Jonathan Clements's Blog, page 417

Who Needs Munis?

IT’S A COMMON PLOY among columnists: You start with the provocative statement—and then spend the rest of the article dancing like crazy, trying to defend it. Today’s provocative statement: Except in a few rare instances, I’m not sure why anybody would ever own municipal bonds.

At first blush, this sounds not just provocative, but downright stupid. If you’re in a high income-tax bracket and investing money through a regular taxable account, it would be foolish to buy taxable bonds and then pay income taxes on the interest you earn. You would be better off sidestepping that tax bill and instead purchasing lower-yielding but tax-free municipal bonds.

That’s correct, except for one small issue: Why would you buy bonds in a taxable account? Why not use your taxable account to pursue a tax-efficient stock strategy, such as investing in broad stock market index funds, so you take advantage of the special low rates on long-term capital gains and qualified dividends? Meanwhile, to the extent you want to own bonds, why not purchase taxable bonds in your retirement account and reap the benefit of the higher yield?

This suggestion would not be helpful for two groups of high-income investors. First, there might be folks who have little or no money in tax-favored retirement accounts, so there’s no way they could buy all the bonds that their portfolio requires in a retirement account. Second, there may be high-income earners who want nothing to do with the stock market, so their entire portfolio is in bonds. For these investors, I graciously concede that owning municipal bonds in their taxable account makes sense.

But not for anybody else.

“Wrong,” you cry. “I’m worried about a financial catastrophe, such as losing my job or a huge medical bill. That means I need easy access to cash—and the right strategy, at my lofty tax bracket, is to own munis in my taxable account.”

Maybe not. Imagine you have $100,000 in stock-index funds in your taxable account and $100,000 in taxable bonds held in your retirement account. Your world then implodes. Not only do you lose your job, but also the stock market plunges 30%.

Now, you have $70,000 in stocks in your taxable account, which you are loath to sell at such depressed prices. Meanwhile, your bonds have rallied to $105,000, but you can’t get access to that money without paying tax penalties, because it’s sitting in a retirement account and you’re under age 59½.

Game over? Not at all. Let’s say you need $20,000 to cover your living expenses for the months ahead. You cash in part of your stock-index fund holdings, perhaps realizing a tax loss in the process. Even with a tax loss, that doesn’t seem so smart, because you just sold stocks at fire-sale prices.

But the damage is easily repaired. Within your retirement account, you shift $20,000 from bonds to stocks. Result: You still have the same amount in stocks. Indeed, you have effectively sold bonds to cover your financial emergency.

And, no, this isn’t some crazy pie-in-the-sky strategy: It’s how I handle my own portfolio—with my taxable account entirely in stock-index funds and all my bonds held in my retirement account.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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Savings: 10 Questions to Ask

IF YOU DON’T SAVE DILIGENTLY, you are highly unlikely to amass a decent-size nest egg. Time to make amends? Here are 10 questions to ponder:

Do you regularly spend more than planned? Try writing down every purchase you make. That’ll tell you where your dollars are going—and make you think twice before spending.
How much of your income goes toward fixed living costs? We’re talking about items such as mortgage or rent, car payments, utilities, groceries and insurance premiums. If your fixed living costs are too high, you’ll find it tough to save, no matter how determined you are.
If you have goals other than retirement, are you saving more than 12% of income? That 12% is probably the minimum you should be socking away each year for retirement. If you’re looking to make a house down payment or fund the kids’ college, that will require additional savings.
Is 12% enough? With long-run stock and bond returns expected to be modest, it might be safer to sock away more than 12% for retirement.
Should you force yourself to save—by automating your savings? Many folks use payroll deduction to fund their employer’s 401(k) or 403(b) plan. But you could also automate other savings, such as automatically moving money every month from your checking account to a high-yield savings account or to your favorite mutual funds.
To save even more, how about cutting living costs—and then upping your automatic investments by an equal amount? Let’s say you save $150 a month by downgrading your cable package, cancelling magazine subscriptions, using a cheaper gym, and raising the deductibles on your home and auto insurance. To ensure those savings don’t get squandered, you might immediately increase your automatic monthly investments by $150.
Could you turn debt payments into savings? Suppose you’re about to pay off a student loan or car loan. You’re used to living without the money, so it shouldn’t be any great sacrifice to redirect the sum involved to your favorite mutual fund.
Do you have excess cash in your checking account? Move it to a high-yield savings account or a low-cost money market mutual fund. If you leave the money in your checking account, it’ll earn little or no interest—plus you may be tempted to spend it.
Could your savings be working harder? If you favor lower-cost investments, take advantage of tax-deductible and tax-free retirement accounts, and ensure you collect the full matching contribution offered by your employer’s 401(k) plan, your savings will almost certainly grow faster.
Should you create a wish list for major expenses? By keeping a running list of potential major expenditures—things like remodeling projects, new furniture, new cars and vacations—you’ll give yourself extra time to ponder whether these are good uses for your money.

This is the sixth blog in a series. The earlier articles were devoted to retirement, housing, college, your family’s safety net, and money and happiness. Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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Sell or Sweat?

DON’T GIVE INVESTMENT ADVICE to clients. That’s something I’ve repeatedly learned as a tax lawyer. Still, when financial markets gyrate, many clients want advice about taxes, especially the seemingly simple rules for capital gains—and I have a long-standing fondness for eating three times a day.

Let’s start with the basics. Take an individual who sells an investment that she has owned for more than 12 months. Any increase in its value from its cost basis is taxed at her long-term capital gains rate—15% for most individuals, but as high as 23.8% for those who are in the top ordinary income-tax bracket of 39.6% and subject to the 3.8% Medicare surtax on investment income.

It can get worse. She surrenders more to the IRS when her profit is from the sale of an asset held for 12 months or less. Her short-term capital gain is taxed at higher ordinary income-tax rates—the same rates that apply to income sources like salaries and pensions.

The dilemma: Should savvy investors opt to realize short-term gains, so as to nail down profits, albeit causing them to be nicked for taxes at the same rates as ordinary income? Or is the wiser strategy to stand pat until those profits become long-term, meanwhile hazarding declining prices that could more than offset the lower taxes?

Consider an example. Let’s say Norma Bates’s regular income-tax bracket is 25%. (In 2017, that rate applies to taxable income between $37,950 and $91,900 for singles and between $75,900 and $153,100 for joint filers.) Norma has a sizable unrealized gain on shares of Beefsteak Uranium, a volatile stock she has owned for fewer than 12 months.

She’s considering selling her BU shares for fear of plummeting prices, perhaps caused by terrorist attacks or world instability (cue countries like North Korea, Iran and Russia). Norma’s worst fear: photos of BU’s top execs being booked on charges of securities fraud and larceny, a result of cooking the books, spending company funds on personal indulgences or some other kind of corporate chicanery.

Her first option: Unload the shares now and secure the short-term gain, but lose 25% of her profit to the IRS. Depending on where she lives, she may also owe state and even city taxes.

Her other option: Hold off on a sale until the gain becomes long-term, and forfeit no more than 15% of it to the IRS, plus local levies.

How much of a drop can Norma endure while waiting until she qualifies for that lower rate and still be no worse off after taxes? For the answer, she can use this three-step calculation:

Figure her after-tax short-term profit from her BU shares.
Divide this amount by her after-tax profit on the same amount of long-term gain.
Multiply the short-term gain by the resulting decimal.

To see how the math work, let’s plug in some numbers. Suppose Norma’s paper profit is $10,000. Her combined federal and state bracket is 30% for short-term gains. For long-term gains, it’s 20%.

A $10,000 gain taxed at 30% entitles the tax collectors to $3,000, leaving Norma with $7,000.
The same $10,000 taxed at 20% leaves her with $8,000. Divide $7,000 by $8,000 and you get 0.875.
Multiply $10,000 by 0.875 and the result is $8,750. A smaller long-term profit of $8,750 taxed at 20% leaves Norma with $7,000—the same profit she would have received were she to sell for a $10,000 gain and be taxed at 30%.

When does a decision to sweat out the 12-month holding period leave Norma worse off after taxes? Not until her paper profit drops from its present $10,000 to below $8,750—that is, by more than $1,250. Is it worth waiting? Clients have to decide that one for themselves.

Julian Block writes and practices law in Larchmont, NY, and was formerly with the IRS as a special agent (criminal investigator). His previous blog was Hitting Home. This article is excerpted from Julian Block’s Year-Round Tax Savings, available at JulianBlockTaxExpert.com. Follow Julian on Twitter @BlockJulian.

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On Our Own

IT ALL BEGAN WITH AN AFTERNOON phone call between Andrew, my twin brother, and me. I made an off-the-cuff comment about starting our own company. For the previous eight years, both of us had worked at a large lawn care company and then, for a few brief months, at a medium-sized landscaper.

Neither of us doubted we would be successful. But we were taking a large financial risk: Starting our own company meant leaving the security of a regular paycheck, health insurance, a workplace retirement plan, a company vehicle and more. We both had mortgages and, of course, utility bills to pay and groceries to buy. I was single at the time, but Andrew had a family to provide for, so it was important for him to have a salary from our new company.

Meanwhile, I drew on savings to cover personal expenses. In earlier blogs, I have mentioned that I am frugal. Not only did I know how to keep my expenses to a minimum, but also being careful with my money had allowed me to accumulate a healthy amount of savings, so I was well prepared for the lean months that lay ahead. I wouldn’t take a salary for the entire first year. Fortunately, health insurance was a relatively modest expense, because of my young age, and I never considered going without. To do so would, in my opinion, be penny wise and pound foolish.

At our previous employer, we both had a company vehicle. Rather than buy a new vehicle, I gave Andrew my car to make sales calls, while I used our new company’s first truck not only to perform the fall work that we had been contracted to do, but also for my personal use.

Ensuring that we had sufficient work during the fall months was important, so we would have enough money going into the following spring. There would be large upfront costs, such as trucks, trailers, equipment and materials.

Thankfully, there was a lot of work that first fall, most of it coming from a company whose owner we knew from the lawn care company that had previously employed us. I worked 12- to 14-hour days to get all the work done. It was an exhausting time. Over those fall months, we were able to bring in sufficient money to pay cash for the trailers and equipment needed for the spring, though we borrowed to buy the trucks. We also asked each of our parents for a $10,000 loan, which we repaid within a year.

The short-term personal financial sacrifices that we both made allowed us to avoid having to take out bank loans, which benefitted the company in the long run. In that first year, we had a very small loss. But there was never another year when we weren’t profitable.

Nicholas Clements is one of Jonathan’s older brothers. He is retired and lives just outside Washington, DC. His previous blogs include Growing Up (Part III),  Less Green and  Not a Good Time . Follow him on Twitter @MDScaper .

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This Week/Aug. 20-26

GIVE AWAY MONEY NOW? You might be considering a large financial gift to your favorite charity or to your children. Charitable contributions aren’t limited, though their tax-deductibility can be. Meanwhile, with our kids, we might take advantage of the $14,000 annual gift-tax exclusion. But before we do, we should check we have plenty for own retirement.

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Protection Money

VANGUARD GROUP has long been my favorite fund company—and the place where I now keep all my investment dollars. There’s no mystery why: Among mutual fund companies, Vanguard has long been not only the biggest champion of index funds, but also the firm with the lowest annual fund expenses.

Except that’s no longer the case.

Fidelity Investments, BlackRock’s iShares and Charles Schwab have all muscled onto Vanguard’s turf, offering index funds with lower annual expenses. This is obviously a marketing ploy: By offering cut-rate deals on select index funds, they hope investors will also buy some of their pricier merchandise.

Still, this is a potential bonanza for investors, who can now invest at extraordinarily low cost. Suppose you were aiming to build a global balanced portfolio, with 40% bonds and 60% in stocks. The 60% stock portion is split so you have 40% in the U.S. and 20% overseas, including a 4% allocation to emerging markets. Here’s how much you would pay at four major fund companies:

Fidelity Investments

40% Fidelity Total Market Index Premium Class (0.035%)
20% Fidelity Global ex U.S. Index Premium Class (0.1%)
40% Fidelity U.S. Bond Index Premium Class (0.045%)
Portfolio’s weighted expenses: 0.052%
Annual cost: $52 per $100,000

iShares

40% iShares Core S&P Total U.S. Stock Market ETF (0.03%)
20% iShares Core MSCI Total International Stock ETF (0.11%)
40% iShares Core U.S. Aggregate Bond ETF (0.05%)
Portfolio’s weighted expenses: 0.054%
Annual cost: $54 per $100,000

Charles Schwab

40% Schwab U.S. Broad Market ETF (0.03%)
16% Schwab International Equity ETF (0.06%)
4% Schwab Emerging Markets Equity ETF (0.13%)
40% Schwab U.S. Aggregate Bond ETF (0.04%)
Portfolio’s weighted expenses: 0.0428%
Annual cost: $42.80 per $100,000

Vanguard Group

40% Vanguard Total Stock Market ETF (0.04%)
20% Vanguard Total International Stock ETF (0.11%)
40% Vanguard Total Bond Market ETF (0.05%)
Portfolio’s weighted expenses: 0.058%
Annual cost: $58 per $100,000

The three Fidelity funds are mutual funds, which means you can buy them directly from Fidelity, with no additional cost. All three funds require a $10,000 minimum investment. The other funds listed are exchange-traded index funds, so buyers would likely lose a little to trading spreads and perhaps commissions. In the case of the three Vanguard funds and three of the four Schwab funds, there are corresponding mutual funds with the same annual expenses. The similar-cost Vanguard funds have $10,000 investment minimums, while the Schwab funds have no required minimum.

Keep in mind that expenses aren’t the sole driver of differences in index fund performance. Funds can also help performance by skillfully replicating their target index or by making money from securities lending.

But forget those issues. Based solely on expenses, it looks like Vanguard wouldn’t be anybody’s first choice. And yet I’m not about to move my money elsewhere.

Why not? Vanguard is effectively owned by the shareholders of its funds, and it benefits those shareholders by operating its funds at cost. If Vanguard is operating at cost, all of these other firms are either barely breaking even and possibly losing money. How long will these firms—which, unlike Vanguard, are profit-making entities—be willing to operate that way?

Maybe it’s forever. But maybe it’s only until the investment dollars stop pouring in, at which point these firms might decide its time to make a little money off the assets they’ve gathered. At that juncture, shareholders will face a tough choice: They can either stick with funds that are no longer dirt cheap—or they can move to lower-cost funds. The problem: Selling could trigger capital gains taxes if investors own their index funds in a regular taxable account. By contrast, selling in a retirement account wouldn’t trigger taxes, but it would be a hassle—and investors could incur modest transaction costs and perhaps find themselves out of the market for a few days.

Or these investors could just stick with Vanguard, where there shouldn’t be any sudden price hikes. Right now, on our hypothetical balanced portfolio, that would mean paying as much as $15 a year extra for every $100,000 invested. I think of it as protection money—and it strikes me as small price to pay.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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Happiness: 10 Questions to Ask

COULD YOU SQUEEZE MORE HAPPINESS from your dollars? Here are 10 questions to ponder:

Which expenditures from the past year do you remember with a smile? Which prompt a shrug of the shoulders and maybe even a twinge of regret? Use those insights to guide your spending in the year ahead.
Could you commute less? Research tells us that commuting is terrible for happiness. You might move closer to the office or try to work at home a few days each week.
When during your life do you recall being happiest? Try to figure out what made it a happy time and what role money played. Could this help you to use your money more wisely in future?
Are there chores you dislike, such as mowing the lawn, cleaning the house or making dinner? Paying others to do these chores could be a good use of your money—and deliver a big boost to your happiness.
Should you make more time for friends and family? Many activities, such as exercising, eating lunch and going to the movies, are far more fun when you do them with others.
Which activities are you most passionate about and find most absorbing? Could you rearrange your life, so you devote more time to these activities?
Are you making yourself feel poor? If you live in a town where most of your neighbors are richer, shop at stores you can barely afford or eat at restaurants where the bill is always a nasty shock, you’re likely hurting your happiness.
What career would you pursue if money weren’t an issue? In middle age, many folks grow weary of their current jobs and think of changing careers. What would it take financially to make such a big change?
Which major expenditures would you like to make in the years ahead? Whether it’s a major home remodeling project, a special vacation or a new car, you’ll get more happiness from the dollars you spend if you plan ahead, so you have a long period of eager anticipation.
What are you grateful for? You may be able to squeeze a little more happiness from your latest pay raise or last year’s family reunion if you pause for a moment and think how lucky you are.

Want to read more about money and happiness? Check out HumbleDollar’s Nine Simple Strategies for a Happier Life and Five Takeways from Happiness Research.

This is the fifth blog in a series. The earlier articles were devoted to retirement, housing, college and your family’s safety net. Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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Hitting Home

WHEN IT COMES TO YOUR HOME, ignorance about taxes isn’t bliss—and it could be disastrous. I often field tax questions from homeowners. Most don’t understand how they’re affected by continuously changing tax rules. Even worse, they’re totally unaware that the rules have changed.

Want to save thousands of dollars? What follows are reminders of how to sidestep tax pitfalls and take maximum advantage of frequently missed—but perfectly legal—opportunities:

Mortgage points. Do you plan to purchase a new dwelling around year-end? Try to wrap things up by Dec. 31. If, to obtain a mortgage, you pay points (each point equals 1% of the loan amount) to the lender, that will qualify you for an itemized deduction on Schedule A of Form 1040 for the current year.

You can take an immediate deduction in full for points paid on a loan to purchase, construct or improve your main home—but not a rental property or a second home that you use as a vacation retreat.

Refinancing an existing mortgage. Do that and you need to familiarize yourself with a different set of rules. Use the loan proceeds to improve your home and you can fully deduct the points. Refinance just to take advantage of lower interest rates and you must claim points only in dribs and drabs over the loan’s full term—by dividing what you paid in points by the number of monthly payments you will make over the life of the loan.

Borrowers who refinance for a second or third time frequently overlook sizable write-offs. Serial refinancers are entitled to immediately deduct what remains of the points from previous refinancings. But borrowers fail to recall those points, because they don’t show up on the closing papers of new refinancings.

Typically, several thousand dollars fall right through the cracks. For refinancers in a combined 30% federal and state bracket, every $1,000 they write off lowers taxes by $300—more than enough to pay for a pleasant night on the town.

Keep track of home improvements. The money spent yields no current deduction, but is added to your home’s cost basis—the figure used to determine gain or loss on a sale of the property. Hence, improvements reduce any taxable profit when you eventually sell.

Like most home sellers, you’re probably aware of rules that relieve you of taxes on a home-sale gain of as much as $250,000 for a single person or a married person filing a separate return, and up to $500,000 for a married couple filing a joint return. But many people are unaware that anyone with a gain greater than the exclusion threshold of $250,000 or $500,000 is stuck with taxes on the excess. No longer are sellers allowed to postpone taxes on their entire gain by buying another home that costs more than what they received for the one sold.

IRS audits. In the event the IRS questions how you calculated the gain, the audit will be less traumatic and less expensive if you’ve kept meticulous records that track the dwelling’s basis. Those records should include what you origin­ally paid for your property, plus settlement or closing costs, such as title insurance and legal fees. They should also include what you later shell out for improvements, such as adding a room or paving a driveway, as opposed to routine repairs or maintenance that add nothing to the place’s value, such as painting or papering a room or replacing a broken windowpane.

Bundle ordinary repairs into a bigger job. It might pay to postpone repair projects until they can be done in connection with an extensive remodeling or restoration project. Adding the smaller jobs into the bigger job may allow you to include some items that would otherwise be considered repairs, such as the cost of painting rooms.

Julian Block writes and practices law in Larchmont, NY, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. This article is excerpted from Julian Block’s Home Seller’s Guide to Tax Savings, available at JulianBlockTaxExpert.com.

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College, Then and Now

WORKING AT A COLLEGE is a bit like being in a time warp. Every year, I get older, but the students don’t. The 20-somethings I deal with make me realize just how much times have changed since I attended college.

Tuition. When I was a college student in the 1980s, 529 plans didn’t exist. Of course, tuition costs were also much lower, so there wasn’t as much need for a college savings plan.

Because I had to pay my own way through school, I chose to attend a local community college to get my basic prerequisite coursework out of the way. Tuition was $19 per credit or, if you attended fulltime, $209 per term. Back then, if you paid fulltime tuition, you could take as many credits as you wanted. Whether you took 12 credits or 24, it cost the same. In an effort to finish school as quickly as possible, I often loaded up on coursework, taking 14 to 18 credits per term.

These days, tuition at the community college I attended stands at $110 per credit and there’s no longer a break for fulltime students. Taking more credits means paying more tuition. Of course, tuition at an in-state community college is still a bargain. That’s especially true compared to a private four-year school like the one I work at, where tuition currently runs $53,900 per year.

Financial help. I paid for most of my education through merit scholarships. I applied for as many as I was eligible for, most of which were worth $250 to $500. I earned scholarships through my involvement with the 4-H program and the American Dairy Goat Association, as well as other organizations. Those small awards provided enough money to pay for all my tuition for the two years I attended community college, and also covered the cost of the used textbooks I purchased. In addition, I worked part-time at the college as a student adviser, earning $3.35 an hour. The main benefit of the job was that it allowed me to register for classes before other students did, ensuring I could always reserve a place in the classes I needed to take.

Today’s college students have access to over $3 billion in private scholarship money. But the overwhelming majority of financial aid comes from the $46 billion awarded by the U.S. Department of Education. The average cost of a textbook rose 82% between 2002 and 2013. One result: A $250 scholarship wouldn’t cover one semester’s worth of books for the average student these days.

The students who work for me now make $11.25 an hour—more than three times what I made back in 1985. Even though the average cost of tuition and fees at most universities increased 179% between 1996 and 2015, a part-time job can still provide students with a way to cover some of the fees and expenses of college, so they don’t have to take out so much in loans.

Dorm life. When I’d finished taking my prerequisite classes at a community college, I moved away from home and enrolled at an in-state university to get my bachelor’s degree. I was fortunate that my best friend from high school lived in a house located just off campus. She let me sublet a bedroom in the house for $75 a month. I didn’t own a car, so I rode a bicycle to class every day. My college diet consisted mostly of peanut butter sandwiches and Top Ramen soup.

Fast forward to 2017. Many of the students I work with reside in dorm rooms nicer than the apartment I currently live in. The college cafeteria is filled with food choices to satisfy every diner—from grass-fed beef entrees to organic, hand-picked local produce. Many students still travel around campus on bicycles, but the parking lot is filled with cars outfitted with license plates from around the country. Owning a car as a teenager is far more common now than it was in the 1980s.

Seeing what students have access to these days sometimes makes me envious. But knowing that I escaped from college with no debt makes me thankful for growing up in a simpler time.

Kristine Hayes is a departmental manager at a small, liberal arts college in Portland, Ore. Her previous blogs include  Growing Up (Part I) and To Buy or Not to Buy.

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This Week/Aug. 13-19

BUYING A CAR? Think twice before financing it through the dealership. While dealership loans are convenient, the interest rate charged will include the dealership’s markup. That means you can likely get a lower rate by going to a bank or credit union—or by using a home equity line of credit. Unlike an auto loan, the interest on home-equity borrowing is typically tax-deductible.

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