Tag: Taxes

Is an Employee Stock Purchase Plan (ESPP) Worth the Risk?

September 16, 2020

One question I’ve gotten from readers a few times over the years is whether the participation in a so-called Employee Stock Purchase Plan (ESPP) is worthwhile.

A little bit of background: some corporations offer their employees to buy stocks of their company at a discount of up to 15%. There are some strings attached, though. For example, there are often minimum holding periods, anywhere between a few months and up to two years. The discount is also taxed as ordinary income, though the subsequent capital gains may qualify for treatment as long-term gains.

If you can liquidate the stocks right away and pocket the discount, then participating is likely a no-brainer. Take the money out of the ESPP and invest it in a low-cost index fund. It’s a nice boost to your contributions in your taxable account after you’ve maxed out all your other tax-advantaged options. 15% adjusted by your marginal income tax rate – federal and state. That would still be more than 10% for most people! Pretty sweet!

But what should you do if there’s a minimum holding period? During that time, part of your portfolio is now concentrated in one single corporation. The opposite of diversification. So, it’s a tradeoff: You get the discount but you also take on additional risk. Is it still worthwhile? This is an inherently quantitative question. Without putting hard numbers behind this we can talk about this until the cows come home. The only way to answer this question is through a quantitative exercise. And it turns out, the numbers look like it’s indeed worthwhile to participate in an ESPP, especially if you can get the full 15% discount, the maximum allowed under federal law.

Let’s take a closer look…

Continue reading “Is an Employee Stock Purchase Plan (ESPP) Worth the Risk?” →

The Ultimate Tax Hack: We Are Moving To Monaco! (No we’re not! Happy April Fool’s Day!)

April 1, 2020

Despite the postponement of the deadline this year, April is still tax season for us! Oh, how much I dread this part of the year! And it’s not even the paperwork! If I could do twice the paperwork to cut my taxes in half, I’d gladly do so. So, certainly, for me, the problem is not the filing of my taxes! The discomfort of tax season is 100% due to paying income taxes. Sure, we moved to Washington State to eliminate the state income tax – a big plus compared to California – but that still leaves that pesky federal tax. Last year, we still ended up in the 22% federal tax bracket for ordinary income and 15% for long-term capital gains and qualified dividends. I still don’t the final, final tally yet but it looks like our total federal tax bill will be about $23,000. That hurts! And it hurts more having to pay taxes for the blockbuster year 2019, right around the time the market is melting down this year!

So we developed the ultimate tax hack! Move to a location without any(!!!) income taxes! At all! That location is Monaco, a tiny sovereign nation on the Mediterranean coast surrounded by Southern France. It has no income tax, no capital gains tax and no property tax, how awesome is that?

We did a reconnaissance visit to the Cote d’Azur last year, including Monaco, and we absolutely fell in love with the place! I mean, where else in the world can you watch a Formula One race looking out of your apartment window?

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Yup, that’s the hairpin curve you’ve seen in the Formula One races!

It’s sunny and warm year-round and the food and wine are outstanding.

Let’s look at the numbers in more detail… Continue reading “The Ultimate Tax Hack: We Are Moving To Monaco! (No we’re not! Happy April Fool’s Day!)” →

Asset Location: Do Bonds Really Belong in Retirement Accounts? – SWR Series Part 35

Welcome back to another installment of the Safe Withdrawal Rate Series. This one is about taxes. Amazing, how after 30+ installments in the series, I have written conspicuously little about taxes. Sure, I’ve done some Case Studies where, among many other issues, I delved into the tax planning, most recently in the Case Study for Becky and Stephen. But I’ve never written much about taxes and tax planning in the context of the Series.

There are two reasons why I kept the tax discussion on such a low burner: First, my background: If I had an accounting Ph.D. and CPA instead of an economics Ph.D. and a CFA charter, I would have written a whole lot more about taxes! Second, pinning down the Safe Withdrawal strategy and the safe withdrawal rate is my main concern. Most (early) retirees will have extremely low tax liabilities as I outlined in a post last year. You’d have to try pretty hard to pay more than a 5% federal effective tax rate in retirement. So, as long as you stay away from anything clearly irresponsible on the tax planning side, you’re fine. Don’t stress out over taxes in retirement unless you have a really, really large nest egg and taxable income deep into the six-figures during retirement.

But you don’t want to leave any money on the table either. So, I still want to write about taxes if I encounter something that captures my attention. And I came across a topic that’s most definitely interesting from a withdrawal strategy perspective: Asset Location (as opposed to Asset Allocation).

Imagine you target a particular asset allocation, say 60% stocks and 40% bonds. Or 70/30, or 80/20, or whatever suits your needs the best. How should we allocate that across the different account types? If we put all the different accounts into three major buckets…

  1. Taxable, i.e., your standard taxable brokerage account: Interest, dividends and realized capital gains are taxable every year they show up on your 1099 tax form. But you don’t have to pay taxes on capital gains until you realize them.
  2. Tax-deferred, i.e., your 401(k) or your Traditional IRA. Your account grows tax-free until you actually withdraw the money (or roll it over to a Roth). So, so can realize as much in interest income, dividends, capital gains along the way, as long as you keep the money inside the account.
  3. Tax-free, i.e., your Roth IRA or your HSA. The money grows tax-free and you can withdraw tax-free as well.

… then where do we put our bonds and where do we put our stocks? It would be easy, though likely not optimal to simply keep that same asset allocation in all three types of accounts. But is there a better way to allocate your stock vs. bond allocation?

Sure, there is! One of the oldest pieces of “conventional wisdom” investment advice I can remember is this:

“Keep stocks in a taxable account and bonds in your tax-advantaged accounts.”

Or more generally:

“Keep the relatively tax-efficient investments in a taxable account and relatively tax-inefficient investments in a tax-advantaged account.”

Most stocks would be considered more tax-efficient than bonds because a) dividends and capital gains are taxed at a lower rate than interest income and b) you can defer capital gains until you actually withdraw your money, which is a huge tax-advantage (more on that later).

So, it appears that we should ideally load up the taxable account with stocks and the tax-advantaged accounts with bonds. Hmmm, but that doesn’t sound quite right, does it? Why would I want to “waste” the limited shelf space I have in my tax-advantaged accounts with low-return bonds while I expose my high-return stocks to dividend and capital gains taxes? So, it would be completely rational to be skeptical about this common-sense advice!

So who’s right? Conventional wisdom or the skeptics? Long story short: they’re both wrong! You can easily construct examples where either conventional wisdom or the skeptics prevail. So neither side should claim that their recommendation is universally applicable. The asset location decision depends on…

  1. Your expected rates of return,
  2. Your expected tax rates,
  3. Your investment horizon. Yup, you heard that right, it’s possible that you want to go either one way or the other depending on the horizon. Though, this is not really a separate case but really only a result of asset allocation drift. Accounting for that, we’re back to the two cases, but more on that later!

Let’s look at the details…

Continue reading “Asset Location: Do Bonds Really Belong in Retirement Accounts? – SWR Series Part 35” →

How much can we earn in retirement without paying federal income taxes?

Update 11/22/2019: After I published a shorter version of this piece on MarketWatch and the story was picked up by YahooFinance as well I got a lot more readers! Thanks and welcome to my blog! Make sure you subscribe to be notified of future blog posts! Both on Yahoo and MarketWatch I saw the expected assortment of hate comments. They fall into two categories, see below plus my response:

  • “I’m a CPA and this doesn’t make any sense!” My response: You’re either not a CPA at all or you’re a really bad & incompetent one. The standard deduction and the 0% bracket for capital gains are all very well-known in the financial/tax planner community. The same goes for the taxability worksheet for Social Security.
  • “How unfair that you retired already and don’t pay taxes while I’m working so hard and pay a lot of taxes!” My response: I hear ya! I’ve paid a ton of taxes throughout my work life. A seven-figure sum, more than most people pay over their entire lifetime. Keep that in mind if you complain about the unfairness of the U.S. federal tax system!

* * *

The question “how much can we earn without paying federal income taxes” is relatively easy to answer for most people. The standard deduction for a married couple is $24,400 in 2019 (if both are under 65 years old) and the top of the no-tax bracket for capital gains is $78,750. So, we can make a total of $103,150 per year, provided that our ordinary income stays below the standard deduction and the rest (2nd bracket + any leftover from the std. deduction) comes from long-term capital gains and/or qualified dividends. With our daughter, we also qualify for the child tax credit ($2,000 p.a.), so we could actually generate another $13,333 per year in dividends or capital gains, taxed at a 15% so that the tax liability of $2,000 exactly offsets the tax credit for a zero federal tax bill.

Once people file for Social Security benefits, though, things become a bit more complicated. That’s due to the convoluted formula used to determine how much of your Social Security is counted as taxable income, see last week’s blog post! So, calculating and plotting the tax-free income limits is a tad more complicated. Oh, and talking about tax planning in retirement: as promised, I will also go through an update on the Roth Conversion strategy for the Becky and Stephen case study from two weeks ago.

Let’s get started…

Continue reading “How much can we earn in retirement without paying federal income taxes?” →

Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope

I was always working under the assumption that once we claim Social Security, 85% of our benefits will be counted as ordinary income on our federal tax return. That may also be a good assumption for a lot of retirees, especially if their overall income in retirement – pensions, capital gains, dividends, distributions from retirement accounts, Social Security, etc. – is high enough. Then, indeed, exactly 85% of your benefits will be taxed. This 85% figure is also the absolute maximum you’ll ever have to include in your federal taxable income. So, as a conservative estimate, it’s fine to use this 85% figure for our retirement cash flow and tax planning.

But in practice, the calculation is a lot more complicated. In fact, that share is calculated through a pretty convoluted formula that takes into account not just your Social Security benefits but also other income, even some ostensibly tax-free income like Municipal bond interest. In the chart below, the x-axis is for the annual Social Security benefits for a married couple filing a joint return (0-$80k), and each line corresponds to a level of all the other income (e.g., pensions, annuities, interest, capital gains, dividends, etc.) also going from $0 to $80,000 in $1,000 steps, so there are exactly 81 lines going from blue via yellow to red. When I plotted this function it looks like the folks at the IRS created a piece of art; that portion in the upper left looks almost like a Bifurcation diagram or Mandelbrot fractal!

SocSecTaxes Chart01
The share of Social Security subject to Federal Income taxes (Married filing Jointly). x-axis=Social Security benefits and each line is for a different level of other taxable income (e.g., pensions, annuities, interest, capital gains, dividends, etc.). There are 81 “other income” lines corresponding to income levels from $0 to $80,000 in steps of $1,000.

In any case, for retirement planning, doing a more thorough analysis of our tax on Social Security rather than using the lazy rough estimates has at least four advantages:

  1. The 85% estimate is likely way too conservative so you may over-prepare for retirement and over-accumulate assets. Why not enjoy your money now? Case in point, the Becky and Stephen case study last week; I was way too cautious with the tax assumptions in retirement and underestimated the sustainable, historical fail-safe retirement budget by about $2,500 per year!
  2. The exact calculation of taxes on Social Security benefits has implications on your Roth conversion strategy: There’s no need to be aggressive with your Roth conversions if only a tiny fraction of Social Security is taxable and you have not much other income to fill up your federal Standard Deduction!
  3. But for others, the convoluted formula also has a different, not-so-nice side effect. For some retirees, 401k or Traditional IRA distributions might be taxed at a higher rate than you might think. It’s called the retirement “Tax Torpedo,” more details on that below. So, if you don’t do enough Roth conversions and then later distribute money from a 401k you might face a higher tax burden than expected!
  4. Even some of the ostensibly tax-free income (municipal bond interest or dividends/long-term capital gains in the first two federal tax brackets) may not be so tax-free after all. Because that income is included in the Social Security tax computation, you might face backdoor taxation of seemingly tax-free income. How sneaky!!! It might be optimal to do some tax gain harvesting prior to claiming Social Security!

So, in any case, I will go through some detailed calculations here today, and also link to an easy-to-use Google Sheet I created for you if you want to calculate your own retirement tax estimates. Let’s take a look…

Continue reading “Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope” →

Stuck With a High-Expense-Ratio Fund? Here’s a Google Sheet to Weigh the Pros and Cons of Dumping that “Stinker” in Your Portfolio!

This is a question that’s been on my mind for a while, partially out of curiosity and also because it’s been raised by readers a few times: Suppose you didn’t get the “memo” on passive investing early enough in your life and you now have some high-expense-ratio funds in our portfolio. So, is it too late to switch to a low-cost fund now? Maybe you’re lucky and your funds are actively-managed and they actually beat the broad index reliably. Good for you, but more often than not people are unhappy with the performance of their high-fee funds and like to switch to a low-fee, passively-managed index mutual fund at Fidelity, Schwab or Vanguard. Or move to one of the many index ETFs. Fees will be in the low single-digit basis points, around 0% to 0.015% for some of the Fidelity index funds and around 0.035% for the “Admiral Shares” Vanguard funds. Of course, if this is a fund in a tax-advantaged account where you can just switch between funds without any tax consequences you should just do so if you have that option. But the story gets a lot more complicated in a taxable account! We now have to weigh the pros and cons of switching to a low-cost fund:

Pro: You get rid of that “stinker” mutual fund and replace it with a low-fee, or even zero-fee index fund and eliminate the drag from the high expense ratio. We could be talking about a 0.5% difference in fees and maybe as much as 1.0 or 1.5%. And that’s every year! This can accumulate to a very large pile of cash over time!

Cons: You may have to realize capital gains today. There is a tax inefficiency from having to realize capital gains before you actually need the money in retirement. And this inefficiency takes two forms:

1) for most of you, there’s a good chance that marginal tax rates will be lower in the future, especially in retirement. Your high income right now might put you into a high marginal tax bracket (both Federal and State), while in retirement you might face much lower (or potentially zero) marginal rates. It’s best to defer capital gains until then!

2) even if your future projected tax rate is the same, there’s a potential inefficiency due to realizing capital gains twice; once today when switching to the new fund and once in the future when liquidating that fund in retirement, thus compounding the drag from taxes. It’s best to defer capital gains and pay taxes only once in retirement.

So, depending on how much in built-in capital gains you have right now, how much you can lower your expense ratio and what your current and projected future tax rates are, it may be optimal or suboptimal to dump that high-expense fund. In other words, it is the choice between two evils: The one evil is the drag from the high expense ratio and the other is the drag from tax inefficiency. Which one outweighs the other? Hard to tell, unless you put some numbers in a spreadsheet and do a proper “horse race.” And that’s what we do here today. Let’s take a look…

Continue reading “Stuck With a High-Expense-Ratio Fund? Here’s a Google Sheet to Weigh the Pros and Cons of Dumping that “Stinker” in Your Portfolio!” →

Where are they now? A Case Study Update with “Captain Ron”

From 2017 until early 2018 I ran a series of ten case studies for readers who volunteered to open their books and serve a real-world safe withdrawal rate guineapigs. The second case study in July 2017 was for Captain Ron (not his real name) who was planning to FIRE and enjoy early retirement with his wife on a sailboat! That title picture you see up there, that’s their actual boat! Sounds like a great adventure, not just the financial aspects but also the lifestyle changes are daunting! So, how did that all go? Captain Ron just sent me an update on how life has been, so Ron, please take over the wheel…

***

We retired in September 2017 as planned and are really enjoying life. Financially things are great and we have adjusted to the sailing life, but that first year of cruising was a surprisingly difficult transition. More on that later.

Continue reading “Where are they now? A Case Study Update with “Captain Ron”” →

Good and bad reasons to invest in individual stocks rather than index funds

Hi everybody! I’m back from a two-week blogging hiatus! Things got busy at the office right before I left and we also had to prepare for our road trip and ERN Family World Tour, currently in beautiful New Mexico and moving on to Texas soon! I was amazed at how little work I got done while traveling! Early retirement is a lot more work than I thought!

IMG_0523_small
In Pecos National Historical Park, New Mexico.

In any case, today’s topic has been on my mind for a while: What would be reasons to hold individual stocks? Not all but the majority of folks in the FIRE community apparently favor just plain passive index investing and I have been an index investor myself for the longest time. But occasionally we should definitely question our assumptions. Especially those that sound like the good old “We’ve always done it this way!” And one “excuse” to look into this topic is the ChooseFI podcast featuring Brian Feroldi a few weeks ago. Brian talked about his adventures as a stock picker! I thought it was a great episode, though, of course, I didn’t agree with everything. But it got me thinking about what would be good reasons and what would be not so good reasons for me to abandon my index-only approach. Let’s look at my favorite eight…

(this post may include affiliate links)

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Here’s an idea for a new ETF

Actually, not one ETF, but two! Or more! How can there be a need for a new ETF? Aren’t there enough already? Earlier this year, Motley Fool argued there are too many ETFs (1,929 at that time, probably over 2,000 by now) and they are covering pretty much every thinkable (and unthinkable) benchmark. Soon we might have more ETFs than publicly traded equities in the U.S., how crazy is that??? Why would I propose a new ETF that doesn’t already exist?

Here’s some background. I’m an index investor at heart and I like tax optimization. For so many years now, I’ve held equity index ETFs and Mutual Funds in both taxable accounts and tax-deferred accounts (both retirement and deferred compensation at work). It’s so painful to see the dividend payments in the taxable accounts getting taxed every year. Sure, it’s only about 1.9% dividend yield in the S&P500 right now but for us, that’s taxed at 15% federal, 10+% state (California!) and 3.8% Obamacare tax, for a total of almost 30% marginal tax! Isn’t there a better way? Sure! Simply put the taxable equity allocation into stocks that pay zero (or close to zero) dividends and keep the high-dividend stocks in the tax-deferred account where they can compound in peace and be taxed only once upon withdrawal rather than every year along the way! So, the two ETFs that I wish existed would exactly replicate the S&P500 if held in equal shares. But individually they’d have non-index weights and one would hold the equities with the lowest dividend yield and the other with the high-yield equities!

Notice that most folks already do this tax optimization across asset classes: Hold the tax-inefficient asset classes (bonds, REITs, etc.) in tax-deferred accounts and equities in taxable accounts. So, why not do this within the equity asset class as well for additional tax efficiency? How much extra after-tax return would we get out of this? Let’s look at the numbers…

Continue reading “Here’s an idea for a new ETF” →

A dog, a homework and a reader question about Robo Advisors

There is a first time for everything. A first time in about two years! I didn’t get today’s designated blog post up and running in time! The dog ate my homework! Well not literally but only figuratively. Things are busy at work and last weekend we had to move (again). After a month and half of couch-surfing with friends and relatives and some vacation time in between, we finally moved into a slightly more permanent place, an AirBnB in Oakland. Hopefully, our last place in the Bay Area before I finish my job in mid-June. Right as we settled in at the new place and I wanted to get working on my blog post my laptop gave up its ghost! The new one I wanted was not available at Costco and needs to be shipped. ETA TBA! What to do now? Well, I could just skip this week’s post, right? I figure once we go on our long trip to Europe, Asia, Australia and New Zealand in the second half of 2018 I will likely reduce the blog post frequency to 1-2 per month anyway. Vacations are a lot of work! But as long as we’re here I’ll try to keep up with the weekly posts on Wednesdays.

So, what about today’s post? Simply repurpose something I had already done! I receive a lot of emails with personal finance questions from readers. I can’t answer them all because I don’t have an army of Macedonian content writers working for me! But a few weeks ago I got an interesting question via email that I couldn’t help but answer! It’s about Robo advisors! And why two Robo advisors are worse than one! That’s something I have to share on the blog as well! Let’s take a look…

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