The tax man cometh

“In this world nothing can be said to be certain, except death and taxes” –Benjamin Franklin

 

I love this woodcut from the 1600s.  I imagine the artist drew it so the skeleton’s hand is asking for the guy’s life, but it kind of looks like he has his hand out asking for money like he’s collecting taxes.  Either way, if you’re death or the tax man, you probably aren’t too popular.

Obviously taxes are important when you’re thinking about investments and your retirement.  Uncle Sam (for all you foreign readers, what is the name of the personified tax collector in your country?) is definitely going to take his share of your earnings and investments.  Given the progressive nature of most countries’ tax codes, as your nest-egg gets larger and larger, they take a bigger percentage, so that raises the stakes.

The government has built the tax code to offer huge tax breaks to people saving for retirement, particularly allowing people to defer taxes from their earning years to their retirement years. That’s really all that accounts like 401k’s and IRAs are doing, taking money you earn when your income is high and allowing you to pay taxes on it when your income is low.  It may not seem like a big deal at first but suffice it to say, optimally managing your tax situation can be the difference of hundreds of thousands of dollars.  As always, it’s important to remember that I’m not a tax expert; also I’ll be making assumptions on future stock returns which in no way guarantee that is what will actually happen in real life.

 

Working tax rate versus retirement tax rate

US tax rates go up pretty quickly the more money you make.  So when you’re in your prime earning years, that is when your tax rate is going to be the highest.  Take my old neighbors Mr and Mrs Grizzly as an example.  They both work and have a combined income of $150,000.  Throw in a couple assumptions like they have two cubs, a mortgage, and live in the great state of California, and they are paying a total of about $41,000 in taxes, about 27% (there’s a great website that I used for these estimates).  Look a little deeper and their marginal tax rate is 43%; that means if they earned one more dollar they would pay $0.43 in taxes, and conversely if they lowered their income by one dollar they would save $0.43 in taxes.  Wow!!!  That’s a lot in taxes.

Now let’s fast forward and think of Mr and Mrs Grizzly in retirement.  Their house is paid off and they don’t have to save for their cubs’ educations, so what they need to support their retirement lifestyle is $80,000 (believe me, I will have many future posts dedicated to estimating how much someone needs per year in retirement, but for now let’s just take the $80k on faith).  Each year they tap into their savings and the $80,000 breaks down into three buckets: $20,000 is interest and dividends; $30,000 is long-term capital gains on the profits from their investments over the years; and $30,000 is the basis, the original money they invested which doesn’t get taxed.  Run your tax calculator again and they’re paying a measly $1,200 in taxes!!!  Read that again; it’s not a misprint.  That’s only 2% compared to the 27% they were paying while they were working.  And their marginal tax rate is 4% in retirement instead of 43% while they were working.

That, my friends, is some powerful stuff!!!  Now, how do Mr and Mrs Grizzly translate that into cash money?

 

The value of deferring taxes

During their working years, Mr and Mrs Grizzly set up their budget to save $1000 per month.  Because they are avid readers of the Stocky Fox, they know they should save that through their 401k’s (in this unfortunate example, let’s assume their cheapskate company doesn’t offer any matching).  In a year they will have saved $12,000 but since 401k’s are tax deferred they don’t pay taxes on that money, saving themselves $5160 in taxes (remember, their marginal tax rate is 43%).  Nearly $5200!!!  That’s some serious honey comb.  They do that each year and after 30 years (let’s assume a 2% dividend and a 5% stock increase), and they have a nice little honey pot of $1.12 million for retirement.  They’ll withdraw their $80,000 per year and pay the lower tax rate on it, and life is good.

The Grizzleys are sitting pretty, but what would happen if didn’t use their 401k to defer taxes and instead invested their money in a normal brokerage account?  Each year, they’d pay the $5200 in taxes but then they would also have to pay taxes on the dividends.  If you assume the same investments as we did above, 2% dividends and 5% stock increase, after 30 years they would have $815k.  That’s nothing to sneeze at, but that’s about $300k less than what they had with their 401k.  Those numbers seem crazy, but that’s the power of tax deferral.

2015-02-16 deferred taxes graphic (qd)

So the lesson is that using tax deferred accounts offers a really powerful way to accelerate the growth of your nest-egg by cutting out the tax man (in a totally legal way, of course).

To Roth or not to Roth

images

As you enter the world of investing, one of the first decisions you need to make it whether to open a Traditional IRA or a Roth IRA.  Of course, I’m taking for granted that you’re using an IRA to save money, because we know that being smart with taxes is one of the most important things you can do.  As you read this, remember that I’m not a tax expert, but here is how I look at this issue.

These IRA cousins are both tax advantaged, but they go about it in different ways.  With a Traditional IRA, you are allowed deduct your contribution from your taxes that year; however you pay taxes on the money when you withdraw it in retirement.  Conversely, with a Roth IRA you contribute with after-tax dollars but then when you withdraw the money in retirement it’s tax free.

So basically with Traditional and Roth IRAs, you’re making a choice between paying taxes now or later.  If you lived in a world where your tax rate didn’t change over time, there would be no financial implications in the choice between the two IRA types.  The math would work out the exact same.  However, we don’t live in that world.  We live in a world where your tax rate goes up the more money you make.  In this world, we want to pay taxes when our tax rate is at its lowest.  So where does that leave us?

I did some quick estimates of what someone’s marginal tax rate would be in a high tax state (California—where the Foxes used to live) and a low tax state like Florida.  I did this at three different income levels: $50,000 (when you’re just starting out), $100,000 (after you’ve been working for a while), and $20,000 (when you’re in retirement—remember you’ll spend more than that but only $20k will be taxed as income).

MARGINAL TAX RATES

High-tax state

Low-tax state

$50,000 (early working career)

33%

25%

$100,000 (later working career)

37%

28%

$20,000 (retirement)

17%

15%

 

Wow!!!  Look at that.   We all knew that we would have the highest tax rate when our income peaked.  But did we really expect that we’d be paying double the tax rate when we were starting out compared to when we were retired?  That’s a huge difference.

Now, remember that the major difference between a Traditional IRA and a Roth is when you pay your taxes.  For a Traditional IRA, you’re getting a deduction while you’re working so that $5000 you contribute in your early years gives you a $1667 tax deduction ($5000 x 33% tax rate), and a $1850 deduction ($5000 x 37% tax rate) in your middle years.  Of course you’ll have to pay taxes on that money when you retire, which would be about $850 ($5000 x 17%).  Compare that to a Roth IRA where you’re paying taxes on that $5000 during your early years ($1667) and your middle years ($1850) in order to avoid paying taxes in retirement ($850).

In a world where we want to maximize our portfolio by minimizing our taxes (legally, of course), the answer seems clear—GO WITH A TRADITIONAL IRA.  The back of the envelop math says that going with a Traditional IRA will save you about $1000 per year that you contribute.  Remember that $1000 per year over a working career of 40 years, adds up to about $150,000.  Those are pretty high stakes for what seems like a pretty innocuous choice.

So why do so many people instead go with a Roth IRA?  Why did Stocky Fox himself open up a Roth IRA instead of a Traditional IRA?

  • Don’t understand rules: A major culprit is that many investors don’t understand the tax rules all that well.  Because of that they don’t have a strong opinion on which type of IRA to pick so they go with the one that others tell them is better (which leads to the next reason).
  • Roth IRAs are marketed better: For some reason it seems that Roth IRAs are marketed better than Traditional IRAs.  I don’t know if it’s because “Roth” sounds like an actual name and that draws investors, or what.  But my experience tells me that the average investor would pick a Roth just because that “feels right”.
  • Uncertain tax future: As my loyal readers Mike and Rich have pointed out in the past, the future tax rates are uncertain.  Today we know that a current tax rates make a Traditional IRA a better option, but what if those tax rates change in the future?  It could definitely impact the decision, but who really knows what will happen?  If I could predict the future I would own my own Caribbean island.
  • Get the pain done with: As a kid I used to eat cupcakes upside down; start with the cake and finish with the best part, the frosting.  Some use my cupcake strategy to get the “hard part” over and done with; they choose a Roth IRA because they get the taxes out of the way and then it’s smooth sailing.  This is following your heart instead of your head which may not make sense financially but we all do it.
  • Bad advice: You’ve heard me rail about investment advisers who maybe aren’t all that good.  A lot of people might take advice on which IRA to choose from someone who really hasn’t done the analysis, so they say “yeah, go with the Roth.  Just as good as any.”

I’m sure there are many more reasons but that’s my list.  At the end of the day I think Traditional IRAs are the best choice for most people just because with them, when you do finally pay taxes in retirement you’re probably paying at a lower rate than any time during your working career.  And that choice can be of the six-digit variety.  Yikes!!!

Of course, you there are special circumstances where maybe a Roth IRA works better.  Maybe you’re a kid with really low income (less than $10,000 like from a summer job), but those are probably more the exception.

 

Let me know what you think in the comments section.

Making college pay off

 

On Monday we asked the insane question: “Is college a waste of money?”  We came up with an insane answer: “A person would do much better financially saving that tuition money and not going to college.”

Such a bold conclusion deserves some intense scrutiny.  Let’s look at this more closely and see what the key drivers are.

 

Base case

Recall from the last post that Smarty goes to private school ($280,000 total).  Fasty works at a job making $36,000 per year straight out of high school and Smarty spends four years in college then makes $60,000 per year once she’s out of school.

Results—FASTY comes out ahead by $2.7 million (11% better than her sister).  This is where we were yesterday.  Now let’s start looking at our assumptions.

 

Scholarships

Of course, this is a big one.  Scholarships effectively bring down the cost of college, potentially to zero if you get a full-ride scholarship.  The larger scholarship Smarty gets, the more the race tilts in her favor.

 

Public college

Public college is a much more affordable option, at $100,000 instead of $280,000.  Except at the very top (Harvard, Stanford, Chicago) there’s no reason to believe that Smarty couldn’t get as good an education at a public school like University of North Carolina-Chapel Hill compared to an average private school like Wake Forest.

Results—This has a huge impact.  SMARTY comes out ahead by $680,000 (4%) if she goes to a public school.  It’s not an overwhelming advantage, but the decision between public and private school makes a huge difference.

 

Wage growth

We assumed that Fasty would make $36,000 her whole career and Smarty would make $60,000 her whole career.  Those are the average incomes for people, but in real life people’s wages start lower and grow higher.  There’s a lot of debate and controversy here about wage growth and if it goes to everyone or just those at the very top (here is a link that a grad school friend posted).

If you look at more detailed data, it shows that those with college degrees have wage growth 33% higher than those without degrees.  To account for this, let’s assume Fasty starts out at $22,000 and Smarty starts out at $33,000.  Then let’s assume that Fasty’s wages grow 2.0% each year while Smarty’s grow at 2.7%.

Results—This actually has a pretty low impact.  FASTY comes out ahead.  If you assume public college Fasty is $233k (2%) ahead which is pretty much a tie.  If you assume private college then Fasty is ahead $4.8 million (39%).

 

College major

Let’s cut to the chase.  This is where the real action happens.  What you study at college has the biggest impact on what you earn.  Starting salaries for STEM (science, technology, engineering, math) majors are 30-50% higher than those for liberal arts and teaching majors.

Also, the income growth is much higher.  STEM majors can expect their wages to grow about 50% faster than teaching and liberal arts majors.  In fact, teaching majors have wages that grow SLOWER than those people without a college degree.  So if Smarty went into teaching, she would make more than Fasty at first, but Fasty’s income would pass Smarty’s eventually.

Results—This actually has a profound impact, even when you assume public college.  With a STEM degree, SMARTY will come out $3.0 million (19%) ahead.  You can play with the numbers, but it’s really hard to find a realistic set of assumptions where Smarty doesn’t win with a STEM degree, with the possible exception of private college.  This is true for medical and business degrees as well, just not to the same degree (degree-degree, did you see what I just did there 😊?).

As good as things look for a STEM degree they look that dismal for a liberal arts, career-focused (journalism, public policy, recreation, industrial arts, agriculture, etc.), social sciences, or teaching degree.  FASTY will easily come out ahead to the tune of $3.2 million (33%) if Smarty gets a liberal arts or teaching degree.  This assume public college; if we assumed private college, that would be drastically worse for Smarty.

 

Master’s degree

By attending college Smarty will give herself an option that Fasty just won’t have: the ability to get a master’s degree.  This is the route I took, going to college and then after working a few years getting my MBA. In a way, this is really more of the same, and links very closely to the “College major” discussion.

Getting a graduate degree doubles down on your college decision.  If you pick a major which puts you ahead, typically getting a master’s degree in that same area will puts you further ahead.  Conversely, if you pick a major that puts you behind, getting a master’s degree will put you even further behind.

Results—If Smarty gets a STEM degree she’ll come out ahead.  If she gets her master’s, instead of being about $3.0 million ahead she’d be about $3.6 million ahead.  That’s a bit of upside but not too much.  Conversely, if she gets a liberal arts degree and then a master’s on top of that she’d go from being $3.2 million behind to $6.0 million behind.  Yikes!!!

 

Taxes

Taxes always suck, but they are going to hurt Smarty a lot more then they’ll hurt Fasty.  Smarty got her degree and got a higher paying job, and that means she’ll be paying a much higher tax rate than Fasty.  Fasty makes less money and that helps in two ways.  First, she pays a lower tax rate.  Second, because her income is low she doesn’t pay taxes on her investment income.

As Smarty makes more money which is really her whole strategy by going to college, that will help her win the race against her twin, but that will also mean she’ll pay higher taxes and that has a moderating effect.

Results—The very best outcome for Smarty was a STEM degree from a public college, and then her master’s.  That resulted in her coming out ahead by about $3.6 million.  If you add taxes to that, she only comes out ahead about $1 million.  That’s still a lot, but taxes are making something that was a total sure thing a bit more suspect.

Of course, if you consider taxes on all the less favorable scenarios for Smarty (private college, liberal arts degree, etc.) it takes a bad situation and makes it even worse.

 

Smart non-college kids

We’ve been making an assumption that I think is actually flawed, and has the potential to tip the scales in Fasty’s favor pretty drastically.  Remember, we assumed that Fasty and Smarty are identical in every way—equally smart and equally hard working.

In our society, smart and hard-working high school graduates typically go to college.  That’s just what they do because they’ve been told a million times that is what they should do.  It’s a bit of a circular argument.

When we look at the data for high-school graduates with no college, those are people who never went on to college.  Maybe they were late bloomers, maybe not ambitious, maybe just plain not smart.  Based on my argument above, very few (although some for sure) had the option to go to college and passed it by.

I say all this because what would happen if Fasty is smart enough and hard working enough to go to college but chooses not to?  There’s every reason to believe that she would do much better in her career and make much more money that the “average” high school degree person we’ve been talking about.

Imagine she gets an entry-level job at a factory.  She is punctual, hard-working, figures out better ways to do things; all those things would have helped her in college but now she is applying that to her non-college job.  That will set her apart from many of the other high-school graduates who didn’t have those qualities and abilities, probably one of the main reasons why they didn’t go to college.  Eventually her talents will be recognized and she’ll get more opportunities at higher wages.  Maybe it won’t be as fast as if she earned her degree, but it doesn’t have to be.  Remember, she also has $280,000 in her bank account.

Results—If Fasty’s salary is higher or can grow faster than the average for a high-school grad, then the calculations drastically shift towards Fasty.  Remember that Fasty won the race most of the time.  It was when Smarty got a STEM degree that things changed, and that’s because Smarty had a higher salary and faster income growth.  However, if Fasty’s hard work got her even a little bit higher salary and faster salary growth, she would close the gap.

 

Other considerations

College dropouts—This is the real killer.  How many kids start college but don’t finish.  They end up with the job prospects of Fasty but without the head start.

Fifth-year seniors—Increasingly college kids aren’t finishing their degree in four years.  That is a double whammy because it delays them making money for another year and they have to pay an extra year of tuition.

Living at home—There are a lot of ways to get the benefits of college without the full-blown college experience.  Living at home (and eating Mom’s cooking) is one that drastically cuts down the cost of attendance.

 

We’ve come along way.  After Monday’s post I was pretty pessimistic on college.  I don’t know if this post made that better or worse.

Definitely we learned that private college makes it near impossible to come out ahead financially.  More importantly, what you study makes or breaks the decision; STEM and healthcare and business will probably put you ahead while liberal arts and teaching and social sciences will doom you.  There’s other stuff too, but I think those are the two most important.

Come back on Monday when I tell you what Foxy Lady and I are planning on doing with ‘Lil Fox and Mini Fox.

Saying “I Do” impacts what Uncle Sam says he’ll take

discount-wedding-cake-toppers

Foxy Lady and I have been thinking about getting a divorce.  We don’t want to leave each other or be with someone else.  We still love each other, probably more now having been through 6 years of marriage and having brought two amazing cubs into the world, than when we were first married.  And let’s be honest: there’s no way I could do any better.  Foxy Lady is foxy, is an amazing mom, has a high-powered career, let’s me stay at home with the cubs.  She probably could do better, but don’t tell her that.

So we still want to remain fox and vixen, but just not in the official “married” sense.  What gives?  Since it’s a topic of this website, it probably has something to do with personal finance.  By being married we pay about $15,000 more in taxes than if we were living in sin as two single foxes.  Let me explain:

The federal tax code (and that of many states) is extremely complex and curiously set up.  It is meant to be progressive (wealthier people pay a higher percentage of their income in taxes), but in an attempt to achieve that goal, lawmakers have created a bit of a cluster that has some seriously screwed up features.  The “marriage penalty” is one of those.

 

Paying more if you’re married

Let’s look at two nearly identical couples: Mr and Mrs Leopard who are married, and Mr Tiger and Ms Lion who have been living together but never tied the knot.  Mr and Mrs Leopard each have good jobs and each make $100,000.  Similarly, Mr Tiger and Ms Lion each have good jobs and each make $100,000.

Mr and Mrs Leopard file jointly and owe taxes of $43,000 on their $200,000 income.  However, Mr Tiger and Ms Lion together owe taxes of $39,000 on their $200,000 income.  What the hell?!?!?!  Mr and Mrs Leopard are seriously pissed.  Mr Tiger and Ms Lion just paid for their annual family vacation Disneyworld.  Or better yet, they can use that money to fund an IRA and in 30 years they’ll have an extra $320,000, thanks solely to the fact that they never said “I do.”

That seems like a pretty big deal.  Being married or not has a 10% impact on the amount of taxes you pay.  How is that possible?  This is fundamentally an issue of figuring out who the IRS thinks is rich, remembering that we have a progressive tax code.

The IRS looks at two people with a combined income of $200,000 as being richer than one person making $100,000.  Maybe that makes sense.  The couple is probably pooling expenses like housing and the bills that go along with that.  A single person is bearing those housing expenses on her own.  That, in a nut shell, leads to the IRS taxing the $200,000 couple more than the $100,000 individual.

That’s all well and good until you have situations like Mr Tiger and Ms Lion.  The rationale that the expenses for two single people go out the window because they are really acting like they are married, sharing their living expenses just like Mr and Mrs Leopard.  When you choose filing status you can pick “Single” or “Married” but you can’t pick “Single but pretty much act like we’re Married.”  That’s the loophole.

 

Paying more if you’re Single

The opposite effect also occurs.  Imagine Ms Ocelot and her boyfriend Mr Panther.  Ms Ocelot has a high powered career where she’s making $200,000.  Mr Panther is a freeloader who watches TV and plays video games all day and occasionally writes on his blog which doesn’t generate any money.

Ms Ocelot pays $50,000 in taxes on her $200,000 income.  But if she made an honest man out of Mr Panther, their tax bill would fall to the same $43,000 that the Panthers pay.

That $7000 annual difference is just the same effect as above, but in reverse.  The IRS views a single person making $200,000 as being richer than a couple making that same amount.  Again, it kind of makes sense; that income is only supporting one person in the “single” example but two people in the “couple” example.

 

What it all means

“Stocky, what is the point you are trying to make?  Surely, you aren’t suggesting deciding on marrying someone based on the tax code.”  I kind of am.  Are you married because the state of Illinois or the US government says you are?  Not really.  You’re married because you love your partner, you want to take on life together with that person, you are committed to her until the end of your days.  That’s how it is for me.

If the government said there was a clerical error and our marriage certificate was never filed so I wasn’t actually married to Foxy Lady, I wouldn’t love her any less.  I wouldn’t be less committed to her and the two cubs we’ve brought into this world together.  Actually, I have a few friends, and maybe you do too, who are as committed to each other as any married couple, but they aren’t married in law.

But since the federal government says Foxy Lady and I are married, legally we MUST file as “Married” and that ultimately leads to us paying about $15,000 more in taxes than if we acted in the EXACT same way but just never signed that piece of paper six years ago.  And that’s serious money.  $15,000 in our case or $4000 in Mr and Mrs Leopard’s case or $7000 in Ms Ocelot’s case really adds up.  Over a life time, that could be a million dollars.

 

Marital advice from Stocky

So does Stocky endorses people who make similar incomes to not get married and couples where one person makes a lot more money to get married?  It seems severe, but why not?  This is one savings strategy that could pretty much fully fund your retirement.

Of course there’s the big caveat that you need to be in a very strong relationship.  One so strong that legally being “married” or “single” doesn’t impact the real-life state of your relationship.  If yours is at that level then seriously consider taking the free money the IRS is making available.

Yet, when I give that advice to people, recommending that they get divorced (but remain totally committed like they were married), they look at me like I’m crazy.  How could I even suggest touching the most sacred of unions for a few bucks.  Totally get it.  And to date, no one has followed my advice on this, so there you go.  But if your marriage is such that it can survive the US government saying your single, there could be some serious dollars in it for you.

 

You’ve ready my crazy theory on how to reduce your taxes.  What do you think?

The power of a single percentage

2014-02-18 (1 percent)

“How can something so small be so impressive?” –Belinda Heggen

1% doesn’t seem like a lot.  It’s the extra sales tax my city adds, hoping I don’t notice it.  It’s the maximum amount of gross stuff food companies can put in packaged food without having to tell us (I don’t know it that’s true or not).  But in investing 1%, while so easy to overlook, can make a huge difference.  Here we’re going to find out how we can get that 1% to help us.

Let’s go back to my neighbors, Mr and Mrs Grizzly.  Each year they will save $10,000, investing it in a stock index mutual fund with an expected annual return of 6%.  After 30 years, they expect to have $790,581 saved (good time for the disclaimer that I am not predicting future stock performance, just giving an example), a tidy little sum to help see them through their golden years.

However, Mrs Grizzly starts playing with her spreadsheet and changes the annual return from 6% to 7% just to see what happens.  She’s astounded to see that the $790,581 that she gets with a 6% return balloons to $944,608 if she assumes a 7% return; that increase in the annual return of 1% led to an increase in her nest egg of 19%.  Tempting fate she sees what happens with an 8% return: $1,132,832.  She’s a millionaire now.  Cranking the return up to 9% made her nest egg $1,363,075; just increasing her return 3% nearly doubles how much she and Mr Grizzly will have to retire on.  Ladies and gentlemen, welcome to the power of compound interest!!!

Percentage graphic

The point here is that a seemingly small 1% change in your investment return can make a huge difference over time.  By tailoring your investment strategies to collect as many “1% coupons” as possible, you can substantially increase, even double, the value of your nest egg.

So how do we get those higher returns?  Most people will default to higher stock returns: “It’s a no-brainer.  Instead of investing in the stocks and mutual funds that return 6%, let’s invest in the ones that return 7%.”  Unfortunately, after reading A Random Walk Down Wall Street we know this isn’t so easy.  For any given level of risk, our investment return is probably going to be what it will be.

Now that changing the actual investment return is out, what are our options?  Fortunately there are a lot of other things that affect our total return beyond just what our investments give us.  We’ll dive into each one of these with its own blog post, but a few to think about at a high level are:

  1. Mutual fund management fees: Each year mutual funds charge between 0.05% all the way up to 1.50% or more for management fees.  Going from high-cost mutual funds to low-cost funds can easily get us a 1% coupon.
  2. Financial planner fees: There are a lot of people out there who are more than willing to tell you how to invest your money for a small fee.  Except that fee doesn’t tend to be all that small: about 1-2% of your total assets.  Do-it-yourself investing can absolutely give you that 1% coupon, and the results you produce will probably be similar to those your investment adviser would.
  3. Being smart with taxes: You know Uncle Sam is going to take his cut.  However, you can delay when he takes his share with IRAs, 401k’s, etc.  This allows you to keep the money longer, and it allows to you be taxed on the money later in your life when you will probably be in a lower tax bracket.  Being smart with your taxes can easily get you a 1% coupon.
  4. Take the “free money” offered to you: Many of us work for companies that match 401k contributions.  Except they only give you the extra money if you invest in your 401k.  So at least putting in up the minimum amount of get the match can absolutely give you one or two 1% coupons.
  5. Proper asset allocation: We all know that some of your investments should be in higher return, riskier investments like stocks and some should be in lower return, less risky investments like bonds.  Properly assessing your portfolio to know how much you already have in less risky investments (especially things like pensions, Social Security, your home equity, etc.), can allow you to safely put more money in investments like stocks.  Over the long term, this could easily increase your return each year and get you a 1% coupon.
  6. Fully investing: So many people I talk to have $10,000 or $20,000 or $50,000 in their checking account that they’re “just waiting to figure out what to do with it.”  These are certainly Champagne problems, but they are also fertile ground to find 1% coupons.  Just taking that money and putting it in a bond fund instead of a checking or money market account could easily give that extra 1% or more; investing in a stock fund will provide even greater returns over the long run.

Those are just a few examples of how you can squeeze an extra 1% or more from your investment returns.  You’ll notice that none of those strategies include “outsmart Wall Street and pick the stocks that are going to do the best.”  I’m not that smart; I wish I was because then the Fox family would own its own island in the Caribbean next to Johnny Depp’s island.  These are all really simple strategies that anyone can do, and each of which takes less than a couple hours to set up, and can lead to hundreds of thousands of dollars over your investing lifetime.  The Fox family has benefited by these little strategies probably to the tune of 4-5% extra return each year over what seems typical among your average American investor, and that has equated to hundreds of thousands of dollars.

So here’s the bottom line:  As you read this blog, we’ll constantly be finding “extra 1% coupons” that you can redeem to increase your overall investment returns.  As Mrs Grizzly showed, even one of those can add $150k to your nest egg.  If you can gather two or three or even more, you can double your nest egg.

The tax man cometh

2015-02-13 image (grim reaper)

“In this world nothing can be said to be certain, except death and taxes” –Benjamin Franklin

I love this woodcut from the 1600s.  I imagine the artist drew it so the skeleton’s hand is asking for the guy’s life, but it kind of looks like he has his hand out asking for money like he’s collecting taxes.  Either way, if you’re death or the tax man, you probably aren’t too popular.

Obviously taxes are important when you’re thinking about investments and your retirement.  Uncle Sam (for all you foreign readers, what is the name of the personified tax collector in your country?) is definitely going to take his share of your earnings and investments.  Given the progressive nature of most countries’ tax codes, as your nest-egg gets larger and larger, they take a bigger percentage, so that raises the stakes.

The government has built the tax code to offer huge tax breaks to people saving for retirement, particularly allowing people to defer taxes from their earning years to their retirement years. That’s really all that accounts like 401k’s and IRAs are doing, taking money you earn when your income is high and allowing you to pay taxes on it when your income is low.  It may not seem like a big deal at first but suffice it to say, optimally managing your tax situation can be the difference of hundreds of thousands of dollars.  As always, it’s important to remember that I’m not a tax expert; also I’ll be making assumptions on future stock returns which in no way guarantee that is what will actually happen in real life.

 

Working tax rate versus retirement tax rate

US tax rates go up pretty quickly the more money you make.  So when you’re in your prime earning years, that is when your tax rate is going to be the highest.  Take my neighbors Mr and Mrs Grizzly as an example.  They both work and have a combined income of $150,000.  Throw in a couple assumptions like they have two cubs, a mortgage, and live in the great state of California, and they are paying a total of about $41,000 in taxes, about 27% (there’s a great website that I used for these estimates).  Look a little deeper and their marginal tax rate is 43%; that means if they earned one more dollar they would pay $0.43 in taxes, and conversely if they lowered their income by one dollar they would save $0.43 in taxes.  Wow!!!  That’s a lot in taxes.

Now let’s fast forward and think of Mr and Mrs Grizzly in retirement.  Their house is paid off and they don’t have to save for their cubs’ educations, so what they need to support their retirement lifestyle is $80,000 (believe me, I will have many future posts dedicated to estimating how much someone needs per year in retirement, but for now let’s just take the $80k on faith).  Each year they tap into their savings and the $80,000 breaks down into three buckets: $20,000 is interest and dividends; $30,000 is long-term capital gains on the profits from their investments over the years; and $30,000 is the basis, the original money they invested which doesn’t get taxed.  Run your tax calculator again and they’re paying a measly $1,200 in taxes!!!  Read that again; it’s not a misprint.  That’s only 2% compared to the 27% they were paying while they were working.  And their marginal tax rate is 4% in retirement instead of 43% while they were working.

That, my friends, is some powerful stuff!!!  Now, how do Mr and Mrs Grizzly translate that into cash money?

 

The value of deferring taxes

During their working years, Mr and Mrs Grizzly set up their budget to save $1000 per month.  Because they are avid readers of the Stocky Fox, they know they should save that through their 401k’s (in this unfortunate example, let’s assume their cheapskate company doesn’t offer any matching).  In a year they will have saved $12,000 but since 401k’s are tax deferred they don’t pay taxes on that money, saving themselves $5160 in taxes (remember, their marginal tax rate is 43%).  Nearly $5200!!!  That’s some serious honey comb.  They do that each year and after 30 years (let’s assume a 2% dividend and a 5% stock increase), and they have a nice little honey pot of $1.12 million for retirement.  They’ll withdraw their $80,000 per year and pay the lower tax rate on it, and life is good.

The Grizzleys are sitting pretty, but what would happen if didn’t use their 401k to defer taxes and instead invested their money in a normal brokerage account?  Each year, they’d pay the $5200 in taxes but then they would also have to pay taxes on the dividends of their investments at about a 33% marginal tax rate (special thanks to my ChicagoBooth classmate, Rich, for correcting me on this).  If you assume the same investments as we did above, 2% dividends and 5% stock increase, after 30 years they would have $815k.  That’s nothing to sneeze at, but that’s about $300k less than what they had with their 401k.  Those numbers seem crazy, but that’s the power of tax deferral.

2015-02-16 deferred taxes graphic (qd)

So the lesson is that using tax deferred accounts offers a really powerful way to accelerate the growth of your nest-egg by cutting out the tax man (in a totally legal way, of course).