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Off to College – The Tax Mistake to Avoid

It was one thing to start writing about Social Security and Retirement when I was still over a decade away, and quite another to write as a retiree with Social Security just a few years away. College is in that same category and my topic today.

I started saving for my daughter’s college the month she was born. We started to save all we could, as I had a forecast, from a spreadsheet I pulled up from then – the cost then was $20,000, as listed on one of the college planning sites, and with a 5% annual increase, this year would cost $48,000, and the 4 year bill, $208K. The cost I tracked was for private, out of state, schools. Better to plan for the high end than to assume a closer state school and come up short.

In the back of my mind, I knew that I was planning to retire early, but looking nearly 20 years out, I made the assumption that we’d both be working until college graduation. This assumption meant we shouldn’t plan to get any aid. In hindsight, we hit a bit of a Catch-22. By saving for college, we pushed ourselves into a situation where we wouldn’t qualify for aid. To be clear, had we planning for the “retirement before college” we might have paid off the mortgage and lined up an equity line for some of our spending over the 4 years. This is the irony to how aid is given. You can own a home with a $200K mortgage, and have $200K in the bank. In this case, that $200K is fair game, you’re paying tuition. But, no mortgage, no savings, you’re likely to get some aid. I’m not advocating this approach, but I am certain there are many who manage to game the system this way.

I do want to look at two things that can snag you, no matter how good your intentions. Both are related to the American Opportunity Credit (AOC). This is a credit of $2500 against college expenses. Not a tax deduction, a credit. It’s calculated as 100% of the first $2000, and then 25% of the next $2000 of college cost. The first potential snag is related to the 529 College Savings Account. This account allows you to save money post tax, and then use the money for college with no tax on the gains. A bit similar to the Roth IRA as far as tax treatment goes. But, here’s the rub. If you take the money for all college expenses from the 529 account, you have no expenses left to claim the AOC. What if you have the exact amount saved? You are still better off using $4000 cash to pay for school. You get back $2500, and can easily afford the tax if you withdraw from the 529 after school is over. In my case, I came very close to using money from a tax-favored Coverdell Education Savings Account (which is pretty similar to the 529) for the full first semester tuition, until I realized this. It would be awful to hit this issue and lose $2500 due to this.

The other AOC issue has to do with MAGA MAGI, Modified Adjusted Gross Income. The ability to take this credit is phased out over the MAGI between $80K-$90K if filing single or $160K-$180K if joint. If you are nowhere near this range, either low or high, you may not have any decision to make. On the other hand, say you were going to be at exactly $90K and filing single. Consider, you are in the 25% bracket, but with the loss of the AOC, the last $10K really cost you $5K. If you can plan ahead and bump your 401(k) or IRA deduction by $10K, your tax bill will be $5K less. Even a stock loss of up to $3K will help you along. For joint filers, the range is $20K wide, so the impact is a bit less dramatic. The $2500 difference over $20K of income feels like a phantom 12.5% vs the 25% for a single filer.

For further reading IRS Publication 970 is a great read to end your exciting summer.

Any questions or comments? Feel free to leave them below.

The Broken 401(k) Solution

Over 5 years ago, I wrote Fixing the 401(k) loan. It was in response to the number 1 reason to avoid the loan, the fact that it’s a risk. One day, you are working, paying all your bills, funding your 401(k), and doing it all right. The loan was to clean up the 18% credit card that was a result of medical bills, and you had no choice. Better to pay yourself, than to pay 18% for years. The risk of course is that if you lose your job, the loan is called in. If you don’t pay it back, it’s deemed a withdrawal, and you have taxes as well as a 10% penalty due. Ouch. This is why the 401(k) loan is frowned upon. Even if you just change jobs, you may not easily get the new 401(k) set up and move enough from the old account in time to borrow from the new account to pay the old. Just thinking about this give me heartburn.

Recently, I’ve been giving great thought to this. Not because I had a loan, but because my wife and I are retired. We’ve done very well using the advice that I offered readers in The 15% solution, a recommendation to strive to keep one’s tax bracket from creeping higher than 15% by strategically taking advantage of pre-tax retirement accounts while working. Now, retired, it’s a matter of throttling withdrawals to straddle the 15/25% line. Our budget has been fine these five years, but I’ll admit, we’d probably go over if we hit a very large expense, such as the new roof I’m anticipating. With other factors such as a rental property, the 15% bracket and 25% bracket aren’t precise. 15% results in about 20% of the last $10K as tax, and the 25%, closer to 29% of the next $10K. To keep it simple, let’s call it a 10% hit for going over.

As I pondered this, the light bulb moment came. I have Schedule C income, and therefore I was able to open a Solo 401(k). With just part time income, it’s not a large balance. However, I can transfer funds from my old job’s 401(k) or my IRA to this account. And the Solo 401(k) permits a loan, same rules as my old employer’s 401(k). I can borrow up to $50K or 50% of the account balance, whichever is lower. The interest is negotiable, typically, prime or a bit higher. My wife can follow the same strategy, offering us a combined $100K of accessible funds.

For the retiree, I can think of another important benefit. As I wrote about in the article The Phantom Couple’s Tax Rate Zone, a couple taking Social Security benefits can think they are in the 15% bracket, but the next $1000 of IRA withdrawal causes more SS money to be taxed. So, instead, they pay $275 on the next thousand (or $2750 on the next $10K). Obviously, they can’t do this each and every year. This strategy is for a one-time, or once every few years, event. It’s a cheap way of shifting taxable income out by a year or averaging it over the next couple years.

When I discussed how to beat the standard deduction, I shared a strategy that I used by year end. I’ll walk you through it now. As retirees, we pay our own health insurance premium. Normally, it’s not deductible as it’s just about 10% of our annual income. I wondered what the impact would be if I just paid ahead, paying the 2017 premiums in December 2016. I checked to be sure that prepaid premiums were deductible, and saw they are. I already had the 2016 tax software, and saw that it worked just fine, I’d see a combined 20% refund on the extra premium. Which immediately let me bump our withdrawal to again top off the 15% bracket making the benefit a full 30%, including our state tax. I offer this anecdote as part of this post for one reason. If I didn’t want to take a larger withdrawal and didn’t have the funds to pre pay the insurance, the 401(k) loan would have been my backup. Say my premium was $10K. The average of all 12 payments is mid-year, making my 20% benefit not a 20% annualized return, but more like 40%. The full $10K, along with just $500 or so in interest goes back into the 401(k), and you are still $2500 better off.

One last example of the beauty of the Solo 401(k). You have an IRA, which is valued at $100K, but includes $50K of non-deducted deposits. This could be for any reason, but likely because you started a job some time ago that offers a 401(k). Now, if you were to convert this whole IRA to a Roth, you’d be subject to tax on $50K, the portion that was deducted from income. If only there were a way to convert just the non-deducted $50K, so it could grow for decades, tax free. There is. You arrange a transfer of the $50K into your Solo 401(k). This leaves the remaining $50K with a $50K basis, and the Roth conversion is tax free. 8%/yr for 30+ years and this money should double 4 times to over $400K, only now, it’s tax free.

There’s a lot here to absorb. As you can see, the Solo 401(k) adds to the flexibility of your retirement investing, whether or not you take advantage of the loan provision. If you have any questions about any strategy I mentioned here, please drop a comment. Have you been caught with a 401(k) loan while changing jobs or getting let go from your job? Share your story with my readers.



Stock Allocation in a Balanced Portfolio

This is a guest post from Gabe Lumby, CPA. He runs Cash Cow Couple & Tightwad Travelers with his brother Jacob. When he isn’t busy running his online businesses, he enjoys spending time with his family and fishing for crappie on the local lakes in Southwest Missouri.

When putting together an investment portfolio, the options are endless. This is especially true when dealing with stocks.

There are a million different possible combinations and categorizations including active vs passive, value vs growth, small-cap vs large-cap, domestic U.S. vs international, and sector specific vs market wide. There are also a number of different options that attempt to blend these various categories.

Then there is the issue of (index) mutual funds and exchange-traded funds (ETFs). Both of these vehicles are used to accomplish the same investing objective of diversification. They are just different means to an end. Whether you own an S&P 500 index fund or an S&P 500 index ETF, you still essentially own the S&P 500. It just so happens that ETFs are usually slightly more tax efficient and sometimes have lower expense ratios, which give them a slight advantage.

Let’s jump into the various categories that are available when choosing stock allocation in a diversified mutual fund or ETF.

Actively Managed vs Passive

An actively managed mutual fund attempts to beat the market through buying under priced securities and selling overpriced securities. Most actively managed funds have a fund manager and a squad of analysts attempting to find the next hot deal. Some will try to find market trends, others will try to use valuations like the P/E ratio, but the goal is always to outperform the broad market index.

Most actively managed funds have much higher expense ratios than passively managed alternatives. Herein lays the problem. Because it’s so difficult to properly forecast short term movements in the stock market, managers have a tough time outperforming an index after accounting for fees. Most research shows that actively managed funds tend to underperform their passive alternatives over a long period of time.

A passive fund tracks a market index such as the S&P 500. The fund manager, which is usually a computer, only makes trades to keep the fund in balance with the associated market index. Because of the efficiency of this process, passive index funds (and ETFs) tend to have very low fees and their only goal is to replicate the gain of their respective index – such as the S&P 500 or Russell 2000.

In light of the evidence available that compares each, I choose to invest entirely in passive ETFs.

Value vs Growth

Value stocks are those that have a low price to earnings or price to book ratio. There are multiple hypotheses on why some companies have lower valuations at any given time, but let’s not get too concerned with that.

The thing to remember is that value stocks have historically outperformed growth stocks over a long period of time. They tend to slightly underperform during bull (upward) markets (like the 2000 tech boom) but significantly outperform during bears (when the tech bubble popped).

A growth fund contains stocks that are expected to grow more rapidly compared to the rest of the market. Growth stocks typically have some recent history of above-average growth in earnings. Investors like to see this growth and that makes these stocks appear sexy and attractive. This pushes prices higher during good markets, but often results in crashes that tend to destroy growth stocks later on.

Overall, I like a value tilt with my portfolio. It has outperformed in the past and I’m hoping it will continue to do so in the future. I have no idea if that will be the case.

Small-Cap vs Mid-Cap vs Large-Cap

A small-cap fund holds stocks that generally have market capitalization of between $250 million and $2 billion. A large-cap fund holds stocks that have a market capitalization of more than $10 billion. There are also mid-cap funds that hold between $2 billion and $10 billion.

Small cap companies have historically done very well when compared to larger, more established firms. This might be because investors tend to favor the more established firms which usually pay dividends, which lowers both the risk premium and expected return, or possibly because the smaller companies have much more room for growth and expansion.

On the other hand, small cap stocks usually involve more risk and volatility and there is debate on whether or not they outperform larger companies on a risk adjusted basis.

I still choose to hold some small cap ETFs in hopes that they will continue to outperform in the future. I’m not too concerned with volatility because I won’t touch the funds for many years.

U.S. Domestic vs International

A U.S. domestic fund consists entirely of U.S. stocks while an international fund consists of stocks outside the U.S. (at least from a U.S. perspective). You may be surprised to learn that the U.S. stock market capitalization makes up only around 1/3 of the total world stock market capitalization. Therefore, it’s wise to diversify and hold stocks from many different countries.

Foreign stocks are often broken down into EAFE and emerging markets on the broadest scale. EAFE stands for Europe, Australia, and the Asia Far East, all of which are supposed to be indicative of developed first world foreign nations. In recent years, these countries have been highly correlated with U.S stocks.

Emerging markets are slightly less developed countries which tend to be more risky and less correlated to the returns of U.S equities.

There is a diversification benefit provided from adding as much diversification as possible in a portfolio.

Sector vs General Funds

A sector fund consists of stocks that are part of a particular industry or sector. For example, there are energy, health, precious metal, and telecommunication sectors. REITs, or real estate investment trusts, are another sector that investors can appreciate.

Holding a sector like energy involves more risk than just choosing to hold the entire stock market. This is easily understood because the entire market would include energy stocks. Choosing to hold a specific sector involves idiosyncratic risk, which means it doesn’t reward the investor for taking the risk.

REITs can be a nice addition to a portfolio because they represent an asset class (real estate) that isn’t as available inside the broader market. Holding and REIT index like the one provided by Vanguard should provide additional diversification benefits over time. I own both domestic and international REIT funds.


If you are just getting started, I know this can all be a bit overwhelming. Don’t worry, it gets easier. More importantly, you don’t have to be an expert to get started investing.

If you can’t tell, I like Vanguard a lot. If you want to choose your own investments, Vanguard ETFs are robust and entirely free to trade. Consider what I wrote above and find an allocation that works for you.

If you are brand new to investing and don’t want to mess with implementing the above advice yourself, we would recommend Betterment as the best robo advisor option in 2017. Betterment does have a few competitors for you to compare and the robo advisor space is constantly evolving. Robo advisors offer a low cost investment option that is ideal for those not wanting to DIY and for those who don’t want to be sold some product by a financial salesman.

How do you choose your stock investments? Let me know your thoughts with a comment below!


How Much Should You Think About Taxes When Investing?

This is a guest post from Eric Rosenberg, a finance writer at Personal Profitability, InvestmentZen, and other personal finance, technology, and travel publications.

In many cases, investment gains are measured in terms of small percentage gains. But just because you earned a gain on an investment doesn’t mean you get to keep it all. Outside of some special rules for retirement, healthcare, and college savings accounts, you have to pay taxes on your investment gain. With real dollars at stake, it is important to understand how investment taxes work before you get hit with a surprise bill. Read on to learn how it works and how you can plan for capital gains taxes.

Taxes on investment gains

When you invest, some investments may go up and others go down. When you earn a profit while investing, it is called a capital gain, and is taxed under rules called the capital gains tax. Prior to the Affordable Care Act, capital gains taxes were a little simpler. Today, there are tiers of capital gains taxes depending on your overall income and the age of investments when you sell and recognize a gain.

If you are single and earn up to $37,950 per year or married and earn up to $75,900 in combined household income, you don’t have to pay any taxes on long-term capital gains. Long-term is defined as an investment you owned for one year or longer. Above those income levels, the long-term capital gains tax rate is 15% up to $418,400 in annual income when single or $470,700 when married. If your income is above that, I’m jealous! But that also means you fall into the highest capital gains tax bracket of 20%.

In most cases, short-term capital gains are taxed at your regular income tax level. For example, a married family filing jointly earning a combined $70,000 per year falls into the 15% tax bracket. Short-term gains would be taxed at 15% for this family, while long-term capital gains would require no capital gains tax.

Because most families earn less than $75,900 per year, most families would pay no long-term capital gains tax. The remaining 38% of the population falls into the 15% or 20% category.

Capital Losses and Tax loss harvesting

If you do fall into an income range where you owe capital gains taxes, you have some options to save on taxes. The two most common options for most investors include capital losses and tax loss harvesting.

The IRS understands that some investments lead to profits and others lead to losses. Rather than charging taxes on gains and ignoring losses, tax regulations allow you to offset capital gains with capital losses. For example, if you have one stock investment that earns $10,000 in one year and another loses $8,000, you would have a $2,000 net gain and only have to pay taxes on the $2,000 profit.

This is a simplified version of opportunities to lower taxes through a process known as tax loss harvesting. With tax loss harvesting, investors can sell investments with a loss and re-buy a similar investment to capture the loss for tax purposes. Capital losses can accumulate and carry over from year-to-year, so capturing a loss this year can offset a capital gain next year.

Manual tax loss harvesting is possible, but far from simple. The best results from tax loss harvesting require a computer. Robo-advisors like Betterment and Wealthfront stand out from other investment apps because they make tax loss harvesting automatic. With automated robots handling this behind the scenes, you can capture more tax losses to offset capital gains.

Retirement and other tax advantaged accounts

But wait, there’s more! The tax rules above only apply to regular old investment accounts. These accounts are considered taxable, as there is no protection from capital gains taxes when investing in a standard investment account. There are other accounts, often offered by the same brokerages, that offer a tax advantage over a regular taxable investment account.

Some accounts shield you from taxation as long as your cash and investments remain in the account. Some account contributions are considered pre-tax and others are considered post-tax contributions. Here’s how they work:

Pre-tax contributions are made in accounts like a 401(k) through your employer or a traditional IRA at your brokerage. In these accounts, you do not pay any income taxes on the contributions you make to the account in the year you earn the income. Then, you can invest and watch your investments grow for decades without paying any taxes. When you withdraw during retirement, withdrawals are taxed at your new income tax rate, with is presumably lower in retirement than when you were working full-time.

Post-tax contributions are made in accounts like a Roth IRA or Roth designated 401(k). In this case, you pay income taxes on your contributions, but do not pay any taxes on capital gains or withdrawals in retirement. This type of account is best for younger investors with a long-time horizon before retirement.

Retirement accounts are the most common tax advantaged accounts, but they are not the only option. 529 college savings accounts offer similar rules to pre-tax accounts like a traditional IRA. Healthcare focused HSA accounts offer both tax free contributions and withdrawals, which is the best of both! With these accounts, you can plan better for capital gains taxes, as some are tax-free and others offer a very long-time frame before taxes kick in during retirement.

Plan for taxes but don’t let them dictate your investments

I was once discussing taxes with a friend who insinuated that people would want to earn less as tax rates increase. That is a ridiculous idea! I would rather earn an extra dollar and give 40% to the government than not earn the dollar at all! The same is true of capital gains taxes.

While taking advantage of legal strategies to lower your tax bill is a wise financial decision, taxes should not scare you off from investing or dictate your investment decisions. The only time I have let taxes change an investment decision was when I was just a few weeks away from turning a short-term gain into a long-term gain, lowering my taxes on that specific gain on an investment I already had. I have never bought or sold investments just for tax reasons, and most people that don’t have many millions invested are typically best off doing the same.

If you hit a hot investment that brings you hundreds or thousands of dollars in gains, it is a time to celebrate. Sure, you’ll pay a portion of that gain in taxes, but you get to keep at least 80%. With so much to gain from investing, do not let taxes scare you away. You have much more to gain than to lose, and paying capital gains taxes is proof of a winning strategy.

The next time you see an article with a scary headline about capital gains taxes, don’t let it cloud your judgement on investment decisions. Investments should be focused on a long-term strategy to grow your wealth over time. Taxes are a part of the equation, but are far from an obstacle to success.

The 2017 tax plan – A look at a single parent return

First, the disclaimer. The proposed tax plan has so few details that it’s tough to discuss its impact with any degree of accuracy. I accept that caution, but so should all the people who are flag waving supporters of this plan. Last time, I wrote how a couple’s taxes might be affected, now let’s look at a single mom’s taxes. This mom has a good income, $60K/yr, and was left, from a death or divorce, with 2 children. She has a house, worth $260K with a $210K mortgage, putting the payment at $1000/month, or 20% of her monthly income. Her itemized deductions total $19,124. This includes mortgage interest, property tax, state tax, and donations. With 2 children, she has $12,150 in personal exemptions, and ends with a taxable $28,716 and a federal tax of $3,845. The new plan/proposal? She gets a standard deduction of $12,000. Since her mortgage interest and donations don’t exceed this, she doesn’t itemize. Her taxes are simple, to be sure. 10% of the taxable $48,000, or $4,800. Nearly $1,000 more.

What we don’t know is what extras will be offered to families with children, all we have is the vague line, “tax relief for families with child and dependent care expenses.” Hopefully, this will help, but keep in mind, the current Dependent Care FSA (flexible spending account) benefit is lost when the child turns 13. If you think your child’s cost drop at 13, you don’t have kids of your own. And I am still looking at the line, “Protect the home ownership and charitable gift tax deductions.” Home ownership, not interest, which again, gives us just enough ambiguity if the property tax deduction remains.

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