Jonathan Clements's Blog, page 428

Money Well-Wasted

MOST MONEY CONVERSATIONS, especially with financial advisors, orbit around the concept of increasing dollars.

When is it best to buy stocks? Answer: in a down economy. Reallocate money from bonds.

When is it best to buy bonds? Answer: in a thriving economy. Reallocate money from stocks.

When is it best to save? The answer invariably seems to be: always.

On the one hand, I embrace this concept. A chronic self-tither, I consistently give 10% of my income to savings and sometimes more. On the other hand, despite—or perhaps because of—the habit I just described, I also recognize over-savers can take things too far, robbing themselves of the fulfillment and joy that spending brings.

There’s nothing wrong with spending money—as long as it’s spent on things that deliver plenty of happiness. Research shows we enjoy experiences over things. We most cherish time with friends and family, and also activities where we are in “flow”—those moments when we’re completely absorbed by work or hobbies that we’re passionate about. I recommend 10% Happier for those interested in more on this topic.

For me, such “non-necessary items” include awesome coffee, fancy dinners (preferably with good champagne), pedicures with my girlfriends, personal training, deep tissue massage, life coaching and therapy. All are things I value because they generally involve people I love or they support hobbies where I feel in flow.

I derive no greater joy than when investing in the nutrients on my plate, whether at farmers’ markets or over dinner deserving of a sixth star. As an artist, I thrill at the hue of egg yolks from pasture-raised hens, ruby beets, eggplant purples and the verdant green of rough-chopped beans. As a friend and lover, I feel rich sharing rich nutrients with people I love. As an entrepreneur, I value investing in my body and brain.

I first learned the value of diet when researching ways to reduce crippling anxiety—the kind that prevented focus and sleep—while running my first agency. I was dumbfounded when I learned my “uber-healthy diet” was a major culprit for chronic stress. If we eat crazy chemicals, we feel crazy. If we eat wholesome foods, we feel whole. I’m confident some of my ahas can help you, too:

Most “health food” ingredients are chock-full of chemicals. Simple rule of thumb: Avoid boxes and wrappers.
Low-fat diets limit creativity and happiness. Optimal brain function requires that one-third to half of calories come from fat.
It’s easy to ruin “good fat.” Olive oil goes bad when heated. Instead, cook with fats that are solid at room temperature, like coconut oil, ghee or duck fat.
We get depressed when we don’t eat enough complex carbs. (They metabolize as happiness-producing chemicals, like dopamine and serotonin.) Our bodies absorb the most nutrients from sprouted, organic grains.
When it comes to meat, the current FDA definition for “organic” is extremely loose. The wrong meats can make our bodies hotbeds for disease. Purchase grass-fed meats, free range chicken and wild caught fish.

For me, eating good food thrills my taste buds, while positioning me to be my best self. The experience is also a reminder that I live the life I choose, that I’m always in control.

Since good food can be insanely expensive, especially grass-fed meats, here are a few cost-effective solutions I’ve found that you might find useful, too:

One in five fruits and veggies don’t meet most stores’ cosmetic standards. Imperfect Produce delivers food to consumers that grocery chains consider too ugly to sell—at 30% to 50% below the normal cost.
Most grocery store prices are high because they’re effectively the middleman between food producers and consumers. Businesses like Thrive Market eliminate middleman costs and offer healthy, organic food at wholesale prices, generally 25% to 50% below retail.

Caitlin Roberson, author of 30 Ways to Happy , lives and works in Silicon Valley, where she helps top tech executives change the world through business storytelling. Her previous blog was Self-Tithing. Caitlin obsessively lifts weights and attends hip-hop classes, so she can tithe in Napa, guilt-free. You can learn more about her at CaitlinRoberson.com  and follow her on Instagram @CRobRobber .

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A Year for Generosity

MANY OF MY CLIENTS make donations to their favorite philanthropies in the final months of each year. With lower tax rates in the offing, this could be a good year to make such gifts—especially for those who have appreciated property to donate.

Many clients reflexively write checks, as that’s the easiest way to qualify their gifts for charitable deductions. But before they reach for their checkbooks, donors who want to make major gifts—and also lose less to the IRS—will do themselves a favor if they first familiarize themselves with other often-overlooked ways to contribute.

For instance, the charitably inclined realize significant tax benefits when they donate appreciated property owned for more than 12 months that would otherwise be taxed as long-term capital gains when sold. Some common examples are shares of individual stocks, mutual funds and exchange-traded funds.

The “give ’em away” gambit permits contributors of appreciated assets to deduct their full market value when donated. Savvy benefactors also avoid all of the federal and state taxes assessed on profits realized from the sale of these investments, effectively decreasing the cost of donations.

An example: Alex Vennebush decides to fulfill pledges aggregating $20,000 to several schools. Astute Alex also wants to diversify his investment portfolio. He decides to sell $20,000 in shares of Lady Godiva Accessories (LGA), one of his big winners that has skyrocketed in value since he paid $2,000 for the shares a number of years ago.

How will this all play out when Form 1040 time rolls around? For the 2017 tax year, Alex expects to be in a combined federal and state bracket of 35%. Although sending checks totaling $20,000 will trim his taxes by $7,000, he’ll be liable for federal taxes of $2,700 (15% of the $18,000 profit) on the gain from the LGA sale. (Like most other individuals, Alex’s federal long-term capital gains rate is 15%. The rate goes 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.)

As a less taxing alternative, I advise Alex to donate the LGA shares to the schools. They’re all tax-exempt entities that incur no taxes when they sell the shares and so end up with close to the same amount of money. Not only does Alex garner the same $20,000 write-off and $7,000 tax reduction, but he also avoids the $2,700 capital gains tax levy. His total savings of $9,700 effectively decreases his $20,000 contribution’s cost to $10,300.

Keep two key caveats in mind. First, there’s no additional tax break if Alex donates shares owned less than 12 months. The IRS restricts his write-offs to what he paid for the shares or their current value, whichever is less. Second, Alex shouldn’t donate depreciated shares or other losing investments. Instead, he should sell the shares and then donate the sales proceeds to charities. That will allow him to claim both the donation deduction and the capital loss.

What should Alex do if he’s unsure whether to relinquish his position in LGA? He should still donate the shares, while using the $20,000 in cash that he would’ve otherwise donated to repurchase the shares. That way, he preserves the $20,000 deductions and dodges $2,700 of capital gains taxes on the $18,000 gain. Moreover, his repurchase makes it possible for him to measure any gain or loss on a subsequent sale against the new, higher cost basis of $20,000, not the original one of $2,000.

That brings us to 2017. President Trump is adamant that his top priority is to lower tax rates. If he and Congress cut that kind of deal, when would the reduced rates take effect? Probably prospectively, beginning with 1040 forms for the 2018 tax year, which will be filed in 2019, a change that could cause Alex’s bracket for 2018 to drop below 35%.

What to do? I recommend Alex accelerate into 2017 donations that he intends to make in 2018. But, you might wonder, what difference does it make when he deducts his charitable donations? By donating in 2017, Alex garners the tax savings one year sooner—and, as an added bonus, he applies his donation deductions against higher-taxed 2017 income, instead of lower-taxed 2018 income.

Julian Block writes and practices law in Larchmont, NY, and was formerly with the IRS as a special agent (criminal investigator) . His previous blogs include Losing Interest and Capital Punishment. This article is excerpted from Julian Block’s Year Round Tax Strategies, available at JulianBlockTaxExpert.com. Follow Julian on Twitter @BlockJulian.

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This Week/Oct. 29-Nov. 4

HOW MUCH HOUSE CAN YOU AFFORD? Ponder the question from two angles. First, there’s how much you could potentially borrow. You can find out at HSH.com. Second, there’s how much it makes sense to borrow. If you took on the maximum mortgage possible, would you have enough left over each month to save for retirement and the kids’ college?

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Preconceived Notions

I JUST INVESTED $1,000 on behalf of a grandchild who may never be born. This reflected two of my enduring preoccupations: figuring out the best way to use my limited wealth for my family’s benefit—and getting an early start, with an eye to squeezing maximum advantage from investment compounding.

To those ends, when I visited my daughter in Philadelphia last weekend, I helped her open a 529 college savings plan. Hannah humored her father by committing to invest $25 automatically every month. Her fiancé calculated that if they saved a tad more—$500 a month, to be precise—they’d have $212,000 after 22 years, assuming a 4% real rate of return. That’s the sort of sum you need to get a child through a private college these days. To get things rolling, I tossed in an initial $1,000 and plan on adding more in the months and years ahead.

But this isn’t just about dollars and cents. It’s also the power of example. This year, in addition to opening a 529 for Hannah, I helped her and her brother fund their retirement accounts. I also set up accounts for my two stepdaughters, with the money earmarked for a future house down payment. Along the way, all four kids will—fingers crossed—learn a little about investing and the benefits of thinking long-term, and I get to pass along the values I think are important.

For now, Hannah’s 529 plan will be split evenly, with half the money going into a low-cost U.S. total stock market index fund and half going into an international index fund. Hannah is the owner the account. Who’s the beneficiary? For now, that would also be Hannah.

What about the grandkid who doesn’t yet exist? According to IRS Publication 970, you can change the beneficiary of a 529 to another family member, including a child, stepchild, sibling, step-sibling or cousin, without triggering income taxes or tax penalties. What if Hannah never has a child? She can always name a niece or nephew as beneficiary.

I could, of course, have opened the account myself, named Hannah as beneficiary and then later changed the beneficiary to a future grandchild. But under current rules, 529 plans owned by someone other than the parent can badly hurt financial aid eligibility, so it seemed smarter and simpler to have Hannah as the account’s owner.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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October’s Update

OCTOBER IS USUALLY a busy month, as I update HumbleDollar’s money guide with the tax thresholds for the coming year. But with a major rewriting of the tax code under way in Washington, DC, many of the 2018 figures that were just released by the IRS will likely never go into effect.

For instance, the standard 401(k) contribution limit is slated to rise from $18,000 in 2017 to $18,500 in 2018—but there’s talk on Capitol Hill of limiting tax-deductible contributions to $2,400. We’re also likely to see major changes in federal income tax rates, the standard deduction and what can be included among a taxpayer’s itemized deductions.

Still, I went ahead and updated a host of figures, including those for traditional IRAs, Roth IRAs, the federal estate tax exclusion and the gift-tax exclusion. Both the estate tax and gift-tax exclusions are scheduled to increase in 2018. In addition, I revised the site’s section on the federal payroll tax, which shouldn’t be affected by the new legislation.

I also updated numbers throughout HumbleDollar’s money guide based on the Federal Reserve’s 2016 Survey of Consumer Finances, which was recently released. I summarized some of the findings in a blog earlier this month.

This week, the College Board unveiled its annual reports on college tuition and financial aid. You can read some of the key findings in the money guide’s college chapter.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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A Rewarding Experience

A FRIEND RECENTLY ASKED ME the interest rate on my credit card. I admitted I had no idea. I pay off the balance in full every month and therefore don’t know, or care about, the interest rate.

I’m a minority in this regard. Only 35% of us pay off our credit card balance each month. We’re dismissed as “deadbeats” by profit-hungry credit card companies, perhaps with some justification: We reap the benefits of credit card rewards programs designed to lure the other 65% of the population into using their cards on a regular basis—and then foolishly carrying a balance.

There are different credit card rewards strategies. One involves having multiple cards and matching purchases to the card offering the highest reward for that specific item. For instance, you might use a credit card that offers 4% to 6% back on groceries at the supermarket, while using a different card—one with enhanced travel rewards—when purchasing a plane ticket. Another system involves carrying just one credit card, which offers a somewhat lower percentage cash back, but on a wider variety of items. Since I have a relatively low disposable income, and don’t travel much, the single card system works best for me. I do, however, try to figure out ways to maximize the rewards I get.

A recent example: I decided to replace my well-loved Kindle Fire with a newer model. Instead of purchasing the device directly through Amazon using my Costco Citi Visa card, I chose instead to purchase an Amazon gift card at my local grocery store using my credit card. This allowed me to earn 1% cash back, as well as a 30-cent-per-gallon discount off my next gasoline purchase. The grocery chain I shop at frequently runs this promotion to entice people to purchase gift cards through their stores. I then used my gift card to purchase the Kindle and used my Visa card to buy my discounted gas, generating an additional 4% cash back.

So far this year, I’ve racked up $340 in cash back. When my rewards check arrives next February, I’ll cash it in at my local Costco. I could, instead, use the check as credit toward items I purchase at Costco. But I’d rather continue to charge those purchases on my card, thereby earning additional cash back.

Taking advantage of credit card rewards programs pays off handsomely for those of us with the discipline never to carry a monthly balance. What if you don’t pay off your balance in full? The rewards you collect will likely be tiny compared to the interest you end up paying.

Kristine Hayes is a departmental manager at a small, liberal arts college in Portland, Ore. Her previous blogs include Driving Down Costs and Getting Sued .

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Losing Interest

SEVERAL OF MY CLIENTS took advantage of low interest rates earlier this year and refinanced their home mortgages for the second or third time. I alerted them to the tricky tax rules on deducting mortgage interest. Here’s the gist of what I told them.

Let’s say Amy Brown owns a personal residence. Her lender is willing to let her refinance for more than the balance on her existing mortgage. Under the tax rules, she’s allowed to deduct interest payments on the refinanced loan, as long as the new mortgage’s size is no larger than the balance on her existing loan.

But what about deducting interest on the part of the refinanced loan that exceeds the existing balance? And does it matter that she plans to use the excess to pay off credit card balances and other debt that charge higher rates of interest, which is often a smart strategy?

I explained that whether Amy is entitled to deduct interest on the excess amount depends on how she uses the proceeds from the refinancing and the amount of the proceeds. When she uses the amount in excess of the existing mortgage to buy, build or substantially improve a principal residence or a second home, her interest payments come under the rules for home acquisition loans. Those rules allow her to deduct the entire interest, as long as all her home acquisition loans combined don’t exceed $1 million. That limit drops to $500,000 for married couples filing separate returns.

Another set of rules, however, apply when borrowers use the excess for other purposes. Those rules prohibit deducting interest on “consumer loans.” This wide-ranging category includes credit card bills, auto loans, medical expenses and other personal debts, such as overdue federal and state income taxes. There is a limited exception for interest on student loans, one of those above-the-line subtractions that you can take directly on the first page of Form 1040, where you also list items like deductible alimony payments and IRA contributions.

Fortunately, Amy is able to sidestep these restrictions, thanks to the rules for home equity loans. Those rules allow her to deduct the interest she pays, provided the amount in excess of her existing mortgage, plus all other home equity loans, don’t exceed $100,000. That sum is reduced to $50,000 for married couples filing separate returns. It makes no difference how Amy uses the $100,000: She could pay off credit card debt, buy a car or even take a vacation.

What happens when her refinanced loans are partly home acquisition loans and partly home equity loans? There’s an overall limit of $1.1 million, which is a combination of $1 million from the home acquisition debt and $100,000 from home equity debt. That number drops to $550,000 for married couples filing separately. And what if her loans exceed the ceiling of $1 million for home acquisition loans and $100,000 for home equity loans? The excess will usually be categorized as nondeductible personal interest, unless the loan proceeds are used for business or investment purposes.

There’s yet another complication—if Amy is burdened by the alternative minimum tax. Under the AMT rules, Amy can deduct the interest on home acquisition loans of up to $1 million ($500,000 for married couples filing separately). But AMT rules deny any deductions for interest on home equity loans for first or second homes, unless Amy uses the loan proceeds to buy, build or substantially improve a dwelling.

Julian Block writes and practices law in Larchmont, N.Y., and was formerly with the IRS as a special agent (criminal investigator). His previous blogs include Capital Punishment, Unending Pain and Moving On. This article is excerpted from Home Seller’s Guide to Tax Savings, available at JulianBlockTaxExpert.com. Follow Julian on Twitter @BlockJulian.

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This Week/Oct. 22-28

FREEZE YOUR CREDIT. This will prevent data thieves from taking out loans and credit cards using your identity. But it also means you’ll need to contact the three credit bureaus and unfreeze your credit temporarily whenever applying for credit. Sound like a hassle? As an alternative, consider setting up an initial fraud alert and then renewing it every 90 days.

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Bought and Paid For

STOCK BUYBACKS are here to stay. The Securities and Exchange Commission opened the door in 1982, when it ruled that companies could repurchase their own stock without triggering accusations of share price manipulation. Ever since, more and more companies have taken advantage. Indeed, in recent years, U.S. corporations have spent more money buying back their own shares than paying out dividends.

Good news? I see both plusses and minuses. Here are the plusses:

Once you figure in buybacks, U.S. stocks may be less overvalued than the market’s dividend yield suggests. Today, the S&P 500 companies are paying 2% in dividends, below the 3% average for the past 50 years. But if you factor in today’s 2.4% buyback “yield,” the total payout is closer to 4.4%. In a recent paper, Philip Straehl and Roger Ibbotson point out that total payouts, along with the growth in those payouts, has better explained long-run stock market returns than dividends alone. Their total payout model produces a forecasted 5.1% after-inflation annual return, versus 3.6% if you analyze just dividends.
Buybacks are a more tax-efficient way to return cash to shareholders. If a company pays a dividend, every shareholder who owns the stock in a taxable account will have to fork over a sliver to Uncle Sam. By contrast, buybacks cash out investors wanting to sell, without inflicting taxes on shareholders who stick around. Those shareholders benefit, because there are now fewer shares with a claim on the company’s earnings and dividends.
New share issuance has long been the enemy of existing shareholders, who historically have seen their claim on the economy’s profits diluted at a rate of some 2% a year. Thanks to buybacks, shareholders across the U.S. stock market have, by some measures, suffered no dilution over the past decade.

Sound compelling? Offsetting these plusses are some notable minuses:

While regular quarterly dividends are viewed by companies as a commitment they’re loath to break, stock buyback programs are often quietly dropped—and usually at the worst possible time, when the economy is struggling and share prices are at bargain prices. Corporations have proven to be terrible market timers, buying their own shares heavily in 2007, as stock prices neared their peak, and then abandoning their buyback programs during the market rout that followed. In the years since, as share prices have bounced back from their early 2009 low, so too has the amount of stock bought back.
Because corporations have emerged as major buyers of their own stock, their terrible timing will likely exacerbate market movements, driving up share prices during bull markets, while removing a major source of buying power when markets tumble.
Why are buyback programs shelved when the stock market is down sharply? No doubt part of the reason is fear, as corporations hoard cash during lousy economic times. But there’s a less savory explanation: When shares are down sharply, employees are less likely to exercise their stock options, so there’s less need to buy back shares to offset the resulting dilution. Indeed, a cynic might take today’s 4.4% total payout and view the 2% dividend yield as a reward to shareholders—and the larger 2.4% buyback yield as a lavish perk for senior executives. An obvious question: Has the ability to repurchase stock, and thereby hide the dilution caused by stock options, made companies more liberal in issuing options?
Even if buybacks make sense for some companies, they won’t make sense for all companies. If corporations have extra cash, there are a variety of possible uses: They could pay dividends, buy back shares, purchase another company or reinvest in their own company. Buybacks can seem like the least bad choice: There’s no tax bill for current shareholders and no risk the money will be frittered away on a bum corporate acquisition or foolish capital spending.

But to make financial sense, buybacks should occur at prices that management considers lower than their stock’s intrinsic value. If that isn’t the case, they’re rewarding departing shareholders at the expense of longer-term investors. Even if top executives believe their stock is undervalued, buybacks may not be the best use of the company’s cash—if, say, the company could earn a higher return by reinvesting the money back into the company’s operations. Are corporations pondering such issues as they weigh whether to buy back stock? Somehow, I suspect not.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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We Know Jack

THE BOGLEHEADS had their annual conference this week in the Philadelphia area, where Vanguard Group’s headquarters is located. Devotees of Vanguard’s 88-year-old founder John C. Bogle, the Bogleheads usually meet online at what’s probably the world’s best investment forum.

The star of their annual meeting was, of course, Jack himself. His latest book, an extensive revision of The Little Book of Common Sense Investing, just came out. What was on Jack’s mind? Here are just some of his comments.

“Among our competitors, I think Dodge & Cox is the best. They’re in the investing business, not the marketing business.”
“I’m glad to see my ideas accepted by the public.” But Jack worries about Vanguard’s rapid growth and its impact on the company. Vanguard is now easily the largest fund company and manages almost a quarter of the industry’s assets.
 “You can’t have all the active managers winning,” regarding the risk that too many investors will index and that will make the market inefficient. Jack notes that just a quarter of the U.S. stock market is now indexed by individual and institutional investors. Meanwhile, he points out that less than 8% of actively managed stock funds outperformed their category’s benchmark index over the past 15 years.
“With so much money coming into index funds at high valuations, there’s a risk of large redemptions” in the next market downturn.
“If you’re investing for a lifetime, there’s no better way to do it,” referring to index funds that weight stocks by market capitalization. Jack expressed skepticism about index funds that weight stocks equally or based on fundamentals.
“People should relax about the precision of all this,” talking about when and how often to rebalance.
“I spend half my time worrying about why I have so much in stocks and half my time worrying about why I have so little.” Jack says his portfolio is split evenly between stocks and bonds.
“If you’re putting money to work today, you should want a good market decline.”
“It’s a nice business to be in, if you aren’t the clients,” referring to hedge funds-of-funds.
Jack expects stocks to return 4% a year over the next 10 years, with dividends delivering 2% and earnings climbing at 4%—but falling price-earnings ratios subtracting two percentage points. Meanwhile, he thinks a mix of corporate and government bonds might give investors 3% a year. “With that 10-year forecast, I won’t be around to know whether it’s right or wrong.”

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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