Harry Sit's Blog, page 18

Roth Conversion with Social Security and Medicare IRMAA

I showed how to estimate the effect of Roth conversion and capital gains when you get health insurance from the ACA marketplace in the previous post Roth Conversion and Capital Gains On ACA Health Insurance. Some readers expressed interest in seeing the same for retirees on Social Security and Medicare.

Table of ContentsRoth Conversion for RetireesCase Study SpreadsheetDownload the SpreadsheetScenario – Married Filing JointlyAge and Filing StatusIncome and MedicareBaseline TaxesExplore Roth ConversionAdjust the Chart ScaleSet the Starting PointExtend the RangeSave the SpreadsheetScenario – SingleLimitationsRoth Conversion for Retirees

When you do a Roth conversion, you transfer an amount of money from your pre-tax account to your Roth account. This makes you pay taxes on the transferred amount now in the hope of avoiding paying taxes at a higher rate in the future. It’s a form of prepayment.

As in other situations of prepayments, sometimes it makes sense to prepay, and sometimes it doesn’t make sense to prepay. You convert to Roth and prepay taxes now when you think your tax rates in the future will be higher than your tax rates now.

You need to know what tax rate you pay on your Roth conversion in order to judge whether it makes sense to convert. The tax rate you pay on your Roth conversion depends on how much you convert. Conversely, if you set a limit on the tax rate you’re willing to pay on a Roth conversion, you need to know how much you can convert before you hit that maximum tax rate.

Case Study Spreadsheet

My favorite tool for this type of planning calculation is the Case Study Spreadsheet created by user MDM on the Mr. Money Mustache forum. Using downloaded tax software also works, but tax software for the current year usually doesn’t come out until November or December and it’s often incomplete pending updates at that stage. The Case Study Spreadsheet is updated much sooner.

It’s an actual spreadsheet file, not an online one. You will need Microsoft Excel or compatible software to open it. As with anything downloaded from the internet, you will have to trust the source. I had some interaction with the author over email. I trust this spreadsheet.

The spreadsheet does a lot of things. It looks overwhelming if you are only looking for one feature out of many. I will show you how this spreadsheet calculates the effect of Roth conversion when you are on Social Security and Medicare. I used version 22.06a released on November 26, 2022.

Download the Spreadsheet

The link to the most recent version of the spreadsheet is in the first post in the Case Study Spreadsheet updates thread in the Mr. Money Mustache forum. Click on the link and choose File -> Download to save the file to your computer. Make a copy of the spreadsheet and only work with the copy. This way you can always start fresh from another copy of the original spreadsheet to model different inputs.

If your computer uses Windows, right-click on the copy in the file folder and click on Properties. Check the Unblock box to enable macros in the spreadsheet.

Open the copy in Microsoft Excel or a compatible program. Click on Enable Editing in the yellow ribbon you see in Excel.

Scenario – Married Filing Jointly

I’ll use this scenario of a married couple as the first example.

A retired couple, both age 66, Florida residents, married filing jointly with no dependents. They live on $60,000 of Social Security benefits, $20,000 of Traditional IRA withdrawals, $5,000 of interest income, and $10,000 of qualified dividends. They have no other income or deductions. Both of them enrolled in Medicare Part B and Part D.

They’d like to know how it affects their taxes if they convert different amounts from their Traditional IRA to Roth.

Age and Filing Status

Click on the Calculations tab at the bottom of the spreadsheet. First, you enter your filing status, your number of dependents, and ages in green-shaded cells starting at cell G2.

You go down to cell H37 to enter your state of residency.

Income and Medicare

Next, you enter your income. Because the couple in our scenario are both retired, we skip the paycheck items and go down to the non-paycheck income starting at cell D23. You only input into cells shaded in green. Use annual numbers here.

Because they’re both on Medicare, we enter their Medicare Part D premium in cell AF78. This is the monthly premium for one person. If they’re on different Part D plans, use the average premium of the two plans. Here we assume their monthly Part D premium is $40 per person.

Baseline Taxes

Now we go back to the tax calculation area starting at cell F11. This shows their baseline income taxes.

This retired couple with a gross income of $95,000 pays $2,015 in taxes. That’s only a little over 2% of their gross income.

Explore Roth Conversion

This couple is interested in doing Roth conversion to take advantage of their low tax rates. Scroll down to cell F81 to see a chart like this:

It shows the marginal and cumulative tax rates at different amounts of withdrawals from their Traditional IRA. The number on the X-axis includes the $20,000 they’re already withdrawing from their Traditional IRAs for living expenses.

We make a few tweaks to see the chart better.

Adjust the Chart Scale

By default, the Y-axis in the chart goes between -50% and +50%. The bottom half of the chart is empty right now. Select the Y-axis in the chart, right-click, and click on Format Axis… Set the minimum to 0 and the maximum to 0.6. It will use the full space for the chart.

Set the Starting Point

Because this couple already withdraws $20,000 from their Traditional IRAs for living expenses, we can set the starting point at $20,000 to evaluate only withdrawals above and beyond $20,000 for a Roth conversion. Enter 20,000 in cell P84. Now the chart looks like this:

It shows that converting about $25,000 (to take the total withdrawal from Traditional IRAs to $45,000) will incur a marginal tax rate of about 22%. Then the marginal tax rate spikes up to 50% before it settles down to 22% again when the total withdrawals hit about $55,000.

The spike is the so-called tax torpedo, which happens when additional income makes more of the Social Security benefits taxable (see previous post Calculator: How Much of My Social Security Benefits Is Taxable?). Although the 50% marginal tax rate looks scary, it applies to only a sliver of their income. As they increase their Roth conversion to $90,000, the effect of the “tax torpedo” gets spread out. It only causes a slight increase in their cumulative tax rate (the blue line) — from 22% to 23%. The “tax torpedo” is more like a small ding than a torpedo for this couple.

Extend the Range

Increasing the number in cell P83 will extend the X-axis in the chart to larger numbers. For example, changing cell P83 to $700 makes the chart look like this:

The next four spikes in the marginal tax rate (the gray line) represent Medicare IRMAA. Point your mouse at points before the blue line jumps up. You’ll see the total Traditional IRA withdrawals and the cumulative tax rate associated with each jump. Subtract the baseline Traditional IRA withdrawals for living expenses from the total Traditional IRA withdrawals to get the amount for Roth conversion.

The chart shows they’ll pay about 23% in taxes on their Traditional IRA withdrawals if they convert $115k before their income hits the first threshold for IRMAA. The cumulative tax rate will be 24% if they convert $165,000 and stop before the second IRMAA tier, 26% if they convert $230,000 and stop before the third IRMAA tier, and so on.

Break PointRoth Conversion AmountCumulative Tax RateBefore “tax torpedo”$25,00022%Before the first IRMAA tier$115,00023%Before the second IRMAA tier$165,00024%Before the third IRMAA tier$230,00026%

This couple can decide how much to convert based on the size of their pre-tax accounts and their view of tax rates in the future. Convert more if they have large pre-tax accounts and they think tax rates will be high in the future. Convert less if they don’t have large pre-tax accounts and they think tax rates will be low in the future.

The shape and the breakpoints for your specific scenario will be different. You can follow this example and use the chart to map your own breakpoints and tax rates.

Save the Spreadsheet

You may see a warning like this when you save the spreadsheet:

This is normal. Click on Continue and the spreadsheet will be saved.

Scenario – Single

I’ll do another example for someone in the Single filing status.

A retired person, age 66, Florida resident, single with no dependents, enrolled in Medicare Part B and Part D. She lives on $30,000 of Social Security benefits, $20,000 of Traditional IRA withdrawals, $2,000 of interest income, and $5,000 of qualified dividends. She has no other income or deductions.

Entering 1 in cell G2 for the Single filing status and leave adult #2 blank.

Enter the income in the same green-shaded cells starting at cell D23:

After you adjust the chart scale, set the starting point, and extend the range of the X-axis, the chart looks like this:

The first spike in the marginal tax rate (the gray line) is the so-called “tax torpedo.” The next four spikes are due to Medicare IRMAA. Point your mouse at points before each jump in the blue line. You’ll see the total Traditional IRA withdrawals and the cumulative tax rate associated with each jump. Subtract the baseline Traditional IRA withdrawals for living expenses from the total Traditional IRA withdrawals to get the amount for Roth conversion.

Here are the corresponding breakpoints and tax rates:

Break PointRoth Conversion AmountCumulative Tax RateBefore “tax torpedo”$8,50022%Before the first IRMAA tier$48,00025%Before the second IRMAA tier$74,00026%Before the third IRMAA tier$105,00027%Before the fourth IRMAA tier$135,00027%

She can decide how much to convert depending on the size of her pre-tax accounts and her view of tax rates in the future. Convert more if she has large pre-tax accounts and she thinks tax rates will be high in the future. Convert less if she doesn’t have large pre-tax accounts and she thinks tax rates will be low in the future.

Again, the shape and the breakpoints for your specific scenario will be different. You can follow this example and use the chart to map your own breakpoints and tax rates.

Limitations

The Case Study Spreadsheet is an excellent tool to explore how converting different amounts to Roth affects your taxes, but the part of the spreadsheet used in this post shows only the current year. It doesn’t show the effect of doing so over many years.

For example, you see that you will pay X% in taxes if you convert this much now, but you don’t know whether converting more (or less) would be better in the long run when you take into account the size of your pre-tax accounts, your age, your spending needs, investment returns, your Required Minimum Distributions (RMD), etc., etc. You’ll have to decide yourself whether paying X% in taxes on Roth conversion is “worth it.”

Other software tools such as Optimal Retirement Planner (ORP), Retiree Portfolio Model (RPM), and Pralana Gold look across multiple years based on a set of inputs and assumptions to suggest an amount you should convert to Roth each year. The big question is whether those inputs and assumptions will hold true.

Mike Piper, CPA made a good argument against projecting out too many years in his blog post Long-Term Tax Planning Requires Guessing. Focus on the Near-Term. The future can’t be predicted precisely. Your spending needs will change. Investment returns may be strong or weak. Tax laws change. You won’t know what your tax rates will be in the future.

I see a good reason to only look at the current year with the Case Study Spreadsheet. The decision won’t be “optimal” but trying to “optimize” may be only chasing rainbows. I strive to banish the word “optimize” from my financial life and from life in general.

***

The purpose of a Roth conversion is to take advantage of low tax rates. If your retirement is dicey, the best Roth conversion strategy won’t cure it. If your retirement is secure, a reasonable attempt at Roth conversion is only trying to make an already good situation better. So don’t get stressed out when you don’t know how much you should convert. You can use the Case Study Spreadsheet to find a reasonable answer for the current year.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post Roth Conversion with Social Security and Medicare IRMAA appeared first on The Finance Buff.

Two Types of Bond Ladders: When to Replace a Bond Fund or ETF

Both stocks and bonds are down so far this year. As I’m writing this on November 19, the Vanguard Total Stock Market Index Fund is down 17% and the Vanguard Total Bond Market Index Fund is down 14%.

While bonds lost less than stocks, people seem to be more upset about the loss in their bond investments than the loss in their stock investments because they have different expectations for these investments. They know their stock investments are risky and the stock market can go down or crash at times. They expect bonds to be more stable. They also hoped that bonds would go up in value when stocks are down, in an often-cited zig-zag relationship — when stocks zig, bonds zag (“flight to quality”). Investors are disappointed to see bonds going down by almost as much as stocks.

I sympathize with this sentiment. I also wish my bond investments didn’t drop this much but I know the zig-zag relationship is a false expectation. Sometimes they zig-zag and sometimes they don’t. It’s unrealistic to expect bonds to always hold steady or move up when stocks crash.

Because many people invest in bonds through bond funds or ETFs, they wonder whether investing in bonds directly would’ve made a difference because they can avoid the loss by holding the bonds to maturity and getting paid in full when the bonds mature. Specifically, they wonder whether they should replace their bond fund or ETF with a bond ladder going forward.

Table of ContentsWhat Is a Bond LadderReasons for a Bond LadderCollapsing Bond LadderRolling Bond LadderSource of Bond LossReinvest = Hold to MaturityValue of Holding to MaturityPsychological ComfortWhat Is a Bond Ladder

A bond ladder is a collection of bonds structured to have approximately the same amount mature in approximately equal intervals. The equal amounts and the equal intervals make it look like a ladder.

For example, if you have $10,000 of bonds maturing every year in the next 10 years, that’s a 10-year bond ladder. To build this 10-year bond ladder, you buy $10,000 face value of a 1-year bond, $10,000 face value of a 2-year bond, …, and $10,000 face value of a 10-year bond.

It’s easy to build this ladder with Treasuries through a combination of new issues and secondary market purchases. See How To Buy Treasury Bills & Notes Without Fee at Online Brokers and How to Buy Treasury Bills & Notes On the Secondary Market. You can build a ladder with CDs as well.

The amount that matures each year doesn’t have to be exactly the same. You can add a small amount at each interval to account for inflation (or buy TIPS bonds that automatically adjust for inflation).

The first bond doesn’t have to mature in one year. Your first bond can be a 10-year bond followed by an 11-year bond, then a 12-year bond, and so on.

The interval doesn’t have to be one year either. You can have $20,000 maturing every two years or $5,000 maturing every six months.

As long as you have some set amount maturing at some intervals, that’s a bond ladder.

Reasons for a Bond Ladder

The primary reason for building a bond ladder is to take advantage of the fact that bonds pay back the full principal when they mature. As long as your bonds don’t default, you’re guaranteed to have your principal back on the maturity date. When each bond is guaranteed not to lose money when it matures, the bond ladder as a whole is also guaranteed not to lose money over its lifetime. It’s perceived to be safer than a bond fund or ETF.

What you do with the cash from a matured bond in a bond ladder distinguishes the type of bond ladder you have.

Collapsing Bond Ladder

If you simply spend the money from each matured bond, you have a collapsing bond ladder.

Suppose you started with a 10-year bond ladder with $10,000 maturing each year starting one year from now. After one year, your original one-year bond matures and you get $10,000 paid back as cash. Your original two-year bond has only one year left now and your original 10-year bond has nine years left.

If you spend the $10,000 cash, you’re left with a nine-year bond ladder. If you spend the $10,000 cash again next year, you’re left with an eight-year bond ladder. Your ladder becomes smaller and smaller as time goes by. That’s a collapsing bond ladder. The ladder disappears after the last bond matures.

Rolling Bond Ladder

If you reinvest the cash from the matured bond to the far end of the ladder, you have a rolling bond ladder.

Suppose you started with the same 10-year bond ladder with $10,000 maturing each year starting one year from now. After one year, your original one-year bond matures and you get $10,000 paid back as cash. Your original two-year bond has only one year left now and your original 10-year bond has nine years left. So far you have the same $10,000 cash and a nine-year bond ladder as in a collapsing bond ladder.

If you reinvest the $10,000 cash in a new 10-year bond, you will extend your nine-year bond ladder into a 10-year bond ladder. If you reinvest the $10,000 cash again next year, you’re keeping your 10-year bond ladder intact. Your ladder keeps going and going. That’s a rolling bond ladder. The ladder is maintained until you stop reinvesting and convert it into a collapsing bond ladder.

Source of Bond Loss

We need to understand the source of losses in bonds to answer the question of whether it’s better to replace a bond fund or ETF with a bond ladder.

Bond funds and ETFs hold bonds. Prices of bond funds and ETFs are determined by the prices of their underlying holdings. Investors lost money in bond funds and ETFs this year because the values of bonds held in those bond funds and ETFs dropped.

Bonds don’t know or care whether you’re holding them in a bond ladder or through a bond fund or ETF. Their values will drop by the same amount when interest rates go up. If you would hold only bonds of a certain type in a ladder (for instance, short-term Treasuries), you can invest in a bond fund or ETF that holds that type of bonds as well.

If you hate seeing a lower value in your account statement, only holding bonds in a bond ladder won’t help. If you can ignore the lower market value reported in your brokerage account for your bonds in a ladder because you’re not selling them, you can ignore the lower reported market value for your bond fund or ETF as well when you’re not selling it either.

I bought some bonds two years ago. The interest rates on those bonds were good at that time, relatively speaking. After interest rates went up this year, the values of those bonds dropped. I still had a loss in those bonds even though I’m holding them to maturity.

Reinvest = Hold to Maturity

Actually it doesn’t matter whether I hold those bonds to maturity or not. If I sell them now at a loss and I reinvest the proceeds at the current rates, I’ll have exactly the same amount as holding the bonds to maturity. That’s the definition of their market value. Someone else investing a smaller amount today will grow their investment to the same amount as my bonds when they mature. It makes no difference whether I sell at a loss now and reinvest or I keep my bonds and languish while earning lower rates. I get to the same place either way.

My bonds lost value because I bought them too early. The only way to avoid the loss is not to buy those bonds two years ago. If I had kept the money in a savings account and I only buy the bonds now, I would’ve avoided the loss, but that requires knowing that interest rates would go up and bond prices would come down if I only waited. No one could’ve known that. If interest rates continue going up as much as they have this year, bond investors will lose money whether they buy bonds in a bond fund or in a bond ladder.

Bond funds and ETFs continuously reinvest. It doesn’t matter whether the bond fund managers hold their bonds to maturity or not. Growing the lower value in a bond fund or ETF at today’s higher rates will get to the same place as holding last year’s bonds to maturity in a rolling bond ladder. If you’re going to do a rolling bond ladder, in which you will continuously reinvest proceeds from matured bonds, you might as well invest in a bond fund or ETF.

Value of Holding to Maturity

Holding to maturity makes a difference when you don’t reinvest. You make up for the loss in a bad year when you reinvest at higher rates, but if you must spend the money, you lock in the loss and lose the opportunity to make up for it. Holding to maturity avoids the loss in this case.

If you’re liquidating a bond fund to cover anticipated expenses, a collapsing bond ladder helps with matching matured bonds to orderly withdrawals. This is helpful especially when the withdrawal period is short and the amount to be withdrawn is relatively predictable.

For example, if you’re paying your child’s college tuition, having a four-year collapsing bond ladder matches the cash flow from the matured bonds to the tuition bills. You pay the bill each year with a bond that matures in that year. The ladder is gone when the final tuition bill is paid.

Someone retiring at age 54 can also use a collapsing bond ladder to cover living expenses until they start withdrawing from their IRA when they’re age 59-1/2.

Someone saving money to buy a car in five years can use a reverse ladder. Instead of paying a lump sum now to have a set amount mature each year, they keep buying a bond that matures when they need the money for a car — a five-year bond now, a four-year bond next year, and so on. They’ll have a lump sum to buy the car when the bonds mature.

These are all good cases for investing in a bond ladder. The value of holding to maturity gets diluted when you have a long withdrawal period and the amount to be withdrawn each year is uncertain. If you just retired and will take withdrawals over the next 30 years, the amount to be withdrawn is small relative to the whole portfolio. Bonds don’t lose 15% every year. Not reinvesting only 3% of your bond holdings in a bad year doesn’t make that much difference.

Psychological Comfort

Bond funds and ETFs can feel like a black box. You only see fluctuating prices, which stress you out when the prices keep going down.

Bonds in a ladder feel more transparent. They pay interest like clockwork and they pay back the principal as promised. This feels more orderly. It may still be worth doing when you continuously reinvest or when you withdraw only a small amount each year from your bonds even if the end results are not much different than investing in a bond fund or ETF. Feeling more comfortable psychologically helps you stay with your investments.

Just don’t pay fees to someone who sells you on managing a bond ladder for you. Some brokers sell muni bonds or corporate bonds to retirees for large hidden fees. Some financial advisors create bond ladders to justify their asset management fees by “adding value.” These are all dubious practices. If you want a bond ladder for psychological comfort, do it yourself.

***

The value of doing a bond ladder is in matching withdrawals with matured bonds. The shorter the time span in which you will liquidate your bond holdings, the more valuable it is to do a [collapsing] bond ladder. If you’re not withdrawing anything from your bonds and you’re only continuously reinvesting, there isn’t a financial advantage in doing a bond ladder over investing in a bond fund or ETF. When you have a long time span and you’re only withdrawing a small amount each year, a long ladder doesn’t make that much of a difference from a bond fund or ETF.

You may still choose to do a rolling bond ladder or a long ladder for psychological comfort. Just don’t think it’s worth paying someone to do it for you. If doing a rolling bond ladder or a super-long ladder becomes too much work for what it’s worth, just invest in a bond fund or ETF.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post Two Types of Bond Ladders: When to Replace a Bond Fund or ETF appeared first on The Finance Buff.

Two Types of Bond Ladders: When to Use In Place of a Bond Fund

Both stocks and bonds are down so far this year. As I’m writing this on November 19, the Vanguard Total Stock Market Index Fund is down 17% and the Vanguard Total Bond Market Index Fund is down 14%.

While bonds lost less than stocks, people seem to be more upset about the loss in their bond investments than the loss in their stock investments because they have different expectations for these investments. They know their stock investments are risky and the stock market can go down or crash at times. They expect bonds to be more stable. They also hoped that bonds would go up in value when stocks are down, in an often-cited zig-zag relationship — when stocks zig, bonds zag (“flight to quality”). Investors are disappointed to see bonds going down by almost as much as stocks.

I sympathize with this sentiment. I also wish my bond investments didn’t drop this much but I know the zig-zag relationship is a false expectation. Sometimes they zig-zag and sometimes they don’t. It’s unrealistic to expect bonds to always hold steady or move up when stocks crash.

Because many people invest in bonds through bond funds or ETFs, they wonder whether investing in bonds directly would’ve made a difference because they can avoid the loss by holding the bonds to maturity and getting paid in full when the bonds mature. Specifically, they wonder whether they should replace their bond fund with a bond ladder going forward.

Table of ContentsWhat Is a Bond LadderReasons for a Bond LadderCollapsing Bond LadderRolling Bond LadderSource of Bond LossReinvest = Hold to MaturityValue of Holding to MaturityPsychological ComfortWhat Is a Bond Ladder

A bond ladder is a collection of bonds structured to have approximately the same amount mature in approximately equal intervals. The equal amounts and the equal intervals make it look like a ladder.

For example, if you have $10,000 of bonds maturing every year in the next 10 years, that’s a 10-year bond ladder. To build this 10-year bond ladder, you buy $10,000 face value of a 1-year bond, $10,000 face value of a 2-year bond, …, and $10,000 face value of a 10-year bond.

It’s easy to build this ladder with Treasuries through a combination of new issues and secondary market purchases. See How To Buy Treasury Bills & Notes Without Fee at Online Brokers and How to Buy Treasury Bills & Notes On the Secondary Market. You can build a ladder with CDs as well.

The amount that matures each year doesn’t have to be exactly the same. You can add a small amount at each interval to account for inflation (or buy TIPS bonds that automatically adjust for inflation).

The first bond doesn’t have to mature in one year. Your first bond can be a 10-year bond followed by an 11-year bond, then a 12-year bond, and so on.

The interval doesn’t have to be one year either. You can have $20,000 maturing every two years or $5,000 maturing every six months.

As long as you have some set amount maturing at some intervals, that’s a bond ladder.

Reasons for a Bond Ladder

The primary reason for building a bond ladder is to take advantage of the fact that bonds pay back the full principal when they mature. As long as your bonds don’t default, you’re guaranteed to have your principal back on the maturity date. When each bond is guaranteed not to lose money when it matures, the bond ladder as a whole is also guaranteed not to lose money over its lifetime. It’s perceived to be safer than a bond fund or ETF.

What you do with the cash from a matured bond in a bond ladder distinguishes the type of bond ladder you have.

Collapsing Bond Ladder

If you simply spend the money from each matured bond, you have a collapsing bond ladder.

Suppose you started with a 10-year bond ladder with $10,000 maturing each year starting one year from now. After one year, your original 1-year bond matures and you get $10,000 paid back as cash. Your original two-year bond has only one year left now and your original 10-year bond has nine years left.

If you spend the $10,000 cash, you’re left with a nine-year bond ladder. If you spend the $10,000 cash again next year, you’re left with an eight-year bond ladder. Your ladder becomes smaller and smaller as time goes by. That’s a collapsing bond ladder. The ladder disappears after the last bond matures.

Rolling Bond Ladder

If you reinvest the cash from the matured bond to the far end of the ladder, you have a rolling bond ladder.

Suppose you started with the same 10-year bond ladder with $10,000 maturing each year starting one year from now. After one year, your original 1-year bond matures and you get $10,000 paid back as cash. Your original two-year bond has only one year left now and your original 10-year bond has nine years left. So far you have the same $10,000 cash and a nine-year bond ladder as in a collapsing bond ladder.

If you reinvest the $10,000 cash in a new 10-year bond, you will extend your nine-year bond ladder into a 10-year bond ladder. If you reinvest the $10,000 cash again next year, you keep your 10-year bond ladder intact. Your ladder keeps going and going. That’s a rolling bond ladder. The ladder is maintained until you stop reinvesting and convert it into a collapsing bond ladder.

Source of Bond Loss

We need to understand the source of losses in bonds to answer the question of whether it’s better to replace a bond fund or ETF with a bond ladder.

Bond funds and ETFs hold bonds. Prices of bond funds and ETFs are determined by the prices of their underlying holdings. Investors lost money in bond funds and ETFs this year because the values of bonds held in those bond funds and ETFs dropped.

Bonds don’t know or care whether you’re holding them in a bond ladder or through a bond fund or ETF. Their values will drop by the same amount when interest rates go up. If you hate seeing a lower value in your account statement, only holding bonds in a bond ladder won’t help. If you can ignore the lower market value reported in your brokerage account for your bonds because you’re not selling them, you can ignore the lower reported market value for your bond funds and ETFs as well when you’re not selling them either.

I bought some bonds two years ago. The interest rates on those bonds were good at that time, relatively speaking. After interest rates went up this year, the values of those bonds dropped. I still had a loss in those bonds even though I’m holding them to maturity.

Reinvest = Hold to Maturity

Actually it doesn’t matter whether I hold those bonds to maturity or not. If I sell them now at a loss and I reinvest the proceeds at the current rates, I’ll have exactly the same amount as holding the bonds to maturity. That’s the definition of their market value. Someone else investing a smaller amount today will grow their investment to the same amount as my bonds when they mature. It makes no difference whether I sell at a loss now and reinvest or I keep my bonds and languish while earning lower rates. I get to the same place either way.

My bonds lost value because I bought them too early. The only way to avoid the loss is not to buy those bonds two years ago. If I had kept the money in a savings account and I only buy the bonds now, I would’ve avoided the loss, but that requires knowing that interest rates would go up and bond prices would come down if I only waited. No one could’ve known that. If interest rates continue going up as much as they have this year, bond investors will lose money whether they buy bonds in a bond fund or in a bond ladder.

Bond funds and ETFs continuously reinvest. It doesn’t matter whether the bond fund managers hold their bonds to maturity or not. Growing the lower value in a bond fund or ETF at today’s higher rates will get to the same place as holding bonds to maturity in a rolling bond ladder. If you’re going to do a rolling bond ladder, in which you will continuously reinvest proceeds from matured bonds, you might as well invest in a bond fund.

Value of Holding to Maturity

Holding to maturity makes a difference when you don’t reinvest. You make up for the loss in a bad year when you reinvest at higher rates, but if you must spend the money, you lock in the loss and lose the opportunity to make up for it. Holding to maturity avoids the loss in this case.

If you’re liquidating a bond fund to cover anticipated expenses, a collapsing bond ladder helps with matching matured bonds to orderly withdrawals. This is helpful especially when the withdrawal period is short and the amount to be withdrawn is relatively predictable.

For example, if you’re paying your child’s college tuition, having a four-year collapsing bond ladder matches the cash flow from the matured bonds to the tuition bills. You pay the bill each year with a bond that matures in that year. The ladder is gone when the final tuition bill is paid.

Someone retiring at age 54 can also use a collapsing bond ladder to cover living expenses until they start withdrawing from their IRA when they’re age 59-1/2.

Someone saving money to buy a car in five years can use a reverse ladder. Instead of paying a lump sum now to have a set amount mature each year, they keep buying a bond that matures when they need the money for a car — a five-year bond now, a four-year bond next year, and so on. They’ll have a lump sum to buy the car when the bonds mature.

These are all good cases for investing in a bond ladder. The value of holding to maturity gets diluted when you have a long withdrawal period and the amount to be withdrawn each year is uncertain. If you just retired and will take withdrawals over the next 30 years, the amount to be withdrawn is small relative to the whole portfolio. Bonds don’t lose 15% every year. Not reinvesting only 3% of your bond holdings in a bad year doesn’t make that much difference.

Psychological Comfort

Bond funds and ETFs can feel like a black box. You only see fluctuating prices, which stress you out when the prices keep going down.

Bonds in a ladder feel more transparent. They pay interest like clockwork and they pay back the principal as promised. This feels more orderly. Even if the end results are not much different than investing in a bond fund or ETF when you continuously reinvest or when you withdraw only a small amount each year from your bonds, it may still be worth doing. Feeling more comfortable psychologically helps you stay with your investments.

Just don’t pay fees to someone who sells you on managing a bond ladder for you. Some brokers sell muni bonds or corporate bonds to retirees for large hidden fees. Some financial advisors create bond ladders to justify their asset management fees by “adding value.” These are all dubious practices. If you want a bond ladder for psychological comfort, do it yourself.

***

The value of doing a bond ladder is in matching withdrawals with matured bonds. The shorter the time span in which you will liquidate your bond holdings, the more valuable it is to do a [collapsing] bond ladder. If you’re not withdrawing anything from your bonds and you’re only continuously reinvesting, there isn’t a financial advantage in doing a bond ladder over investing in a bond fund or ETF. When you have a long time span and you’re only withdrawing a small amount each year, a long ladder doesn’t make that much of a difference from a bond fund or ETF.

You may still choose to do a rolling bond ladder or a super-long ladder for psychological comfort. Just don’t think it’s worth paying someone to do it for you. If doing a rolling bond ladder or a super-long ladder becomes too much work for what it’s worth, just invest in a bond fund or ETF.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post Two Types of Bond Ladders: When to Use In Place of a Bond Fund appeared first on The Finance Buff.

How to Buy Treasury Bills & Notes On the Secondary Market

I showed how to buy new-issue Treasury bills and notes in the previous post How To Buy Treasury Bills & Notes Without Fee at Online Brokers. Buying a new issue is the easiest and the least expensive way for most people. You should try to stay with new issues for the most part.

However, sometimes it’s necessary to buy Treasuries on the secondary market. Major online brokers such as Fidelity, Vanguard, and Charles Schwab don’t charge fees for buying Treasuries on the secondary market either. I show you how to do it in this post.

Table of ContentsWhat Is the Secondary MarketReasons to Buy on the Secondary MarketTerm Not Available As New IssueDon’t Want to WaitTIPSKnown Price and YieldNot All Brokers Offer New IssuesDisadvantages of the Secondary MarketBid/Ask SpreadComplicates TaxesMust Place Order When the Market Is OpenNo Auto RollOnline BrokersFidelityVanguardCharles SchwabWhat Is the Secondary Market

Buying on the secondary market is like buying a used car. Someone bought the Treasuries when they first came out as a new issue. Now they’re reselling them. You’re buying these “pre-owned” Treasuries when you buy on the secondary market.

You’re not getting an inferior product when you buy “pre-owned” Treasuries on the secondary market. The U.S. government still guarantees full payments of both principal and interest. As such, you’re not getting a bargain either when you buy on the secondary market as opposed to buying new issues.

Reasons to Buy on the Secondary Market

Two scenarios make it necessary to buy on the secondary market.

Term Not Available As New Issue

New issue Treasuries come in these maturities:

1-month (4-week)2-month (8-week)3-month (13-week)4-month (17-week)6-month (26-week)1-year (52-week)2-year3-year5-year7-year10-year20-year30-year

If you want a Treasury that matures in 9 months, 18 months, or 4 years, you won’t be able to get it as a new issue. Your only option is to buy it on the secondary market. A 1-year Treasury issued 3 months ago has 9 months to run by now. It’ll be your 9-month Treasury if you buy it on the secondary market.

Don’t Want to Wait

New-issue Treasuries come out on a preset schedule. Short-term Treasury Bills come out weekly. Longer maturities (1-year and up) come out only once a month. If you’d like to buy it today and don’t want to wait until the scheduled sale, your only option is to buy on the secondary market.

For example, as I’m writing this, the next scheduled sale for a 1-year (52-week) Treasury will be on November 29 and the one after that will be on December 27. If you miss the November 29 sale and you don’t want to wait until December 27, you’ll have to buy it on the secondary market.

TIPS

New issues of the inflation-protected TIPS only come in these maturities and frequencies currently:

MaturityNew Issue Frequency5-year4 times a year (April, June, October, December)10-year6 times a year (January, March, May, July, September, November)30-yearTwice a year (February, August)

If you want a 2-year TIPS or if you want a 5-year TIPS in November, you’ll have to buy it on the secondary market.

Known Price and Yield

When you buy a new issue, you place your order without knowing exactly what the price and yield will be, because the price and yield are determined by an auction. You’re trusting you’re getting a good price and yield because you’re paying the same price on your small order as banks buying $100 million. Prices can move between the time you place the order and the time the auction completes. The actual yield you get may be higher or lower than the going yield you see when you place the order.

You get a quote when you buy on the secondary market. You know exactly what yield you’re getting. Some people prefer this certainty as opposed to not knowing what price and yield they’ll get when they buy new issues.

This third reason to buy on the secondary market is only personal preference.

Not All Brokers Offer New Issues

Another reason to buy on the secondary market is that not all brokers offer new-issue Treasuries. Merrill Edge, for example, doesn’t offer new-issue Treasuries online. You have to call and pay a fee to have a representative place the order for a new issue, but you can buy on the secondary market online without a fee. If you must use Merrill Edge, buying on the secondary market probably still beats paying a fee every time to buy a new issue.

You can buy new-issue Treasuries online without a fee at Vanguard, Fidelity, Charles Schwab, and E*Trade. See detailed steps with screenshots in the previous post.

Disadvantages of the Secondary Market

I focused on buying new issues in the previous post because buying on the secondary market has some disadvantages.

Bid/Ask Spread

The biggest disadvantage is the bid/ask spread. Bond dealers offer to buy and sell Treasuries on the secondary market. The difference between the price you pay when you buy and the price you receive when you sell is the bid/ask spread. The true price is somewhere in between. You’re paying a slightly higher price than the true price when you buy on the secondary market.

For example, here’s a quote for a 1-year Treasury on the secondary market:

You get a yield of 4.74% when you buy but you must pay a yield of 4.81% when you sell. The true price is somewhere in between. Suppose it’s 4.77%, which means you’re getting a yield that’s about 0.03% less than the fair value when you buy on the secondary market.

Everyone pays the same price and gets the same yield when they buy a new issue. There’s no bid/ask spread. It may be OK if you pay a bid/ask spread to buy a 10-year bond and hold it for 10 years but if you pay a bid/ask spread every month on a 1-month Treasury bill, it adds up fast.

Complicates Taxes

When you buy Treasuries in a taxable account, buying them on the secondary market adds more complications to your taxes than buying new issues. You’ll need to know what to do with accrued interest and, if applicable, amortizable bond premium (see IRS Schedule B Instructions). They’re not impossible to deal with but it’s still extra work.

Selling Treasuries in a taxable account on the secondary market before they mature adds yet more complications to your taxes. If you must buy Treasuries on the secondary market in a taxable account, at least hold them to maturity and don’t sell them on the secondary market.

Buying or selling on the secondary market in an IRA doesn’t affect your taxes.

Must Place Order When the Market Is Open

When you buy a new issue, you need to place your order during an order window but you can do it in the evening or on weekends. You’re good to go as long as your order goes in by the night before the auction date.

When you buy on the secondary market, you must place your order when the bond market is open. That’s typically Monday through Friday, 8:00 a.m. to 5:00 p.m. Eastern Time. This may interfere with your schedule.

No Auto Roll

Some brokers such as Fidelity and Charles Schwab offer an optional “auto roll” feature when you buy new-issue Treasuries. If you enable the feature when you buy, they will automatically place a new order for the same term and face value when this Treasury matures. It’s especially helpful for short-term Treasuries.

This feature is only available for new issues. You can’t “auto roll” when you buy on the secondary market.

Online Brokers

If you have good reasons to buy Treasuries on the secondary market and you understand and accept the downside, here’s how to do it at some major online brokers.

Fidelity

Here are the steps to buy Treasuries on the secondary market in a Fidelity account. Fidelity doesn’t charge fees for buying Treasuries on the secondary market.

Under News & Research on the top, click on Fixed Income, Bonds & CDs.

Click on the Bonds tab.

U.S. Treasury and Secondary are selected by default. Suppose you want a Treasury that matures in November 2023. Enter the from-and-to months in the maturity range fields. The button tells you how many Treasuries fit your search. A CUSIP for bonds is like the ticker symbol for stocks.

You see a list of Treasuries available. Look at the Ask columns when you’re buying. The Yield to Maturity and Yield to Worst numbers are always the same for Treasuries.

You won’t necessarily get the quoted Yield to Maturity in this table because those yields are for the minimum quantity in the Price | Qty(min) column. For example, you’ll have to buy $3 million of face value in the Treasury Bill maturing on 11/02/2023 to get the 4.755% yield to maturity (3,000 in the parenthesis means $3 million because 1 bond is $1,000 of face value).

The $3 million minimum is only the minimum for the quoted price and yield. You can still buy a smaller quantity. You’ll just have to pay slightly more and get a slightly lower yield than a $3 million order.

After scanning the results table, suppose you’re interested in the Treasury bill that matures on 11/02/2023. Click on the Buy button next to this Treasury.

Click on the Account dropdown to select the account in which you will buy this Treasury. Click on More Quotes – Depth of Book and Recent Trades to see the price and yield for the quantity you’ll buy.

Look at the Ask Prices when you’re buying. Find the quote for the minimum quantity you’re buying. If you’re buying $10,000 face value, you won’t get the price and yield for the $3 million minimum or the $250,000 minimum. You’ll pay a slightly higher price and get the yield for a $1,000 minimum order size, which is 4.740% in the screenshot.

If you’re satisfied with the quoted yield, enter the quantity you’d like to buy. 1 bond is $1,000 face value. To buy $10,000 face value, enter a quantity of 10. The minimum order size is 1 for $1,000 face value.

This final screen shows how much you’ll pay for this order. The money will come out of your cash balance and money market funds. Principal and interest payments will automatically go into your cash balance. You can’t “auto-roll” when you buy on the secondary market.

This specific Treasury doesn’t have any accrued interest but some others do. You pay the accrued interest to the current owner and you get it back in the next interest payment. If you’re buying in a taxable account, you’ll have to remember to subtract the accrued interest when you do your taxes. Otherwise you’ll pay more taxes than you really owe.

Vanguard

Follow these steps to buy Treasuries on the secondary market in a Vanguard brokerage account. Vanguard doesn’t charge fees for buying Treasuries on the secondary market.

Click on the three dots next to Transact near the top right of your account and scroll toward the bottom. Click on Trade bonds or CDs.

Click on the Treasuries tab. The Secondary radio button is selected by default. Enter the range of maturity dates you’re interested in and click on Search.

You get a list of available Treasuries. You can click on the heading to sort by maturity or yield. Look at the second line in each row when you’re buying.

You won’t necessarily get the quoted Yield to Maturity in this table because those yields are for the minimum quantity in the Min. qty column. For example, you’ll have to buy $1 million of face value in the Treasury Bill maturing on 11/02/2023 to get the 4.756% yield to maturity (1,000 means $1 million face value because 1 bond is $1,000 face value).

The $1 million minimum is only the minimum for the quoted price and yield. You can still buy a smaller quantity. You’ll just have to pay slightly more and get a slightly lower yield than a $1 million order.

Suppose you’re interested in the Treasury maturing on 11/02/2023. Click on Show more in that row.

Now you will see the price and yield for smaller orders. Look at the Ask side when you’re buying. Find the quote for the minimum quantity applicable to you. If you’re buying $10,000 face value, you won’t get the price and yield for the $1 million minimum or the $250,000 minimum. You’ll pay a slightly higher price and get the yield for a $1,000 minimum order size, which is 4.752% in the screenshot. Click on the Buy link next to the applicable minimum order size.

You’ll see a page full of information about this Treasury. Click on the Buy button if you’re still interested in buying it.

You have to check the box to say you know what you’re doing. Enter a quantity of 10 to buy $10,000 face value. Click on Calculate to see the yield again.

You see a big warning on the top saying you’re paying a higher price for your small order. Nothing you can do here unless you can afford to buy $250,000 or $1 million.

Now comes the final screen before you submit the order or cancel. You see the yield, the accrued interest if applicable, and the net amount that’ll come out of your settlement fund. Principal and interest payments will automatically go into your settlement fund. You’ll have to reinvest those payments on your own.

This specific Treasury doesn’t have any accrued interest but some others do. You pay the accrued interest to the current owner and you get it back in the next interest payment. If you’re buying in a taxable account, you’ll have to remember to subtract the accrued interest when you do your taxes. Otherwise you’ll pay more taxes than you really owe.

Charles Schwab

You can buy Treasuries on the secondary market in a Charles Schwab account as well. Schwab also doesn’t charge fees on buying Treasuries on the secondary market.

Click on Trade in the top menu and then Find Bonds & Fixed Income.

I don’t have more screenshots for Charles Schwab at this moment but the process should be similar to Fidelity and Vanguard. I’ll add screenshots here when I have them.

***

Buying Treasuries on the secondary market fills gaps when the term you want isn’t available as a new issue or when the next new-issue auction is too far ahead. It’s a viable option if you understand and accept the downside of buying on the secondary market. Buying them in an IRA removes the tax complications.

The need to buy on the secondary market is especially applicable to TIPS because new-issue TIPS don’t come in as many maturities as nominal Treasuries and they come out much less frequently.

Bond prices change by the minute. New issues won’t always have a higher yield. If a new issue is coming out shortly, you may decide to wait, but you can buy on the secondary market now and lock in the current yield if the auction for the next new issue is quite far ahead.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post How to Buy Treasury Bills & Notes On the Secondary Market appeared first on The Finance Buff.

When to Stop Buying I Bonds or Cash Out and Buy TIPS

[Rewritten on November 3, 2022. Older comments were from 2018 when this same issue came up.]

The Treasury Department announced rates for new I Bonds sold between November 1, 2022 and April 30, 2023. These new I Bonds will have a fixed rate of 0.4% for life, plus a variable rate that adjusts with inflation every six months. The variable rate in the first six months will be 6.48%. When the fixed rate and the variable rate are combined, the composite rate for these new I Bonds is 6.89% in the first six months.

I Bonds for the Short Term

All existing I Bonds bought between May 2020 and October 2022 will continue to have a 0% fixed rate for life. They will earn a 6.48% variable rate for six months after they finish earning 9.62% for six months. The 6.48% rate is still higher than anything you can find in a safe investment.

If you maxed out on I Bonds in 2022, you’ll have an opportunity to buy I Bonds again in January 2023. All the reasons to buy I Bonds in 2022 are still valid in 2023. I Bonds remain a flexible principal-guaranteed investment. They’re great for short-term money that you might spend or reinvest into something else at any time after holding for one year.

TIPS for the Long Term

However, as long-term holdings, I Bonds now face strong competition from TIPS, which are another type of inflation-protected government bond (see Better Inflation Protection with TIPS After Maxing Out I Bonds for more background on TIPS). The Treasury Department raised the fixed rate on I Bonds because the yield on TIPS is much higher now.

As I’m writing this in November 2022, the yield on TIPS is about 1.6% for all maturities whereas the fixed rate on I Bonds is only 0.4%. In other words, TIPS pay 1.6% above inflation while I Bonds pay 0.4% above inflation. TIPS win over a longer holding period.

I Bonds Advantages

There are still valid reasons for continuing to buy I Bonds in 2023 and keeping the existing I Bonds despite their low fixed rates:

1. There is a limit on how much new I Bonds you can buy each year. If you don’t buy them, you won’t accumulate as much in these flexible inflation-protected investments.

2. I Bonds are guaranteed never to lose value.

3. The existing I Bonds already accrued some interest. Cashing them out will trigger paying federal income tax on the accrued interest. I Bonds are exempt from state and local taxes.

4. Cashing out I Bonds before five years will forfeit interest earned in the last three months.

5. I Bonds are tax-deferred. If your tax rate is high now and it will be lower when you retire, holding on to them until you retire will arbitrage the difference in tax rates.

These factors in favor of buying more I Bonds in 2023 and holding on to the existing 0%-fixed-rate I Bonds are all true. Still, there has to be a point when it’s better to switch to TIPS. If 1.6% real yield versus 0.4% fixed rate doesn’t do it, what if the gap grows bigger?

Quantify the Difference

We need to quantify the advantages of buying more and holding on to the low-rate I Bonds. Then we will see whether the advantages overcome the yield difference. I created a spreadsheet for comparing two scenarios:

A) Hold on to an existing I Bond. Defer tax to the future when the tax rate is potentially lower.

B) Pay any tax and penalty now. Invest the proceeds in TIPS in a taxable account. Pay tax on interest every year.

The spreadsheet is interactive. Assumptions are in blue. Please feel free to change those to numbers applicable to you. The other cells are calculated. Please don’t overwrite those.

You get the current value and the composite interest rate of your I Bond from the Savings Bond Calculator. If the bond hasn’t been held for five years, the value displayed by the Savings Bond Calculator already reflects the 3-month interest penalty.

In the scenario shown, I have an I Bond bought in May 2021 with a 0% fixed rate. It’s still subject to the early withdrawal penalty. In Scenario A, I would hold it for another 10 years. The average inflation in the next 10 years is assumed to be 3%. Finally, suppose I pay a higher tax rate in the next 10 years than the tax rate afterward.

Under these assumptions, I’m still better off switching to TIPS and just paying taxes every year at a higher tax rate. If my tax rates are more or less equal between now and the future, it will be even better to switch to TIPS because there isn’t much tax rate arbitrage. If I have room for TIPS in an IRA, it will be better still.

The result may be different under a different set of assumptions. So play with the spreadsheet with your own assumptions and different scenarios and see how it goes for you.

When to Cash Out 0% I Bonds

The early withdrawal penalty on I Bonds is the interest earned in the last three months. If you decide to cash out and switch to TIPS, you may want to wait until your I Bonds finish earning the 9.62% rate plus another three months for the early withdrawal penalty. If you find the 6.48% rate attractive, you may want to wait until you fully pocket the 6.48% rate as well.

When your I Bonds fully capture the 9.62% rate or the 6.48% rate depends on when the I Bonds were issued. I made this table as a handy reference:

Issue Month3 months after 9.62%3 months after 6.48%January or July4/1/202310/1/2023February or August5/1/202311/1/2023March or September6/1/202312/1/2023April or October7/1/20231/1/2024May or November2/1/20238/1/2023June or December3/1/20239/1/2023

Because I already have enough for short-term flexible spending (“emergency fund” type of usage), here’s my plan for 2023:

1. Check the Daily Treasury Par Real Yield Curve Rates (use the second heading on the webpage). If TIPS yields are still high in January 2023, skip buying I Bonds and buy TIPS for the long term.

2. Check again on the dates in the table above. If TIPS yields are still high at that time and the I Bonds with a 0% fixed rate have been held for at least one year, cash them out to buy TIPS.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post When to Stop Buying I Bonds or Cash Out and Buy TIPS appeared first on The Finance Buff.

2022 2023 Tax Brackets, Standard Deduction, Capital Gains, etc.

My other post listed 2022 2023 401k and IRA contribution and income limits. I also calculated the inflation-adjusted tax brackets and some of the most commonly used numbers in tax planning for 2023 using the published inflation numbers and the same formula prescribed in the tax law. The official numbers announced by the IRS confirmed my calculations.

Table of Contents2022 2023 Standard Deduction2022 2023 Tax Brackets2022 2023 Capital Gains Tax2022 2023 Estate and Trust Tax Brackets2022 2023 Gift Tax Exclusion2022 2023 Savings Bonds Tax-Free Redemption for College Expenses2022 2023 Standard Deduction

You don’t pay federal income tax on every dollar of your income. You deduct an amount from your income before you calculate taxes. About 90% of all taxpayers take the standard deduction. The other ~10% itemize deductions when their total deductions exceed the standard deduction. In other words, you’re deducting a larger amount than your allowed deductions when you take the standard deduction. Don’t feel bad about taking the standard deduction!

The basic standard deduction in 2022 and 2023 are:

20222023Single or Married Filing Separately$12,950$13,850Head of Household$19,400$20,800Married Filing Jointly$25,900$27,700Basic Standard Deduction

Source: IRS Rev. Proc. 2021-45, Rev. Proc. 2022-38.

People who are age 65 and over have a higher standard deduction than the basic standard deduction.

20222023Single, age 65 and over$14,700$15,700Head of Household, age 65 and over$21,150$22,650Married Filing Jointly, one person age 65 and over$27,300$29,200Married Filing Jointly, both age 65 and over$28,700$30,700Standard Deduction for age 65 and over

Source: IRS Rev. Proc. 2021-45, Rev. Proc. 2022-38.

People who are blind have an additional standard deduction.

20222023Single or Head of Household, blind+$1,750+$1,850Married Filing Jointly, one person is blind+$1,400+$1,500Married Filing Jointly, both are blind+$2,800+$3,000Additional Standard Deduction for Blindness

Source: IRS Rev. Proc. 2021-45, Rev. Proc. 2022-38.

2022 2023 Tax Brackets

The tax brackets are based on taxable income, which is AGI minus various deductions. The tax brackets in 2022 are:

SingleHead of HouseholdMarried Filing Jointly10%$0 – $10,275$0 – $14,650$0 – $20,55012%$10,275- $41,775$14,650 – $55,900$20,550 – $83,55022%$41,775 – $89,075$55,900 – $89,050$83,550 – $178,15024%$89,075 – $170,050$89,050 – $170,050$178,150 – $340,10032%$170,050 – $215,950$170,050 – $215,950$340,100 – $431,90035%$215,950 – $539,900$215,950 – $539,900$431,900 – $647,85037%Over $539,900Over $539,900Over $647,8502022 Tax Brackets

Source: IRS Rev. Proc. 2021-45.

The 2023 tax brackets are:

SingleHead of HouseholdMarried Filing Jointly10%$0 – $11,000$0 – $15,700$0 – $22,00012%$11,000 – $44,725$15,700 – $59,850$22,000 – $89,45022%$44,725 – $95,375$59,850 – $95,350$89,450 – $190,75024%$95,375 – $182,100$95,350 – $182,100$190,750 – $364,20032%$182,100 – $231,250$182,100 – $231,250$364,200 – $462,50035%$231,250 – $578,125$231,250 – $578,100$462,500 – $693,75037%Over $578,125Over $578,100Over $693,7502023 Tax Brackets

Source: IRS Rev. Proc. 2022-38.

A common misconception is that when you get into a higher tax bracket, all your income is taxed at the higher rate, and you’re better off not having the extra income. That’s not true. Tax brackets work incrementally. If you’re $1,000 into the next tax bracket, only $1,000 is taxed at the higher rate. It doesn’t affect the income in the previous brackets.

For example, someone single with a $60,000 AGI in 2022 will pay:

First 12,950 (the standard deduction)0%Next $10,27510%Next $31,500 ($41,775 – $10,275)12%Final $5,27522%Progressive Tax Rates

This person is in the 22% tax bracket but only less than 10% of the $60,000 AGI is really taxed at 22%. The bulk of the income is taxed at 0%, 10%, and 12%. The blended tax rate is only 9.9%. If this person doesn’t earn the final $5,275, he or she is in the 12% bracket instead of the 22% bracket, but the blended tax rate only goes down slightly from 9.9% to 8.8%. Making the extra income doesn’t cost this person more in taxes than the extra income.

Don’t be afraid of going into the next tax bracket.

2022 2023 Capital Gains Tax

When your other taxable income (after deductions) plus your qualified dividends and long-term capital gains are below a cutoff, you will pay 0% federal income tax on your qualified dividends and long-term capital gains under this cutoff.

This is illustrated by the chart below. Taxable income is the part above the black line, after subtracting deductions. A portion of the qualified dividends and long-term capital gains is taxed at 0% when the other taxable income plus these qualified dividends and long-term capital gains are under the red line.

The red line is close to the top of the 12% tax bracket but they don’t line up exactly.

20222023Single or Married Filing Separately$41,675$44,625Head of Household$55,800$59,750Married Filing Jointly$83,350$89,250Maximum Zero Rate Amount for Qualified Dividends and Long-term Capital Gains

Source: IRS Rev. Proc. 2021-45, Rev. Proc. 2022-38.

For example, suppose a married couple filing jointly has $70,000 in other taxable income (after deductions) and $20,000 in qualified dividends and long-term capital gains in 2022. The maximum zero rate amount cutoff is $83,350. $13,350 of the qualified dividends and long-term capital gains ($83,350 – $70,000) is taxed at 0%. The remaining $20,000 – $13,350 = $6,650 is taxed at 15%.

A similar threshold exists on the upper end for qualified dividends and long-term capital gains. When your other taxable income (after deductions) plus your qualified dividends and long-term capital gains are above a cutoff, you will pay 20% federal income tax instead of 15% on your qualified dividends and long-term capital gains above this cutoff.

20222023Single$459,750$492,300Head of Household$488,500$523,050Married Filing Jointly$517,200$553,850Married Filing Separately$258,600$276,900Maximum 15% Rate Amount for Qualified Dividends and Long-term Capital Gains

Source: IRS Rev. Proc. 2021-45, Rev. Proc. 2022-38.

2022 2023 Estate and Trust Tax Brackets

Estates and trusts have different tax brackets than individuals. These apply to non-grantor trusts and estates that retain income as opposed to distributing the income to beneficiaries. Grantor trusts (including the most common revocable living trusts) don’t pay taxes separately. The income of a grantor trust is taxed to the grantor at the grantor’s tax brackets.

Here are the tax brackets for estates and trusts in 2022 and 2023:

2022202310%$0 – $2,750$0 – $2,90024%$2,750 – $9,850$2,900 – $10,55035%$9,850 – $13,450$10,550 – $14,45037%over $13,450over $14,450Estate and Trust Tax Brackets

Source: IRS Rev. Proc. 2021-45, Rev. Proc. 2022-38.

2022 2023 Gift Tax Exclusion

Each person can give another person up to a set amount in a calendar year without having to file a gift tax form. Not that filing a gift tax form is onerous, but many people avoid it if they can. In 2023, this gift tax exclusion amount will likely increase from $16,000 to $17,000.

20222023Gift Tax Exclusion$16,000$17,000Gift Tax Exclusion

Source: IRS Rev. Proc. 2021-45, Rev. Proc. 2022-38.

The gift tax exclusion is counted by each giver to each recipient. As a giver, you can give up to $16,000 each in 2022 to an unlimited number of people without having to file a gift tax form. If you give $16,000 to each of your 10 grandkids in 2022 for a total of $160,000, you still won’t be required to file a gift tax form. Any recipient can also receive a gift from an unlimited number of people. If a grandchild receives $16,000 from each of his or her four grandparents in 2022, no taxes or tax forms will be required.

2022 2023 Savings Bonds Tax-Free Redemption for College Expenses

If you cash out U.S. Savings Bonds (Series I or Series EE) for college expenses or transfer to a 529 plan, your modified adjusted gross income must be under certain limits to get a tax exemption on the interest. See Cash Out I Bonds Tax Free For College Expenses Or 529 Plan. Here are the income limits in 2022 and 2023:

20222023Single, Head of Household$85,800 – $100,800$91,850 – $106,850Married Filing Jointly$128,650 – $158,650$137,800 – $167,800Income Limit for Tax-Free Savings Bond Redemption for Higher Education

Source: IRS Rev. Proc. 2021-45, Rev. Proc. 2022-38.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post 2022 2023 Tax Brackets, Standard Deduction, Capital Gains, etc. appeared first on The Finance Buff.

Guide to Money Market Fund & High Yield Savings Account (2022)

Both money market funds and savings accounts are good places for temporary savings that you may deposit and withdraw at any moment. If you can afford to lock up your money for a set period of time — for as short as four weeks — you’ll earn more interest in Treasury Bills. See How To Buy Treasury Bills & Notes Without Fee at Online Brokers. If you can afford to lock up the money for at least a year, consider I Bonds. See How to Buy I Bonds.

When the Federal Reserve kept the short-term interest rate close to zero in 2020 and 2021, pretty much all the money market funds paid an annualized yield of only 0.01%. Some online banks and credit unions were more generous at that time. They paid something like 0.65% annual percentage yield (APY), which wasn’t really “high yield” but it was certainly better than 0.01%. Now that the Fed has been raising rates, money market funds have become competitive again.

Table of ContentsWho Sets the Interest RateComparing YieldFDIC InsuranceFees and MinimumsWithdrawal and Transfer LimitsSweep Funds and Purchased FundsTax TreatmentThe Best Money Market FundsVanguardFidelityCharles SchwabMerrill EdgeWho Sets the Interest Rate

Money market funds are an investment product. They’re offered by brokers such as Vanguard, Fidelity, or Charles Schwab. Savings accounts are offered by banks and credit unions. A big difference between how much interest a money market fund pays and how much a savings account pays is in who sets the interest rate.

A side note: Some banks and credit unions also offer money market accounts. They’re just a savings account by a different name, perhaps with slightly different features such as check-writing privileges or a debit card for ATM withdrawals. They’re not the same as a money market fund. For the purpose of this post, I treat money market accounts from banks and credit unions the same as savings accounts.

Money market funds invest in very short-term debt securities in the financial market. The fund manager takes a fixed cut (the “expense ratio”) from what they earn in the market before paying the rest to you. If the market yield goes up, the yield you receive automatically goes up. If the market yield goes down, the yield you receive automatically goes down. You’re at the mercy of the market conditions. That’s why they could only pay 0.01% in 2020 and 2021.

The interest rate on a savings account is set by the bank or credit union. Banks and credit unions want deposits as reserves to make loans. They’ll set a high interest rate if they need to attract more deposits. They’ll set it low if they don’t have a strong loan demand. You’re at the mercy of the bank or credit union. If they decide to stay behind, there’s nothing you can do except jump ship to a different bank, which requires giving your Social Security number, creating new login credentials, opening a new account, linking your checking account, downloading a new mobile app, etc.

Therefore, when you put your money in a savings account, sometimes you get an above-market interest rate, and sometimes you get a below-market interest rate. If you go with a bank that offers a higher interest rate, be prepared to move when they lag behind. You can see the current rates offered by banks and credit unions at depositaccounts.com. When you put your money in a money market fund, you’ll get the market yield minus the fund manager’s cut at all times, no more, no less.

Comparing Yield

The yield on a money market fund changes with the market daily. A money market fund quotes a 7-day average yield. That’s the average yield investors actually received in the past seven days. When the market yield is rising fast, the yield you’ll get when you invest in the money market fund now may be higher than the average yield in the past seven days.

The yield quoted for a money market fund is after subtracting the expense ratio taken by the fund manager. It’s directly comparable with the yield on a high yield savings account. You don’t need to subtract the fund’s expense ratio again from the quoted yield.

The yield on a savings account is fixed until the bank or the credit union decides to change it. It’s completely up to the bank or the credit union as to when they’ll change it and how much they’ll change it.

FDIC Insurance

Money market funds aren’t insured by the Federal Deposit Insurance Corporation (FDIC), National Credit Union Administration (NCUA), or any other government agency. However, if you stick with money market funds offered by large brokers such as Vanguard, Fidelity, or Charles Schwab, they’re generally safe.

A money market fund that wasn’t offered by a top-3 broker did fail during the financial crisis in 2008. If you’re really concerned about safety, you can also use a money market fund that invests only in Treasuries or government debt. The money market fund itself isn’t insured but the underlying investments in the fund are backed by the government.

Savings accounts are insured by the FDIC (or NCUA for credit unions) for up to $250,000. The insurance goes up to $500,000 for a joint account.

Having FDIC or NCUA insurance is nice but I don’t lose sleep over not having it when I use a money market fund from a large broker. When there’s only a small difference in the yields between different types of money market funds, choose one that invests only in Treasuries or government debt for extra safety.

Fees and Minimums

A savings account can have a minimum deposit or monthly fees but the typical good high yield savings accounts don’t have any minimum balance requirement or monthly fees.

A money market fund can also have a minimum investment but many don’t. Many funds that have a minimum investment also have it only as the initial minimum. You need to put that much into the fund to get started but you don’t necessarily need to keep that much in the fund at all times. They don’t kick you out when your balance goes below the initial minimum.

Withdrawal and Transfer Limits

When you need to withdraw from a savings account or a money market fund, you usually just transfer the money to your checking account.

Savings accounts used to allow a maximum of six transfers per month by Regulation D of the Federal Reserve. The Fed removed that requirement from the banks but some banks are still imposing the old limit on their own. Avoid those banks.

Each bank or credit union sets the limit on the amount of the transfer on a per-transfer, per-day, or per-month basis. For example, Alliant Credit Union has an outbound transfer limit of $25,000 per day.

Brokers typically have a higher transfer limit than banks and credit unions. If you often transfer large amounts, use a money market fund.

Sweep Funds and Purchased Funds

A broker usually offers several different money market funds. They make some of them available as the default “sweep” fund in a brokerage account, while other money market funds stay as “purchased” funds.

A sweep fund (sometimes called a “core” or “settlement” fund) serves as the default cash position in your brokerage account. The cash you deposit into the account, dividends not automatically reinvested, or any proceeds from selling your investments “sweep” into this fund daily. Withdrawals and cash for new purchases come out of this fund. The broker may designate one money market fund as the default but they may also let you choose among a handful of funds to serve as the sweep/core/settlement fund.

Your choice for a sweep fund is limited. They don’t make all of their money market funds available as a sweep/core/settlement fund. The ones made available as a sweep fund don’t have the best yield because they have higher costs. The higher-yielding money market funds are only available as a “purchased” fund which requires an extra step to buy or sell just like other mutual funds.

A purchased money market fund isn’t as automatic but you get a higher yield to compensate. If you keep a large balance in a money market fund, it’s worth the extra step to buy and sell manually.

Tax Treatment

You pay both federal income tax and state income tax on the interest earned in a savings account. The tax treatment on the interest earned in a money market fund depends on the underlying investments in the fund.

There are five types of money market funds:

PrimeGovernmentTreasuryNational Tax-ExemptState-Specific Tax-Exempt

The last two types pay a lower yield but are tax-free at the federal level, which can be a good choice if you’re in a high tax bracket depending on the yield difference between tax-exempt funds and taxable funds. The state-specific tax-exempt funds are tax-free at both the federal and the state levels for residents in that state.

Federal Income TaxState Income TaxPrimeYesYesGovernmentYesPartialTreasuryYesNoNational Tax-ExemptNoPartialState-Specific Tax-ExemptNoNoTax Treatment

States don’t tax interest from Treasuries and bonds from their own state. Some states prorate. If 30% of the interest earned by a fund is from Treasuries and in-state bonds, 30% is tax-free for state income tax. Some states require a minimum percentage of interest or a minimum percentage of assets from these tax-free sources to qualify. If the minimum is 50% but the fund only earned 30% from Treasuries and in-state bonds, 100% of the interest is still taxable by that state.

The Best Money Market Funds

The same type of money market funds fish in the same pond, so to speak. The yield you receive from a money market fund depends heavily on the expense ratio the fund charges before paying you.

Among the top-3 retail brokers, Vanguard charges the lowest expense ratios in its money market funds. Even if you use another broker for your investments, you can still use Vanguard just for its money market funds as you do with a bank or a credit union for a high yield savings account.

Vanguard

The default settlement fund in a Vanguard brokerage account is Vanguard Federal Money Market Fund (VMFXX). This fund invests in U.S. government securities. It has an expense ratio of 0.11%. Any cash you add to the brokerage account automatically goes into this fund. There’s no minimum, and you don’t have to do anything extra to buy it.

Vanguard also offers some other money market funds for buying and selling manually. All require a minimum initial purchase of $3,000. Please click here to see the list (click on the Performance tab to see the current yield).

For maximum safety, Vanguard Treasury Money Market Fund (VUSXX, expense ratio 0.09%) invests exclusively in Treasuries. Interest from this fund is exempt from state and local taxes.

Fidelity

The default sweep/core fund in a Fidelity account depends on the account type. You can also change the core fund among a few available choices (except in the Cash Management Account).

The funds available as the sweep/core position include:

FundTypeExpense RatioFidelity Government Cash Reserves (FDRXX)Government0.33%Fidelity Government Money Market Fund (SPAXX)Government0.42%Fidelity Treasury Money Market Fund (FZFXX)Government0.42%Fidelity Core-Eligible Money Market Funds

These core funds don’t require any minimum. As you can see, the expense ratios of these Fidelity money market funds are higher than the expense ratios of Vanguard money market funds, resulting in a lower yield in general.

Fidelity offers additional money market funds for manual purchases. These other money market funds are “semi-automatic” at Fidelity. You must buy them manually but Fidelity will automatically sell them when your core fund is insufficient to cover your withdrawals and trades. This is unique to Fidelity. Both Vanguard and Charles Schwab require manual selling for “purchased” money market funds.

Here are some Fidelity money market funds with a higher yield:

FundMinimumTypeNet Expense RatioFidelity Money Market Fund Premium Class (FZDXX)$100kPrime0.30%Fidelity Money Market Fund (SPRXX)$0Prime0.42%Fidelity Treasury Only Money Market Fund (FDLXX)$0Treasury0.42%Fidelity Non-Core Money Market Funds

Prime money market funds have a higher yield because they invest in corporate debt in addition to government debt. You can earn slightly more by manually buying FZDXX ($100k initial minimum) or SPRXX (no minimum). For extra safety, buy FDLXX because it only invests in Treasuries.

When you buy FZDXX or SPRXX manually, you can receive a yield close to the yield on a Vanguard money market fund while staying in the same account at Fidelity. Fidelity will automatically sell FZDXX or SPRXX when you don’t have enough money in the core fund to cover withdrawals and trades.

Charles Schwab

Charles Schwab doesn’t offer a money market fund as the default sweep in its brokerage accounts. It uses a “bank sweep” as the default, which pays a much lower interest rate.

Schwab offers money market funds only as “purchased” money market funds. You’ll have to buy and sell these funds manually. Here are some of the available funds:

FundTypeNet Expense RatioSchwab Value Advantage Money Fund (SWVXX)Prime0.34%Schwab Government Money Fund (SNVXX)Government0.34%Schwab U.S. Treasury Money Fund (SNSXX)Treasury0.34%Schwab Purchased Money Market Funds

You can receive a yield close to the yield on a Vanguard money market fund while staying in the same account at Charles Schwab but you will have to buy and sell a money market fund manually. For extra safety, buy SNSXX because it only invests in Treasuries.

Merrill Edge

Similar to Charles Schwab, Merrill Edge also only offers a “bank sweep” as the default cash option, which pays a low interest rate.

However, you can buy and sell a number of money market funds manually. See the full list on Merrill Edge’s website. Here are some higher yielding funds:

FundTypeNet Expense RatioBlackRock Liquidity Funds: Treasury Trust (TTTXX)Treasury0.17%Federated Hermes Treasury Obligations Fund (TOIXX)Government0.20%Fidelity Investments Money Market Treasury Only Class I (FSIXX)Treasury0.18%Select Money Market Funds at Merrill Edge

Although these institution-class funds normally require a very large minimum investment, you can buy them at Merrill Edge with only a minimum of $1,000.

***

Both a high yield savings account and a money market fund work for temporary savings. A money market fund has the benefit of automatically adjusting to the current market yield (minus the fund’s expense ratio). You aren’t at the mercy of a bank’s decision to catch up or stay behind. If you’re in a high-tax state, using a Treasury money market fund gives you the highest safety, and the interest is exempt from state and local taxes.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post Guide to Money Market Fund & High Yield Savings Account (2022) appeared first on The Finance Buff.

Calculator: How Much of My Social Security Benefits Is Taxable?

Social Security benefits are 100% tax-free when your income is low. As your total income goes up, you’ll pay federal income tax on a portion of the benefits while the rest of your Social Security benefits remain tax-free. This taxable portion goes up as your income rises but it will never exceed 85%. Even if your annual income is $1 million, at least 15% of your Social Security benefits will still be tax-free.

The amount of the taxable Social Security benefits becomes part of your gross income on your tax return. It’s still subject to your normal deductions to arrive at your taxable income. You still pay at your normal tax rates on the taxable amount. 50% or 85% of your benefits being taxable doesn’t mean you’ll pay a 50% or 85% tax on your benefits. The actual taxation on your benefits is much less.

The IRS has a somewhat complex formula to determine how much of your Social Security benefits is taxable and how much is tax-free. It first calculates a combined income that consists of half of your Social Security benefits plus your other income such as withdrawals from your retirement accounts, interest, dividends, and short-term and long-term capital gains. It also adds any tax-exempt interest from muni bonds. This income is then reduced by a number of above-the-line deductions such as deductible contributions to Traditional IRAs, SEP-IRAs, SIMPLE IRAs, HSAs, deductible self-employment tax, and self-employment health insurance. Finally, this provisional income goes through some thresholds based on your tax filing status (Married Filing Jointly or Single/Head of Household). All of these are in Worksheet 1 in IRS Publication 915.

You can go through the steps in the worksheet to calculate the amount of social security benefits that will be taxable but the worksheet isn’t the easiest to use. I made an online calculator that helps you calculate much more quickly. You only give three numbers plus your tax filing status. You’ll have your answer by clicking on a button.

The calculator works for all types of Social Security benefits. It doesn’t matter whether you’re receiving retirement income benefits, disability benefits, spousal benefits, or survivor benefits as a widow or widower. It only applies to federal taxes though. Different states have different rules on taxing Social Security benefits. State taxes don’t necessarily follow the same rules as the federal government.

Note to email subscribers: The embedded calculator below doesn’t work directly in the email. Please click here to use it online.

function calc() { status = document.forms["SSTaxableCalc"]["filing-status"].value; ss = Number(document.forms["SSTaxableCalc"]["ss"].value); other = Number(document.forms["SSTaxableCalc"]["other"].value); adj = Number(document.forms["SSTaxableCalc"]["adjustment"].value); if (status == "MFJ") { floor = 32000; gap = 12000; } else { floor = 25000; gap = 9000; } income = Math.max(other ss / 2 - adj - floor, 0); above_gap = Math.max(income - gap, 0); half_gap = Math.min(income, gap) / 2; fifty_pct_tier = Math.min(ss, half_gap); eighty_five_pct_tier = above_gap * 0.85; taxable = Math.min(fifty_pct_tier eighty_five_pct_tier, ss * 0.85); tax_free_pct = 100 - taxable / ss * 100; document.getElementById("taxable").innerHTML = Math.round(taxable).toLocaleString(); document.getElementById("percentage").innerHTML = Math.round(tax_free_pct); document.getElementById("results").style.display = "block";}Tax Filing Status:Married Filing Jointly
Single or Head of HouseholdSocial Security benefits:Other income (including tax-exempt muni bond interest):Above-the-line deductions. These include deductible contributions to HSA, traditional IRA, SEP-IRA, and SIMPLE IRA, and deductible self-employment tax and self-employment health insurance.

$ of your Social Security benefits is taxable, which means % of your benefits is tax-free.

When more than 15% of your Social Security benefits is tax-free, additional income outside Social Security will make more of your Social Security benefits taxable, reducing that number toward 15%. Some people call this the tax torpedo, but it’s a misleading term. You actually still pay lower taxes than other people with the same income. See why that’s the case in An Unusually High Marginal Tax Rate Means Paying Lower Taxes.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post Calculator: How Much of My Social Security Benefits Is Taxable? appeared first on The Finance Buff.

Random Thoughts From a Month-Long Trip to Switzerland

I learn something every time I take a long trip to another country. When I went to Peru, it was “Choose what you do.” When I went to Kenya, it was “Take it slow.” When I went to Bolivia, it was “Experience early.”

I took a month-long trip to Switzerland recently. If I sum up the learning from this trip, it’s this — Our way isn’t the only way.

Coffee

Most people drink coffee in a cup or mug here in the U.S. When I was at a mountain hut in Switzerland, I saw people pouring coffee into a bowl, putting butter or jam on their bread, and then dipping the bread into the coffee bowl.

That’s weird to me but they must have their good reasons. Maybe I should try it. Our way isn’t the only way.

Transportation

I drive everywhere here in the U.S. but I didn’t need a car for a whole month while I was in Switzerland. I took trains and buses everywhere. This wasn’t limited to only large cities like Zurich or Geneva. Some small villages I went to had a population of no more than 1,000 people.

Trains go into the airport. You come out of the airport terminal and go directly into the train station. Regional buses wait at the train station. You come off the train and hop on a bus. They have a mobile phone app that tells you which trains and buses to take and you can buy one through-ticket that covers all the connections directly in the app even though the underlying trains and buses are operated by different companies.

The trains and buses aren’t necessarily fast but they are reliable. If the schedule in the mobile app says the train will arrive at 9:37, it shows up at 9:37. If you have only four minutes to switch from one train to another, you won’t miss the connection.

Going by train and bus is so much more convenient and less stressful. Swiss people of course also have cars. They just drive less frequently. Having fewer cars on the road means less pollution, less congestion, less road rage, and fewer traffic deaths and injuries.

As soon as I got back to the U.S., I needed a Uber to get home from the airport. It was such a big contrast.

Having good public transportation isn’t just a matter of population density. The state of New Jersey has more population in a land area about half the size of Switzerland. I definitely needed a car when I visited New Jersey. Our way of everybody driving everywhere isn’t the only way to organize transportation.

Free Enterprise + Public Infrastructure

I watched the movie Heidi before I left for Switzerland. It showed that Switzerland used to be a poor country. The Swiss people raised cattle and sheep in the mountains (famous for Swiss cheese). A poor girl was sent to Germany as the companion to a wealthy family’s daughter. She was laughed at for not being able to read.

Switzerland’s per-capita GDP is higher than that of the U.S. now. It’s as hands-off to capital as it gets. As a small country of only eight million people with a tiny domestic market, it has the largest food company in the world. As a land-locked mountainous country, it has the world’s largest ocean container shipping company. Without large mining resources of its own, it has the world’s largest commodity trading and mining company. Russian oligarchs have their operations there. Two Swiss pharmaceutical companies are in the global top five. Such a small country has a vastly disproportional economic power in the world.

The commitment to free enterprise didn’t stop the country from providing public infrastructure though. Their trains are run by a company 100% owned by the government. The inter-region buses are operated by a subsidiary of the country’s postal system. I saw the bus driver picking up mail from drop boxes along the way.

Tuition at many public universities in Switzerland is under $1,000 per semester. Albert Einstein got his college and Ph.D. degrees at a public university in Switzerland.

Funding public infrastructure obviously requires taxes. Swiss citizens see the long-term benefits to its economy from good public transportation and good public education. Our way of lower taxes isn’t the only way to have a thriving economy.

Direct Democracy

Like the United States, Switzerland also has a federal form of government. Citizens in its 26 states (“cantons”) literally don’t speak the same language. As I traveled from one canton to another and sometimes from the eastern part of the same canton to the western part, all the signs in the streets changed from German to French (I didn’t go to the Italian-speaking part of the country).

Rather than having two political parties dueling with each other and resulting in oscillating policies when one party comes to power versus the other, the Swiss legislature is made up of 11 different parties. With proportional representation as opposed to a winner-take-all system, gerrymandering isn’t a thing. All political leanings are represented. It doesn’t matter if you’re a conservative in a blue state or if you’re a liberal in a red state.

Seven members from 4 different parties form a Federal Council that governs the country. The 7 members rotate to serve a one-year term as the President. The President doesn’t have any more power than any other member of the council. A stable government built on consensus creates a good environment for the economy.

Rather than going through years of litigation and having a judge or a handful of judges overturn laws, Swiss citizens can overturn laws directly in referendums held 3 or 4 times every year. Citizens can also amend the constitution directly in a referendum. The number of signatures needed to put an issue on the referendum is relatively low. The government and the legislature won’t make unpopular moves when they know citizens can easily veto them in a few months. The will of the people prevails.

Here in the U.S., we hold our constitution and the founding fathers in high regard as if they had the best design. I realized it isn’t the only way when I saw how well the Swiss constitution was designed. The American founding fathers had to deal with the problems they were facing at the time. They couldn’t foresee the structural problems they created.

Direct democracy of course also has its problems. The county I live in now needed a new high school due to population growth resulting in overcrowding at the existing high school. When the county school district put a bond issue on the ballot in 2019, citizens in the county voted it down because they didn’t want to pay higher property taxes. Now, three years later, the population grew some more and the overcrowding got worse. The county still needed a new high school but construction costs have gone up a lot and the interest rate for issuing a bond has gone up a lot as well. Citizens have to pay higher property taxes now because they waited. People sometimes make mistakes but on balance I think it’s better to give the power to the people.

***

Back to our usual money and finance topics, sometimes we think our way is the only way, and any other way will result in a disaster. It’s not true. We should always keep an open mind. Living in a low-cost-of-living area works. So does living in a high-cost-of-living area. Entrepreneurship works. So does working a W-2 job. Investing in index funds works. So does investing in real estate. What made us successful isn’t the only way.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post Random Thoughts From a Month-Long Trip to Switzerland appeared first on The Finance Buff.

ACA Premium Subsidy Cliff Turns Into a Slope Through 2025

[Updated after the passing of the Inflation Reduction Act of 2022.]

I have been buying health insurance on an exchange under the Affordable Care Act (ACA) since 2018. Before the ACA, getting health care coverage was one of the biggest challenges for becoming self-employed. Forget about the cost — just getting a policy was a challenge by itself. ACA changed all that. Now self-employed people and others who don’t get health insurance through their jobs can buy health insurance on the exchange.

Not only are you able to buy health insurance, but the coverage is also made affordable by the premium subsidy in the form of a tax credit. How much tax credit you get is calculated off of your modified adjusted gross income (MAGI) relative to the Federal Poverty Level (FPL) for your household size.

Your MAGI for the purpose of ACA is basically:

your gross income;minus pre-tax deductions from paychecks (401k, FSA, …)minus above-the-line deductions, for example: pre-tax traditional IRA contributionsHSA contributions1/2 of self-employment taxpre-tax contribution to SEP-IRA, solo 401k, or other retirement plansself-employed health insurance deductionstudent loan interest deduction plus tax-exempt muni bond interest;plus untaxed Social Security benefits

Wages, interest, dividends, capital gains, pension, withdrawals from pre-tax traditional 401k and IRAs, and money you convert from Traditional to Roth accounts all go into MAGI for ACA. Otherwise-not-taxed muni bond interest and Social Security benefits also count in MAGI for ACA.

Side note: There are many different definitions of MAGI for different purposes. These different MAGIs include and exclude different components. We’re only talking about MAGI for ACA here.

400% FPL Cliff Converted To a Slope

Your tax credit goes down as your income increases. Up through the year 2020, the tax credit drops to zero when your MAGI goes above 400% of FPL. If your MAGI is $1 above 400% FPL, you pay the full premium with zero tax credit. People had to be very careful in tracking their income to make sure it doesn’t go over the cliff.

For a household of a single person in the lower 48 states, that cutoff was just shy of $50,000 in 2020. For a household of two people in the lower 48 states, the cutoff was $67,640 in 2020. See Federal Poverty Levels (FPL) For Affordable Care Act for where 400% of FPL is at for your household size.

Now thanks to the American Rescue Plan Act of 2021 and the Inflation Reduction Act of 2022, for five years only — 2021 through 2025 — this cliff becomes a slope. The tax credit will continue to drop as your income increases but it won’t suddenly drop to zero when your income goes $1 over the cliff.

The chart above shows the ACA premium tax credit at different income levels for a household of two people in the lower 48 states where the second lowest cost Silver plan costs $1,000/month. The blue line is for 2020. The orange line is for 2021. The gap between the two lines represents the change between 2020 and 2021. The new law also increased the tax credit before the old cliff but the increase was much more significant after that point. The tax credit was zero at $70,000 income in 2020, but it will be about $500/month in 2021.

Because health insurance premium is higher for older folks and health insurance costs more in some areas of the country, the tax credit is also higher for someone older with the same MAGI and in areas where health insurance is more expensive.

Not having to watch out for the cliff is a huge relief to people closer to the edge of the old cliff, but the new laws are only effective for five years from 2021 through 2025. Unless another law extends it, the cliff will come back in 2026.

When the Cliff Comes Back

The ACA subsidy cliff is scheduled to come back in 2026. People will have to manage their income and watch out for the cliff again. The most critical part is to project your income before the end of the year and not realize income willy-nilly before you do the projection. If you find yourself close to the cliff before you realize income, you can still adjust. Many people are caught by surprise only when they do their taxes in the following year. Your options are much more limited after the year is over.

Fortunately, it’s relatively easier to stay under the cliff for those who rely on an investment portfolio for income. When you are before 59-1/2, you’re primarily spending money from your taxable accounts. A large part of the money withdrawn is your own savings; the rest is interest, dividends, and capital gains. Spending your own savings isn’t income. If you withdraw $60k to live on, your MAGI isn’t $60k. It’s probably less than $30k.

When you supplement your income with part-time self-employment, you still have the option to contribute to pre-tax traditional 401k, IRA, and HSA. Those pre-tax contributions lower your MAGI, which helps you stay under the 400% FPL cliff when necessary.

100% and 138% FPL Cliff

There is another cliff on the low side, although that one is easily overcome if you have retirement accounts.

In order to qualify for a premium subsidy for buying health insurance from the exchange, you must have income above 100% FPL. In states that expanded Medicaid to 138% FPL, you must also not qualify for Medicaid, which means you must have MAGI above 138% FPL.

These are checked only at the time of enrollment. Once you get in, you’re not punished if your income unexpectedly ends up below 100% or 138% of FPL. If you see your income next year is at risk of falling below 100% or 138% FPL when you enroll, tell the exchange you’re planning to convert some money from your Traditional 401k or Traditional IRA to Roth. That’ll raise your income.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post ACA Premium Subsidy Cliff Turns Into a Slope Through 2025 appeared first on The Finance Buff.