Tax Prep Rant
I’m a believer in do-it-yourself tax prep for situations that are fairly simple, as is mine (even with my wife’s small business to contend with). Following my own advice, I just did our taxes in about three hours. Consequently, I am now experiencing my annual post-tax-prep irritation at the complexity of our tax system and the amount of work required to comply. This year, for the first time, I’ll vent it on a blog, any blog. Oh, OK, this one will do.
Actually, with modern software (TurboTax, and the like) it is far easier than ever to prepare tax returns, but still not as easy as it should be. Because I use tax prep software the focus of my ire has shifted from the tax code to the software implementation (the existence of which facilitates tax code complexity, but that’s a different post). I’m rarely 100% satisfied with my software tax prep experience. There always seems to be little things that aren’t explained or don’t feel quite right.
This year, TurboTax nearly tripped me up by not offering to import my mutual fund data until after I had entered it by hand (which wasn’t hard). But when it finally got around to offering importation, which I accepted, I found my taxable events had been doubled, one set hand entered and another imported. Oops! Easy to fix, but sheesh! How many folks are going to catch that one?
I had a few other minor irritations in my encounter with TurboTax this year, but nothing easy to describe in words. So, let’s move on to my second source of annual tax frustration: the IRS withholding calculator and the use of allowances to index withholding.
Look, I have a very simple request to the IRS or Congress: give me the freedom to do withholding my way and in return you’ll get what I owe you with far less error. I know with better accuracy than anyone else in the world what my taxable income will be in the next tax year. I can look at my 1040 from the prior year, make a few adjustments for things I can predict, and voila, out pops a reasonable estimate of my taxable income. Next, I can look up the tax rates and, presto, I know fairly well what my tax will be next year. Call it X. Now, all I want to do is tell my employer how much to withhold from each of my 26 paychecks. This isn’t hard. It’s X/26.
But wait! I can’t just give that number to my employer. I have to convert it into some integer called “allowances.” The method of converting to allowances is complicated and, um, STUPID!!! To make it easier one can use the IRS withholding calculator. Except, that’s stupid too because it is not based on the entries in my prior year’s 1040. It seems as if it is, but it isn’t. For example, they ask you for your expected wages and your 401(k) contributions. That’s, must I say it again, STUPID. It takes far more work to figure that out than to just look up your taxable wages on your prior year’s 1040 (and then inflate that a little if you really want to).
Also, the withholding calculator has no way of handling self-employment income and the sundry deductions one gets for a small business. Guess where all that information is? ON MY LAST YEAR’S 1040!!! So, thank you very much IRS, but you’ve found a way to make a very simple thing–something I can do in my head–nearly impossible to do half as well and for no good reason.
I know I’m going to get a lot of advice on how to do this in a less frustrating way. Good, give it to me. I want it. And Uncle Sam should want me to have it because the biggest source of error in my tax withholding is due to the cockamamie ways the IRS offers to help me calculate it. And somebody please tell me why withholding allowances make sense. Can’t do it? How about just tell me the formula that converts allowances to dollars. Now that would be helpful!
Bogleheads on Retirement Planning
By middle age or thereabouts, it is a good idea to know a bit about each of several issues relevant to retirement planning other than investing. The relevant topics include estate planning, annuities, social security, health insurance, among others. Knowing a bit about each will help one know which applies to one’s situation and when to learn more. Removing the unknown unknowns is a good idea.
Enter The Bogleheads’ Guide to Retirement Planning. In 20 chapters–each roughly 16 pages–it covers all the essential topics relevant to retirement planning, not just investing. Therefore, before you or your spouse is ten years from retirement The Bogleheads’ Guide to Retirement Planning is recommended reading (assuming you’ve already had a sound retirement investment plan for decades).
The Oblivious Investor reviewed The Bogleheads’ Guide to Retirement Planning last October and I agree with his broad sentiments:
I’ve read books that are intended to be “all you need to know about personal finance.” And I’ve read books that are intended to be “all you need to know about investing.” But The Bogleheads’ Guide to Retirement Planning is the first book I’ve read that’s “all you need to know about planning for retirement.” Note the distinction: This book is not about saving/investing for retirement. It’s about planning for retirement (and everything that’s a part of such planning). The best part about the book, in my opinion, is the breadth of topics covered.
Of course, each topic is treated rather briefly so one would need to turn to other sources for details. (Indeed, it doesn’t suffice as a guide to investing, but the other Boglehead book, The Bogleheads’ Guide to Investing, nicely fills the role.) Each chpater of The Bogleheads’ Guide to Retirement Planning ends with a list of further reading so it serves as a guide to the broader literature as well.
It was a particularly fun read for me because I know (in a sense) some of the authors through their participation on the Bogleheads Investment Forum. A few of them have a had important impacts on my own investment planning, notably tfb (of The Finance Buff) and EmergDoc (Jim Dahle). Another nice touch is that the book includes a chapter on dealing with financial disasters. Since a good portion of the population will face one (divorce, bankruptcy, and the like) it makes sense to be armed with a bit of information about what to do, if only to have a good idea of where to turn for help.
I did find it rather amusing that most chapters include the boilerplate advice to consult a paid professional. That’s odd coming from the Bogleheads who are notorious do-it-yourself-ers. Many readers and most full-blown Bogleheads will not need a professional to assist with some areas, like investment planning or taxation issues. All they need are some good books and a good place to find the details, like the Bogleheads Investment Forum. Seeking professional advice makes good sense for almost everyone in some areas for which legal precision is required, like estate planning.
In conclusion, my recommendation is that young investors read The Bogleheads’ Guide to Investing. That’s all one needs for retirement investment planning, though there are other good books too (many reviewed by The Finance Buff). As retirement approaches, or earlier if you’re just interested, complete your base of knowledge with The Bogleheads’ Guide to Retirement Planning.
How Large an Emergency Fund?
Conventional wisdom is that we all should have an emergency fund (EF), a chunk of cash (or equivalent) set aside for use when financial trouble strikes. When employment prospects are good, I’ve seen recommendations for EFs as low as three months of salary. In times of high unemployment, some recommend EFs as large as one year’s worth of salary.
These are seat-of-the-pants estimates. If anything they’re based on how long it might take you to regain employment after loss of a job. But income replacement isn’t the only purpose of an EF. One might tap it in the event of any financial emergency (e.g. unexpectedly high health care costs, urgent home repair, etc.). My interest in this post is to explore a rational means by which to set one’s EF size. It is based on the work by Charles Hatcher, summarized in a prior post. (See also the Bogleheads Forum discussion of Hatcher’s methods.)
In Should Households Establish Emergency Funds? Hatcher compares the opportunity cost per year of having an emergency fund (the difference in rates of return between a more aggressive investment and that of the EF cash equivalent holding, denoted by the liquidity premium) with its per-year benefits if an emergency occurred (the avoided borrowing costs). The result is a simple expression for the minimum probability, p, of an emergency in a given year such that holding an EF is rational: p=(r2-r1)/rb, where r2 is the rate of return on investments, r1 is the rate of return of one’s EF, and rb is the borrowing rate (Hatcher suggests a APR/2 is a good estimate of the borrowing rate).
Hatcher assumes that the EF is equal in value to the cash needed in an emergency so the expression of the probability of rationally holding an EF given above is independent of EF size. That provides an opportunity to use it to determine a rational EF size as follows. If we interpret p as the lower bound on the annual rate of emergency such that an EF is rational we can ask: what is a typical size for an emergency that occurs with at least that frequency? The answer to that question provides some guidance to the rational EF size.
Let’s use a concrete example. Suppose borrowing costs are 18% APR, which is typical of some credit cards but much higher than a home equity loan. Then rb is about 18%/2 = 9%. Suppose also that the liquidity premium is r2-r1 = 2% then the probability of an emergency must exceed about 22% to justify an EF. That’s about one emergency every five years. Based on one’s own experience one might have a general sense of the size of an emergency that’s likely to occur at that rate. I certainly do. For me this would suggest that an EF no larger than two months of salary ought to be sufficient. Of course, my borrowing costs may be even lower and liquidity premium may be higher. So maybe I could get buy with an even smaller EF.
Instead of relying on my own intuition of typical emergency size over some time period, I’d love to see a study of such a thing. For example, an analysis of variation in monthly household outflow relative to income as a function of important variables like household size, age of head of household, education, and other relevant economic and demographic variables would be useful. From such a study one could estimate various measures of the likely largest emergency that would occur over an interval of time.
I think the foregoing approach is one reasonable place to start in determining a rational EF size. But I wouldn’t end here. I’m not convinced one can know one’s borrowing costs and liquidity premium at the time of an emergency. The former could be higher and the latter lower, suggesting an even higher EF is rational. That’s one reason to increase one’s EF beyond the size suggested above. Another reason is peace of mind. There is no law against being irrationally conservative. Sleeping well at night is worth something.
The Real Cost of College: Less Than You Think
In a NY Times Economix post last November David Leonhardt interviewed Sandy Baum, an economist at the College Board and lead author of the its annual report on college tuition. Baum said several things about the amount of grant aid (as opposed to loans) available to offset the rapidly rising college sticker price.
The majority of students receive some grant aid. According to Baum, two-thirds of full-time college students receive some grant aid and 80 percent attending private institutions do. All that aid reduces the effective price considerably.
The average grant aid for full-time public two-year college students is more than enough to pay the $2,544 published tuition price. So the average net tuition price at these schools is actually zero. At public four-year colleges the average net price is about $1,600 (compared with a list price of $7,020). At private four-year colleges, it’s about $11,900, compared with a list tuition price of $26,273.
These prices don’t include room and board or other costs.
Grant aid has been rising faster than college tuition recently so the net price has been dropping for those receiving aid. Not all the grant money is distributed based on need. Some is distributed on merit. So even if you’re reasonably well off you may not pay full price.
At public four-year colleges, about two-thirds of the institutional grants awarded are non-need-based. And of course, federal tax credits and deductions go primarily to middle- and even upper-income students and families.
For more from the NY Times on college admissions and aid see their The Choice blog. Leonhardt suggested these three posts in particular.
It is a shame that markets for the most important services (health, education) also have the most opaque pricing. At least when it comes to college, the price is likely to be lower than we fear. The same cannot be said for health care.
Paid Child Care: A Crazy Quilt of Crushing Cost
This year is my family’s costliest one for child care. With two children in paid care arrangements we’re really feeling the pinch. It doesn’t help that we live in the costliest state for child care, according to The National Association of Child Care Resources & Referral Agencies report Parents and the High Cost Price of Child Care: A 2009 Update. Fortunately, things will ease up considerably next year when our oldest enters kindergarten and our youngest enters our town’s (paid) public pre-school program, which is far cheaper than day care.
Day care costs and arrangements are insane in this country, at least that’s our experience. We’ve attempted to keep costs reasonable and tried lots of different arrangements. But it has been a crazy patchwork quilt. Since turning one, our older daughter has been in four day care/pre-school settings and both our children have had a half dozen different nannies or baby sitters.
We’ve changed providers so much in part because our family’s needs have changed and in part because of quality issues. A shockingly small percentage of providers we’ve tried impress us. We’re delighted that our town’s public pre-school program is an exception. It is very impressive and has been the highest quality early childhood education our older daughter has experienced. Bravo!
One other bit of insanity associated with child care is the web of cash flows. Take our younger daughter’s current arrangement, a nanny share with another family. There are nine different financial entities involved in flow of money from the families to the nanny:
- Three bank accounts: one for each family, one for the nanny,
- Two employers, each with two dependent care flexible spending accounts (I’m counting this as four entities),
- Two governments: federal and state, for collection of payroll and income taxes, unemployment and worker’s compensation fees.
It is a stunning amount of paperwork and shuffling of money for the care of such a cute, tiny being.
Sometimes I wonder why child care in the U.S. is so complicated and inconvenient. Every parent goes through several years to a decade dealing with it. Few like it. Hardly any I know find it sensible or easy to manage. Nearly everyone thinks it is expensive. It sucks, and it sucks for everyone.
One hypothesis why it doesn’t improve is that parenthood is just so darn exhausting and the demands are unrelenting. Plus, by the time you’re through with it anything you do to improve it won’t affect you. Day care is just one of the earlier challenges of parenthood, but no where near the last. When my kids are through with day care I’ll probably behave just like most other parents who dealt with it: put it behind me, try to forget about it, and not lift one damn finger in trying to fix it. I’ll be too busy dealing with the problems of primary and secondary education, among others. They’re messed up too in their own special ways.
Taxing Financial Transactions
The Obama Administration is looking for ideas in the area of taxing financial transactions. Ezra Klein asked for thoughts. Even though I haven’t read deeply into this area (*) I have an idea to share. I would not be at all surprised if it has already been proposed or considered by those more knowledgeable in this area than I am. Nevertheless, here goes:
We already tax financial transactions in a way via short- and long-term capital gains, the cutoff between the two being one year. If a policy goal is to reduce high-frequency trading I have two ideas that build on the current tax framework: (1) Include a “very short” category with, say, a cutoff of a quarter year, or month (or whatever makes sense to the folks who really know this stuff). This very short category could have, though need not have, an even higher capital gain tax rate than the current short-term one does; (2) Eliminate the ability to write off short-term (or very short-term) capital losses. Ideas (1) and (2) need not be combined.
A third idea is to remove the taxation exemption from otherwise tax preferred accounts (401(k)s, IRAs, 529s, etc.) but only for very short-term trades. I can already hear the howls on this one as it might be characterized as the first step down the slippery slope toward elimination of tax advantaged vehicles. Still, if we want to provide an incentive for buy-and-hold, we can’t ignore tax advantaged accounts, can we? High-frequency trading can be done under those vehicles so why should they be exempt?
The point here is not to penalize everybody who wishes to participate in the market, but to make some (perhaps crude) distinction between types of market behavior. We already do this, as I said, so why not build on it?
What do readers who know finance better than I do think? (TFB, Mike, others?)
(*) This disclaimer serves as notice that this is a deviation from my M.O. You’ve been warned!
Note: I added the paragraph about tax advantaged accounts in a later update to this post.
The Dryer Sock Decade
When both “Frank Curmudgeon” of Bad Money Advice and TFB of The Finance Buff declare a decade as “lost” (TFB) or “misplaced” (Frank) I can’t help but agree. Both are smart commentators on personal finance issues. They know how to compute real internal rates of return. They know what a risk premium is. They both dismantle Ron Lieber’s attempt to put a positive spin on the decade.
So I’ll say it too: in the first decade of the 21st century (more or less) investors lost considerable wealth. The only thing left is to name the no-good-very-bad decade. Frank makes a stab:
I will always think of the 2000-09 period as the Really Fast Decade. Seriously, it feels like it lasted ten months, at most. For investors and savers, one obvious nominee is The Lost Decade. My main objection to this is that the name is already taken, referring to the 1990s in Japan, where two generations of postwar economic expansion came to a sudden and bewildering halt on or about January 1, 1990. Compared to that, our last ten years wasn’t really all that lost. The Misplaced Decade?
Frank is correct that humor is the right salve here. In that spirit I offer The Dryer Sock Decade. Like the mysteriously disappearing footwear of its namesake, the gains it might have offered are gone and wish as you might Ron Lieber they can’t be made to come back.
Are Emergency Funds Rational?
It is conventional wisdom to hold an integer multiple of monthly salary (at least three to six months and perhaps as much as twelve) as cash or cash equivalents in an emergency fund (EF). The purpose of an EF is to allow one to weather an interruption in cash flow (e.g. due to loss of employment) or other financial emergency (e.g. major unexpected expense) without tapping one’s retirement or other dedicated or event-specific investments.
Nevertheless, the financial literature suggests only a minority of American households meet even the weakest test of EF adequacy. This begs the question: which set of Americans are behaving rationally, those with or those without EFs?
I’ve asked similar questions on financial forums and until recently had not received an adequate explanation. If EFs are rational one ought to be able to justify them on the grounds that the borrowing costs they avoid are larger than the opportunity cost of holding low interest EF assets (cash and equivalents). I wanted to see the study that showed this or the opposite.
Only recently did someone point me in the right direction. Should Households Establish Emergency Funds? by Charles Hatcher (Financial Counseling and Planning, 2000) addresses this very question in two ways.
The first is a comparison of the opportunity cost per year of having an emergency fund (characterized by the difference in rates of return between a more aggressive investment and that of the EF cash equivalent holding, denoted by the liquidity premium) with its per-year benefits if an emergency occurred (characterized as the avoided borrowing costs). The result is a simple expression for the minimum probability of an emergency in a given year such that holding an EF is rational. (Hatcher assumes that the EF is equal in value to the cash needed in an emergency so the results are independent of EF size.)
Even with borrowing costs as high as 18% APR (typical of some credit cards but much higher than a home equity loan) and a liquidity premium as low as 2% (well below the expected spread between equity and cash holdings) the probability of an emergency must exceed 21% to justify an EF. That’s about one emergency every five years. Of course for lower borrowing costs or higher liquidity premiums an EF is only rational if an emergency is expected with even greater frequency.
Next Hatcher simulates 40 year life-cycles of two individuals, one with an EF and one without. He varies many of the relevant parameters (borrowing costs, liquidity premium, rate of emergency) and asks, under what conditions does one or the other have higher net worth at the end of the simulated life? Again, it turns out that the EF holder is better off only when borrowing costs are very high relative to liquidity premium and emergencies are fairly frequent (e.g. one every four years).
Hatcher concludes with the right first question about EFs: not how big should they be but who should have one? His results suggest that only those with very high borrowing costs and/or with expected high probability of an emergency should consider an EF. For the rest of us, an EF is not rational. It is not financially optimal.
It is worth noting that Hatcher is not entirely alone in his view of EFs. Bi and Montalto also suggest that a reasonable alternative to EFs are home equity lines of credit (Emergency Funds and Alternative Forms of Saving, Financial Services Review 13:93-109, 2004). (Counter argument: equity lines have to be established in advance of an emergency such as job loss and can be revoked.) Bhargava and Lown suggest diversifying funds that would otherwise constitute a cash (or equivalent) EF holding into more risky and higher return asset classes (Preparedness for Financial Emergencies: Evidence from the Survey of Consumer Finances, Financial Counseling and Planning 17(2), 2006).
So, my question has finally been answered. EFs may not be as universally rational as is suggested by some. I have to admit, I never thought so. My EF has always been on the lower end of what is normally recommended for this reason (also, I have pretty good job security). Nevertheless, I do have an EF, and I’m not giving it up. In part it serves as a cash flow buffer, which I need anyway given variations in monthly expenses. The rest just helps me sleep at night, a factor not included in Hatcher’s analysis.
Personal Debt: McArdle on Ramsey, Etc.
Megan McArdle has intersected with my information sources twice in the last few weeks, this time on the topic of debt. Those of you who read this blog for its personal finance content might be interested in McArdle’s work on this issue.
Her piece in the December 2009 issue of The Atlantic, to which I subscribe, is a close look at Dave Ramsey, his debt reduction and avoidance approach, and McArdle’s own implementation of it.
She was also interviewed on the 7 December 2009 episode of EconTalk, which is among my favorite podcast-delivered programs. The interview begins with a discussion of debt, Ramsey, his system, McArdle’s experience with it, and then turns to other areas in which we struggle with self-restraint (dieting, time-management, organization, and the like). If you’ve never listened to EconTalk and are interested in finance and economics, McArdle’s interview is a good introduction to the program. Give it a try.
Roth Conversion: Do You Have the Headroom?
We’re coming into the time of year when I begin to consider how much of my traditional IRA funds to convert to a Roth IRA. Because there are tax implications one should think Roth conversion through carefully. If you haven’t done this exercise yet this post may help, though there are a lot of other places online to find the same information.
Considering the tax implications of Roth conversion is something more people may be doing in 2010 when the income limits on Roth conversion are eliminated, making Roths available to many who did not previously have access (see the Center on Budget and Policy Priorities report Roth IRA Provision Effectively Eliminates Income Limits on Roth IRAs: Establishes Major New Tax Shelter For High-Income Households).
The first thing to recognize is that every dollar converted to a Roth IRA that has not previously been taxed is taxed upon conversion at your marginal income tax rate. For example, every dollar converted from a tradional (or rollover) IRA is taxed. Earnings converted from a non-deductible IRA are taxed. Assuming you want to pay the lowest possible taxes it is unlikely a good idea to convert your entire traditional, rollover, or non-deductible IRA to a Roth all at once. You’ll probably want to do it gradually, year-by-year. Here’s why:
Every converted dollar that has not been taxed is taxed upon conversion because it increases your taxable income by one dollar. Add enough dollars to your taxable income and you’ll break out of your current marginal tax bracket and into the next one. Suddenly you’re not paying 15% on your converted dollars (if that was your tax bracket) but 25% (the next braket up). Or you’re paying 33% instead of 28%. You don’t have to do that.
You are permitted to convert as much or as little of your IRA funds to a Roth as you like. You can spread it out over as many years as you like. Doing so spreads out the tax payment and gives you an opportunity to match your annual conversion amount to your “tax bracket headroom”: the difference between the top of your marginal tax bracket and your taxable income before conversion.
For example, in 2009 the 15% tax braket for a married couple filing jointly applies to taxable income in the range $16,700 to $67,900. Suppose your taxable income is $50,000 without any conversion funds. You have $17,900 of “headroom” left in the 15% bracket ($67,900 – $50,000). Therefore, you can convert $17,900 of taxable funds to a Roth and only pay 15% tax on those funds.
If you convert more, you’ll pay a higher tax on the additional amount (25% on the next $69,150 of taxable conversion in 2009). But why do that? You can wait until the next tax year to convert additional funds and save on taxes by doing so. This is precisely what I do. Each year, before the end of December, I estimate how much headroom I have in my marginal tax bracket and I convert just enough into my Roth so as not to exceed the top of the bracket. This estimation isn’t precise because I don’t know my taxable income exactly until I do my taxes in March or so, but it is better than guessing and far better than just converting the whole amount.
Caveats and notes: (1) Due to the market downturn, this year it might have been advantageous for me to have converted early in the year an amount beyond the size of my tax bracket headroom. I would have been taxed at a higher rate for some of that conversion but I would have converted at a time when the total was depressed, avoiding taxes in the future when the portfolio recovers. I didn’t do that. I didn’t even try to calculate if it would have been a good idea. (2) In 2010 there is a special option on conversions. You can pay no tax in 2010 and spread the tax due over the two years: 2011 and 2012. For an excellent article on the special 2010 conversion rules see Making a Good Deal for Retirement Even Better (Wall Street Journal). (3) There is also five-year rule that pertains to qualified Roth distributions (of earnings) taken before age 59.5 (an early distribution). The clock on those five years restarts at the time of conversion. If you’re considering taking an early distribution of earnings you should do some more reading about the five year rule. See 5 Year Rule for Roth IRA Qualified Distributions at Good Financial Cents.
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