax exclusion remains at $5 million with the top tax rate moving from 35% to 40%. The portability election was also made permanent allowing surviving spouses to use a deceased spouse’s unused exemption amount. The bad, if you will, is that the Act brought back the Clinton era top marginal tax rate of 39.6% for wealthy individuals with a taxable income of $400,000 and married couples filing

2012

2013

$388, 350 (joint and single filers)

$450,000 (joint) $400,000 (single)

35% Income threshold:

Top rate on income1

Top rate on long‑term capital gains and dividends1

Net investment income tax2

15% $70,700 (joint)

$35,350 (single) None

Personal exemption phaseout and Pease limit on itemized deductions2 Social Security tax, employee share

None

Medicare tax surcharge

None

4.2% Earnings up to $110,100

39.6% Income threshold: 20% $450,000 (joint)

$400,000 (single)

3.8% $250,000 (joint)

$200,000 (single) $300,000 (joint) $250,000 (single)

6.2% Earnings up to $113,700 0.9% Earnings above $250,000 (joint) $200,000 (single)

35% $5.12 million

Top rate on estates

40% At least $5.12 million

(indexed for inflation)

Taxable income Adjusted gross income Sources: The Wall Street Journal; Tax Policy Center; Senate summary of tax bill

1

2

Bearing the Bull | Winter 2013 7


Bearing the Bull