Education, advice, and evasion

Become a Patron!A few years ago I wrote about one of the curious fixations I observed among the wealthy denizens of the finance industry: the need for "personal finance" education. In this telling, the problems troubling American civilization are not the result of financial deregulation, or corporate consolidation, or employee misclassification, or wage theft, or race and gender discrimination, but rather a simple lack of knowledge. If high school students were instructed in how to balance a checkbook, no other changes would be necessary to usher in the gleaming, gilded, capitalist paradise of Galt's Gulch.I already explained why this conceit is absurd, but I've recently been thinking about how to break down the different layers of communication that are passed off under the mantle of financial education.

Financial education

I consider financial "education" the most elementary layer of personal finance communication. People aren't born knowing what a 529 college savings plan is, what the contribution limits are, or what expenses are eligible for tax- and penalty-free distributions, and many people die without knowing what they are. That makes education the pure transmission of information: 529 college savings plans exist. Individual retirement accounts exist. 401(k) and 403(b) workplace retirement savings plans exist.This information may be interesting, but it's not useful on its own as anything more than dinner party conversation, and we're not allowed to hold dinner parties any more.However, when financiers say personal finance "education," what they usually mean is generic financial advice.

Financial advice

The difference between financial education and financial advice is the difference between saying "there is such a thing as individual retirement accounts" and "you should maximize your annual contribution to your individual retirement account."Financial advice, unlike financial education, is tailored to the individual's circumstances. IRA's exist whether or not your income makes you eligible for deductible contributions, Roth contributions, or non-deductible traditional contributions. But whether or not you, personally, should make deductible, Roth, or non-deductible traditional contributions depends on your personal circumstances — and even worse, it changes as your circumstances change! At the most basic level, the more lucrative your non-IRA investment opportunities are, the less inclined you should be to make IRA contributions.Unfortunately, most financial advisors don't know what they're talking about, because they aren't actually trained in giving financial advice: they're trained in tax evasion.

Tax evasion

I once researched, but never published, a post about the role taxes played in post-war Britain on the global export of British music, as performers were required to spend most of the year outside of the United Kingdom in order to avoid taxes on their worldwide income. There's even an anecdote about a Beatle (or was it a Rolling Stone?) insisting his private jet circle over Heathrow until midnight so that he didn't exceed his allotted days on English soil.This is the category of advice financial "advisors" tend to provide: tax evasion stands in as a substitute for actual financial advice. Without knowing anything else about a person's situation, you can tell them to maximize their IRA contributions, maximize their 401(k) contributions, harvest capital losses during high-income years and capital gains during low-income years, strategically name 529 plan beneficiaries, and front-load contributions to donor-advised funds.But it's absurd to call this financial advice. Someone who tells you how to make more money is offering financial advice. Someone who tells you how to spend less money is offering financial advice. But someone who writes a letter for you to the IRS explaining that actually comparable salaries in your industry are $30,000 so you shouldn't be liable for FICA taxes on your sales of $5 million isn't offering financial advice, they're evading taxes on your behalf.You may think that's a service worth paying for, or you may not, but when financiers promote the benefits of financial education, don't forget they're talking about spending scarce classroom time teaching kids how to evade taxes.Become a Patron!

Five profitable things to do with low-interest loans

Become a Patron!I've written many times about my fondness for low-interest, and especially low-fee, balance transfer and cash advance credit cards, which allow consumers to borrow large — sometimes very large — sums of money for a fixed period of time and pay nothing to the bank if the loan is paid off by the end of the promotional period.This is a form of what I think of as "institutional arbitrage," which is possible when different categories of institutions are able to borrow and lend across what should be, but are not, airtight boundaries. This kind of institutional arbitrage is the underlying mechanism for a lot of both travel and personal finance hacking.

My five favorite uses for low-interest loans

1. Swap secured for unsecured debt. A classic example here is something like a car loan that is secured by the vehicle itself. While interest rates on car loans aren't particularly high right now, you might prefer to extinguish your secured car loan with an unsecured, loan-interest credit card loan, so you can keep your car if pressed into default on the unsecured credit card debt. In an even more complicated version of this strategy, you might use unsecured, low-interest credit card loans to pay off student loan debt, which in most jurisdictions is undischargable even in bankruptcy!
2. Make or accelerate "use it or lose it" retirement contributions. I've written before that "use it or lose it" is the most important feature of retirement accounts. When you let a calendar year's contribution deadline pass (usually that year's tax filing deadline), you've permanently reduced your ability to shield dividends and capital gains from annual tax assessment. Taking out a low-interest loan to maximize your annual contribution allows you to lock in guaranteed tax savings, and work out the details later.
3. Meet intermediate financing needs. Some businesses, like resellers, find deep discounts on merchandise while it's out of season or out of favor. Swimming trunks in January, fur coats in August, and so on. They may want to hold onto the merchandise until it's back in season or back in fashion, and low-interest loans are one way of financing that intermediate-term inventory.
4. Meet high balance or deposit requirements. Earning the highest possible interest rate on your cash savings has always required a bit of legwork. I assume back when interest rates were kept artificially low, our ancestors would open bank accounts all over town in order to collect as many toasters as possible to sell to their friends and family. The same principle works today: accounts that offer nothing in interest on your deposit will still offer a cash signup bonus to attract your business. The deposit requirements, however, can be substantial: as high as $50,000 in the case of Citi's current $700 bonus. But if you're playing with the house's money, that's a higher interest rate than you're likely to earn on any other safe investment. Similarly, you might consider funding certificates of deposit with rewards-earning credit cards and then using low-interest loans to pay off your credit balances before any interest is owed.
5. Get cash discounts. I grew up hearing stories, which I choose to believe are true, but have no evidence of whatsoever, that when my father needed a new car, he would walk in the dealership with a briefcase full of cash and make the dealer an offer he couldn't refuse. In the consumer world I don't think there are very many "cash discounts" still available, but in business-to-business interactions I imagine there are still companies willing to accept less, perhaps much less, if you're willing to pay in cash up front. The reason most businesses aren't able to do so is they rely on the lag time between their purchases and sales to finance their operations! But if a low-interest loan allows you to settle immediately in cash, you may find vendors as flexible as my dad (allegedly) did.

Conclusion

Hopefully the above examples illustrate why I call this "institutional arbitrage." If Discover could deposit $50,000 with Citi and earn $700 in interest, they surely would. But Citi doesn't offer $700 signup bonuses to other banks — it only offers them to consumers, so the consumer becomes the intermediating institution. The consumer can take out a consumer loan from one bank, make a consumer deposit in another bank, and earn a return that the lender would not earn and the depository would not offer on their own. Hence, institutional arbitrage.Become a Patron!

Three approaches to cutting federal bonds out of untaxed accounts

Become a Patron!Last month I wrote about the curious fact that mutual funds designed to be held in retirement accounts, where their distributions are generally untaxed year-to-year, nonetheless hold federal bonds that are exempt from state income taxation. I suggested that it should be possible to optimize your retirement account holdings by replacing those federal bonds with taxable corporate bonds.Once I get an idea in my head it's hard for me to let go of it until I follow it to its end, so I decided to see if there was an easy way to make the swap.

How to think about your federal bond holdings

As I wrote in the previous post, if you own virtually any target retirement date or target risk fund, or a total bond market index fund, you probably own a lot of federal bonds simply because they constitute such a large share of the US bond market: about 43% of Vanguard's Total Bond Market Index Fund, for instance, is in federal bonds, and about 35% of its income is attributable to federal sources.What this means is that when you own the Total Bond Market Index Fund, either as a separate mutual fund or ETF or in a packaged target retirement date fund, you're saying you are willing to accept the interest rate the fund pays, given the volatility of the fund and the safety of the fund.When you hold the fund in a tax-advantaged account, however, you are also "paying," in the form of a lower interest rate, for a benefit the fund offers all shareholders, but which you are not using: the exemption from state income taxes of the federal portion of the fund's income stream.Logically, there are three ways you can "cash out" the value of the state income tax exemption you're not using. For these examples, I'll be using the following funds in case you want to check my math or strike your own balance:

• VTBIX to represent the total bond market;
• VCSH to represent short-term corporate bonds;
• VCIT to represent intermediate-term corporate bonds;
• VCLT to represent long-term corporate bonds;
• and VGSH to represent short-term federal bonds.

Option 1: match yield, minimize duration

"Duration" is a term of art that refers to the sensitivity of the price of a bond (or bond mutual fund) to changes in interest rates. A short-term bond has a lower duration because changes in interest rates don't have a big impact on its price: since the bond will mature soon, you can reinvest the principle at the new interest rate frequently. A long-term bond has a higher duration since you have to wait a long time to take advantage of higher interest rates, while if interest rates fall you can happily collect your legacy coupons for years to come.All else being equal, for any given yield, you should prefer your bonds to have a lower duration, thereby reducing their price volatility. As of the time I ran my calculations, you can match the 1.95% SEC yield of VTBIX with a combination of 73% VCSH and 27% VCIT. While offering the same SEC yield, by excluding the long-term bonds present in the total market fund, this corporate bond portfolio has a much shorter duration: 3.57 compared to 6.26.In this option, you're exchanging the unused state income tax exemption for a much lower level of price volatility.

Option 2: match duration, maximize yield

Since we specified at the outset that when you own VTBIX you're implicitly accepting the exposure to changes in interest rates embedded in that fund, another option is to try to match that interest rate exposure while exchanging the state tax exemption for higher-paying corporate bonds.In principle you could achieve this in almost unlimited ways, but I found a simple equilibrium in a corporate bond portfolio of 12% VCSH, 82% VCIT, and 6% VCLT. This portfolio has a duration of 6.24 (still slightly lower than VTBIX) and an SEC yield of 2.31%, about 18% higher than VTBIX.

Option 3: match Treasuries, optimize something else

At this point you might be scratching your head and saying this whole experiment has gone too far. We started with a minor observation about an unused tax benefit, and now we're cutting Treasury securities out of our retirement portfolio entirely? And you're exactly right: remember that Treasuries have not one, but two advantages. The income they generate is generally exempt from state income taxes and they're completely safe (if held to maturity).While the corporate bond ETF's I've been using to illustrate these options only hold investment-grade securities, anyone who lived through 2008 knows that the term "investment-grade" can conceal just as much as it reveals. That being the case, you might simply chop your bond holdings into two categories: the federal bonds you hold because they're ultra-secure and the corporate bonds you hold to optimize some other value, like yield, duration, or credit.As mentioned, VTBIX holds about 43% of its value in federal securities. If that's the level of Treasury security you want in your domestic bond portfolio, you can simply allocate 43% of your domestic bond portfolio to a short-term bond ETF like VGSH. With that out of the way, you can set about optimizing your corporate bonds for some other value. Portfolio Visualizer has a nice, free tool that lets you optimize a portfolio for things like Sharpe ratio or risk parity (note: I have nothing to do with Portfolio Visualizer and don't vouch for any of their tools or results).

Conclusion

As a general rule, bonds are helpful to have even in the most aggressive investment portfolio, not because they're expected to contribute to total return, but because their imperfect correlation with stocks means they periodically present opportunities to rebalance into higher-expected-return assets. Treasury bonds offer the additional advantage of a federal guarantee of their value (if held to maturity) and exemption from state income taxes.In tax-advantaged accounts, you may well value the imperfect correlation of investment-grade bonds with stocks, and you may well value the federal backing of Treasury securities, but you should not value the state income tax exemption at all: you're not paying state taxes on the income either way. That means there should be some margin at which you're willing to shift away from the default allocation to federal bonds, either in order to reduce your risk even more, to collect additional yield from investment-grade corporate bonds, or to optimize your portfolio across both risk and yield.Become a Patron!

Don't pay for tax benefits you're not using

Become a Patron!I had a very interesting conversation today that got me thinking about a tax issue I had never given serious thought to before, and which I think is probably totally unknown to most investors, but that affects virtually all of them: the exclusion of US federal interest payments from state income tax liability. Upon just a moment's reflection, I realized that a vast swathe of US investors are making a simple and (relatively) easily avoidable error.

Asset allocation, asset location, and asset selection

In order to optimize your long-term rate of return, you typically have to take into account three factors:

• Asset allocation, or risk tolerance. This could be as simple as a 60% allocation to stocks and a 40% allocation to bonds, or as complicated as a carefully weighted average of every region and asset class in the world, rebalanced daily. There's no one right asset allocation for everybody but, in general, the more you depend on your assets for ongoing income, the less volatility you should be willing to tolerate in their value, and the more you plan on leaving to your children or grandchildren the less you should care about their day-to-day value and the more you should focus on the long-term potential for appreciation.
• Asset location. Some assets are more tax-efficient than others: if you own mutual funds that are constantly spinning off capital gains, the taxes you pay each year represent a drag on your overall returns. Those funds are best held in accounts where capital gains are shielded from annual taxation. Likewise, shares in companies like Berkshire Hathaway that refuse to pay dividends and instead reinvest their profits internally are a better fit for taxable accounts, since owning them generates little or no tax liability.
• Asset selection. Once you've settled on your asset allocation, and set up your IRA, 401(k), and 529 plan contributions, you still have to implement the allocation by choosing the securities you want to invest in. The simplest example is municipal bonds. Based on your marginal state and federal tax rates, you may find that buying municipal bonds issued in your state of residence gives you a higher after-tax yield on your portfolio's bond allocation than buying taxable bonds, even if the coupon payments on those bonds are in fact lower; after all, keeping 100% of $4.50 leaves you with more income than keeping 80% of $5. But that advantage is lost when you hold municipal bonds in a qualified account: if you get to keep 100% of your coupon payments regardless, just buy the higher-yielding security.

Most federal interest payments are exempt from state income taxes

Just as most municipal bond interest payments are exempt from federal income taxes, a reciprocal rule applies to federal interest payments: while federal income taxes are due on bond payments, state income taxes are typically not. Claiming this exemption involves looking up the share of your calendar year income attributable to federal securities and excluding it from your taxable income on your state return. You can find Vanguard's 2019 guidance here, for example:

• One share of the Vanguard Inflation-Protected Securities Fund paid out 29.2 cents in dividends in 2019, and Vanguard avers that 99.19% of that payout was due to income from US government obligations. That share of the otherwise-taxable income is likely exempt from state taxes.

Target retirement date funds are a bad tax fit for retirement accounts

If you know anything about target retirement date or target risk funds, then the problem is likely coming into view, but I want to dig into it. Take, for example, Vanguard's Lifestrategy Growth Fund. It holds:

• 48.3% Vanguard Total Stock Market Index Fund Investor Shares
• 31.4% Vanguard Total International Stock Index Fund Investor Shares
• 14.2% Vanguard Total Bond Market II Index Fund Investor Shares
• and 6.1% Vanguard Total International Bond Index Fund Investor Shares

A perfectly reasonable asset allocation for someone with a long-term investment horizon. The problem is that it also owns an embedded tax asset: 5.76% of the fund's income in 2019 was attributable to income on federal securities, and could be excluded from state income taxes if it were held in a taxable account. That's because, like most total bond market funds, the Vanguard version is weighted heavily towards US bonds, comprising as they do a majority of domestic bonds.As bad as that is, the situation becomes even more dire in target retirement date accounts: 24.68% of the income from the Vanguard Target Retirement 2015 Fund is attributed to federal sources!Just like municipal bonds pay lower coupons to reflect their lower tax liability to high-income taxpayers, the federal bonds embedded in target-risk funds are able to pay lower coupons due to the embedded tax asset of exemption from state and local income taxes.

Whatever your risk tolerance, don't pay for tax benefits you're not getting

The nice thing about target risk and target retirement date funds is they're calibrated to your risk tolerance and/or age, and that's not something you should sacrifice easily. Whether your risk tolerance indicates an 80/20 or a 40/60 stock/bond asset allocation, that's what you should invest in; I'm not here to judge.But when it comes to asset selection in your tax-exempt accounts, you shouldn't be sacrificing interest payments for the sake of a tax exclusion that doesn't apply to you.On the contrary, you should be able to mechanically achieve higher and/or more stable returns by swapping your federal bond allocation for higher-yielding, taxable corporate bonds and cash or cash-like securities like CD's within your tax-exempt accounts.Become a Patron!

Two interesting strategies for avoiding the SECURE Act's revenue provisions

Become a Patron!One blog I keep an eye on is Michael Kitces's website Nerd's Eye View. The content is rarely very relevant to me personally, but they do a terrific job digging deep into tax planning strategies and IRS rulings, so you can at least learn the outlines of an issue before doing your own research. The latest post, Strategies To Mitigate The (Partial) Death Of The Stretch IRA, contained two suggestions so interesting I wanted to pull them out and explore them further.

The issue: many inherited IRA's have to be completely distributed within 10 years of the account owner's death

In order to raise revenue to pay for provisions like the SECURE backdoor into 529 assets, the law also requires certain inherited IRA's to be fully distributed within 10 years, technically by the end of the 10th year following the account owner's death. Many beneficiaries are excluded from this requirement, the most significant of whom are spouses and minor children of the original account owner. Spouses are entitled to treat inherited IRA's as their own, while the 10-year clock begins for minor children only once they turn 18. For particularly unlucky orphans, that translates to a distribution window as long as 28 years. Note that no relatives except spouses and children are eligible for this treatment, so you can't pass an IRA to a minor grandchild in order to extend the distribution window.For everyone else, the 10-year distribution window raises revenue in two ways. For inherited traditional, pre-tax IRA's, taxes are owed when distributions are taken. By shortening the distribution window to 10 years, heirs have fewer opportunities to elect to take taxable distributions in particularly low-income years.For inherited Roth, after-tax IRA's, while distributions continue to be untaxed, forcing assets out of untaxed accounts mechanically expands the overall base of taxable assets, if for no other reason than making taxable previously-exempt dividends and capital gains distributions.Jeffrey Levine over at Nerd's Eye View makes two extremely cunning suggestions for minimizing this eventual tax burden, which I want to strip down and explain as simply as possible.

Split IRA's between spouses and heirs

The key to this trick is that the 10-year distribution window is triggered anew each time an IRA is inherited. That means passing 100% of your IRA balance to your spouse (who is exempt from the 10-year distribution window), who then passes 100% of their remaining IRA balance to your children (who are subject to the 10-year distribution window), creates a single 10-year distribution window on the death of your spouse.Alternatively, designating part of your IRA to be passed directly to your heirs (triggering the first 10-year distribution window) and part to be passed to your spouse means than on the death of your spouse a second 10-year distribution window is created. Of course, the second window might overlap with the first, but in the case of a spouse that survives more than 10 years after the account owner's death, this strategy could extend the total distribution period for your heirs to up to 20 years.

Tax-sensitive allocation of pre-tax and Roth accounts (some math required)

This strategy is somewhat more complicated, but may be worth considering for folks whose heirs pay taxes at radically different rates. Consider the case of an account owner with $100,000 in IRA assets: $50,000 in a traditional IRA and $50,000 in a Roth IRA. The accounts are invested in identical asset allocations. The parent has two children, one in the 10% federal income tax bracket and one in the 37% federal income tax bracket. How should they designate their account beneficiaries?One suggestion might be to designate each child as an equal beneficiary for each account. Since each child receives an equal share of the parent's assets, there could be no possible complaint of preference or unfair treatment. The problem is that the $25,000 in inherited Roth assets is worth much less to the low-tax heir than to the high-tax heir, and the $25,000 in inherited pre-tax assets is worth much less to the high-tax heir than the low-tax heir!This is like leaving your tennis rackets to your daughter who loves to ski and your skis to your son who loves to play tennis. They're not worthless, but they are worth less.Alternately, you might consider leaving 100% of the Roth account to the high-tax heir, and 100% of the pre-tax account to the low-tax heir. However this, too, is an imperfect solution, since the high-tax heir will receive the entire after-tax amount while the low-tax heir will receive only 90% of it. We can do better.Fortunately, it's relatively easy to calculate an appropriate tax-sensitive beneficiary allocation:

1. Start by allocating 100% of the Roth balance to the highest-tax heir. In our example, the high-tax heir starts with a $50,000 allocation, worth $50,000;
2. Then calculate the after-tax value of the pre-tax balance for each remaining heir. In our example, $50,000 is worth $45,000 to the low-tax heir.
3. Finally, move the Roth allocation to equalize the after-tax treatment for each heir. In this case, the low-tax heir would receive $50,000 in taxable assets and $2,500 in Roth assets, while the low-tax heir receives $47,500 in Roth assets.

Easy enough.Now let's do a way more complicated example. Imagine the same $100,000 in assets, split between the same traditional and Roth accounts, but now to be passed on to 7 heirs, one in each of the 7 federal income tax brackets. The procedure is the same:

1. Allocate 100% of the Roth balance to the highest-tax heir.
2. Divide the pre-tax balance equally among the remaining heirs, while calculating the after-tax value for each: $7,500, $7,333, $6,500, $6,333, $5,666, and $5,416.
3. Reallocate the Roth so that, each heir, including the highest-tax heir, receives an after-tax total of $12,678.

Please note that this is not literally tax-optimal. A truly tax-optimal beneficiary designation would individually weight pre-tax balances towards low-income heirs and Roth balances towards high-income heirs, and would include state and local income taxes. However, this procedure is simple enough that anyone can do it at home, and of course if you want a more sophisticated or more tax-sensitive beneficiary allocation you can and should hire a financial advisor to make the necessary calculations.Become a Patron!

Wage replacement is an important measurement, whether or not it's good policy

Become a Patron!I've written before about the FAMILY Act, the leading Democratic initiative in the House and Senate to create a nationwide system of paid family and medical leave like that enjoyed by citizens of virtually every other country in the world.One of the things advocates say when describing the FAMILY Act is that it's based on a "social insurance model." This is a meaningless phrase if you're not a policy advocate, but in its simplest form, it means that, just like you can only insure a house for the house's value, or take out a life insurance policy up to some multiple of your earnings, the taxes (or "premiums") you pay while working are based on your income, as is the benefit you receive while caring for a new child, family member, or yourself. The direct parallel is to Social Security's old age benefit, where higher-income taxpayers pay more in Social Security taxes, and receive correspondingly higher benefits when they retire.The social insurance model is therefore based on the idea of "wage replacement:" what percentage of your wages should the program replace during qualifying life events? Social Security, for example, uses an extremely complicated weighted average of your highest-earning 35 years, then applies different replacement rates to income in different brackets up to the maximum. The FAMILY Act relies on its own formula, slightly more similar to unemployment insurance benefits, based on your highest earning year in the previous 3 years, up to an arbitrary cap.

There are serious arguments for a wage replacement model

Since at the end of the day I disagree with the wage replacement model, I want to give the absolutely fairest, most compelling arguments for it — and they are compelling!

• Wage replacement encourages higher-income workers to take leave. This is plainly true. If the goal of a paid family and medical leave program is to reduce the cost to workers of using the leave they're entitled to, then the benefit should scale up to the income they sacrifice when taking leave. A new parent with a high income is by definition sacrificing more money when they take leave than a new parent with a low income; if their benefit doesn't reflect that, they'll be somewhat less likely to take leave, or take as much leave as they're entitled to.
• Wage replacement reflects regional living expenses. If differences in wages do not reflect different levels of education or experience, but rather different regional costs of living, then giving higher benefits to higher earners simply reflects those regional differences. A flat benefit would punish leave-takers in high-wage, high-cost-of-living areas, and be a windfall to leave-takers in areas where wages and prices are lower.
• Wage replacement promotes gender equity. There's both a crude and sophisticated version of this argument, so I want to offer both. The crude version is that, at an economy-wide level, male employees earn more money than female employees, and a flat benefit will perpetuate those wage disparities: if either parent can take leave and receive the same benefit, a given family unit will be financially better off if the lower-earner takes the leave and the higher-earner continues to work. In many relationships, that means a female caretaker and a male worker, which is not a pattern the federal government should be explicitly subsidizing. The sophisticated version is that within any individual relationship, whenever there's a higher-earner and a lower-earner they face the exact same choice. Mitigating, although not eliminating, that power dynamic is an important argument in favor of wage replacement regardless of the gender of either worker.

These are serious arguments, and they have convinced the paid leave advocacy community of the advantages of a wage replacement model.

Wage replacement is a complicated, intrusive policy design

I do not think wage replacement is a good policy design, but I understand I have lost this fight, so I will only briefly summarize the problems I see in all such policies:

• It rewards accurate income reporting, and magnifies the existing pain to the low-income workers most vulnerable to underreporting. A tipped worker whose tips go unreported or underreported now loses out on both Social Security old age benefits and the paid family and medical leave benefit they're entitled to.
• It rewards high-income workers in low-cost states. This is the inverse of the second point made above: while some amount of wage differentials are accounted for by regional differences in costs of living, others are not. The more convincing you find the "regional wage-and-cost differences" theory, the less willing you should be to offer wage replacement to a high-income worker in a low-cost state. If $60,000 per year represents poverty wages in Manhattan, but a middle class income in Nebraska, then an identical wage replacement rate will impoverish the New Yorker while the Nebraskan barely notices!
• The inscrutable means-testing formulas make it impossible to know what your benefit will actually be. A flat benefit allows people to plan their expenses around their income. A wage replacement model based on a rolling 3-year period simply makes it impossible to know what your benefit will be. Not because it's impossible to calculate (the Social Security Administration has a nice website showing what your disability and old age benefits will be, based on all the information they have available), but because it's constantly changing. If you get pregnant in July and plan to give birth in March, will your benefit be based on that really good sales year you had 3 years ago or will that year already have rolled off your benefit schedule by the time you take maternity leave?

These are my basic arguments against a wage replacement model, and all forms of means-testing, but as I say, I've lost that fight and have come to peace with it.

Whether or not wage replacement is good policy, it's a good measurement

No one has to agree with me on the downsides of the wage replacement model. I don't always agree with myself! But whether or not wage replacement is good policy design, it's an essential lens when looking at the bevy of alternatives to the FAMILY Act bubbling up in Congress. Precisely because those policy alternatives are so different, you need a set of uniform tools to judge them by.For example, the "bipartisan" Cassidy-Sinema bill offers new parents the ability to claim a present-year $5,000 additional child tax credit, repaid by reducing the child tax credit available in the next 10 years by $500 per year. While this is idiotic program design, the idiocy is not the point of this post. The wage replacement rate is.In the ideal case, a two-parent family claiming the Cassidy-Sinema tax credit would receive a total of $5,000 in the year of their child's birth or adoption to assist them with their expenses during their 12 weeks of federally-guaranteed FMLA leave. The median annual household income in the United States is approximately $63,179, 23% of which (reflecting 12 weeks of leave) works out to $14,579. A $5,000 benefit — even ignoring the fact that it has to be repaid — represents a wage replacement rate of about 34% for the median household.Whether or not you think a paid family and medical leave benefit should be linked to a given individual's or household's income, or be offered as a flat benefit based on qualifying events, you cannot believe that a 34% wage replacement rate is anywhere close to adequate.

Conclusion

The point of this post is not that a social insurance or wage replacement model is the right or wrong way to design a paid family and medical leave policy. Rather, it is to give you an easy, back-of-the-envelope calculation you can perform whenever you hear someone promoting an alternative to the FAMILY Act, which is the only serious attempt to enact such a policy in the United States:

• divide the length of the benefit, in weeks, by 52
• multiple the result by $63,179
• divide the benefit by the result.

That's the wage replacement rate for the median household in the United States. The more valuable you think paid family and medical leave is, the higher you should want that replacement rate to be, and the less valuable, the lower.Likewise, the 66% wage replacement rate in the FAMILY Act is the only viable solution to the cancer of unpaid family and medical leave in the United States. The time to fight about how it can and will be improved is after we've passed it.Become a Patron!

The (weird) optionality of Series EE savings bonds

Become a Patron!There's a cliche at least as old as I am, that while ATM's were expected to reduce the demand for bank tellers, banks actually increased the number of tellers they employed, for the counter-intuitive reason that a bank branch was much easier to administer once simple deposits and withdrawals were handled by machines. Instead of wiping out the retail branch, they instead exploded, with one or two human tellers handling all the business that endless brass windows used to be required for.I mentioned this to my partner today in the context of seeing a teller redeem a US savings bond, something that I guessed any given bank employee was only asked to do once or twice a year; even with a computer's assistance, I remarked, it must be a struggle to remember training they use so infrequently.Then, to my amazement, my partner replied: "US savings bonds? I think I've got some of them around here somewhere."The documents she dug up were so strange and so old even the Treasury Department only reluctantly acknowledges their validity. But I couldn't help but investigate what on Earth these faded documents were for.

Some unique features of Series EE savings bonds

So-called "Series EE" savings bonds have three strange features:

• their value is guaranteed to double within a specified time frame (currently 20 years);
• the owner may choose to report the taxable interest on the bonds upon redemption;
• and the interest may be excluded from federal income taxes if the entire value of the bond is used for certain higher education expenses.

Like most federal debt instruments, the interest on the bonds is entirely excluded from state income taxes.My partner's bonds, in some cases dating back to 1993, were purchased at half of face value, while Series EE bonds today are purchased at face value, but let's set aside that technical nuance for now. I'm more interested in the question, what role could Series EE bonds play in an investment allocation?

A binary interest rate

If you hold a $50 Series EE savings bond for 20 years, it is guaranteed to be redeemable for $100, with the $50 in interest taxable at the federal level but exempted from state and local taxes, which my trusty financial calculator tells me works out to a 3.53% annual interest rate.If you hold the bond for any period of time less than 20 years, it will earn interest at a preposterously low interest rate (0.10% as of this writing, and for many years prior).

Annual interest rate resets

Series EE savings bonds can be cashed in, with accrued interest, after 1 year (with a 3-month interest penalty), or 5 years (with no interest penalty). That means every year you have the opportunity to recalculate whether you are better off holding onto the bond and getting closer to your 20-year 3.53% payout, or resetting the 20-year holding period at higher prevailing rates.These breakeven points are trivial to calculate (these values aren't quite right because for simplicity I'm rounding 0.10% APY down to 0%):

• after one year, if interest rates shoot up from 0.10% to 3.72%, make the exchange;
• after 5 years, they must reach 4.73%;
• 10 years in, they must be 7.18% per year;
• and with 5 years left to go, you'll need to earn 14.87%.

Another way of expressing this is that the closer your bonds get to maturity, the higher the interest rate you should think of them as earning: 3.53% may not be impressive 20 years out, but a 100% interest rate one year out should convince you to hang onto them almost no matter what, when their value jumps from $50.96 to $100.

Series EE bonds could be risk-free complements to 529 plans

Besides a nominal allocation to high-yield corporate debt, I own essentially no bonds, for the simple reason that I'm not smart enough to pick individual bonds, and investment-grade mutual funds don't pay enough interest to merit my attention. I prefer instead to put my "stable" savings into high-yield accounts like the ones I discussed last week.In tax-advantaged accounts like 529 college savings plans, where investments compound tax free and can be withdrawn tax and penalty free for eligible expenses, owning "safe" low-yield bonds makes even less sense. But 529 plans designated for actual education expenses pose a conundrum: what if your stock holdings happen to drop in value the very year you need them?Series EE bonds offer one kind of solution: making a bond allocation to Series EE bonds gives half the tax protection of a 529 account (state, but not federal, income tax exclusion). If the stock investments in your 529 account are shooting out the lights, you can make withdrawals tax and penalty free when your beneficiary enrolls.On the other hand, if your beneficiary happens to enter college during a stock market slowdown, cash out the Series EE bonds and let the stocks in your 529 plan ride. Subject to income limits, potentially all the interest on your bonds could be exempt from both state and federal taxes.

Just a few more complications

This is a modestly interesting idea, and I'm glad I looked into it, but there are a few major problems with actually pursuing this as a college financing strategy.First, the required holding period for Series EE bonds in order to trigger the special interest rate is 20 years. Since most Americans enter college between 17 and 19, you'd have to start planning awfully early, like, zygote-early, in order to make a Series EE investment part of your college financing plan.Second, purchases of Series EE bonds are limited to $10,000 per Social Security number, per year. In light of the above, you'd need to load up on bonds to the maximum immediately if you wanted to be sure to meet the requirements for both the full interest rate and, potentially, the federal income tax exemption.

Conclusion

When I visited the Jefferson County Museum in Charles Town, West Virginia, there was a lovely exhibit on the financing of World War II, with carefully preserved books of "War Stamps" and posters exhorting those on the home front to buy War Bonds. But I've never read a good account of exactly how these confusing documents worked.Series EE savings bonds seem to be somewhat similar to those War Stamps: purchased by relatives, forgotten by recipients, stuffed in drawers and safe deposit boxes, and offering random windfalls when discovered years or decades later.Become a Patron!

What you need to know about the idiotic "QBI deduction reduction" rule

Become a Patron!In the frenzy to pass the Smash-and-Grab Tax Act of 2017, a faction of Republican senators who, totally coincidentally, are the owners of passthrough businesses, insisted on including a special treat: in addition to tax cuts on the profits of C corporations, and cuts to the personal income tax rates they pay on their passthrough income, they demanded that their taxes be reduced again by what's known as the "qualified business income deduction."Like all deductions, the benefits of the QBI deduction flow overwhelmingly to the highest-income taxpayers, since it lowers the marginal tax rate of the lowest-income business owners from 10% to 8%, and of the highest-income business owners eligible for the full deduction from 24% to 19.2%, a benefit 2.4 times larger.For folks with simple tax situations, calculating the deduction is complicated, but no more or less so than optimizing any other combination of deductions and credits. However, the new deduction created one issue that causes an enormous amount of confusion: the QBI deduction reduction.

What is the QBI deduction reduction?

The 20% QBI deduction is applied, as the name implies, to a figure called "qualified business income," which for simple passthrough businesses is simply net profit minus half the self-employment tax. For the 2019 tax year, you multiple that number by 20% and write it down on line 10 of Form 1040, right below the standard deduction, before arriving at your final taxable income. In other words, a dollar earned by a business which is reported on form 1040 doesn't increase your taxable income by $1, it increases it by just $0.80 (after deducting half the self-employment tax).This creates a problem, however, since deductible contributions to SEP IRA's and individual 401(k) accounts are reported as adjustments to income on Part II of Schedule 1, but do not reduce the amount of business income reported on Part I of Schedule 1.If nothing were done, this would allow the owners of passthrough entities to deduct the same income twice: in the 24% tax bracket, a $19,500 solo 401(k) contribution would reduce the owner's tax by $4,680, and then the QBI deduction applied to the same income would reduce it by another $936. This would create an additional, unintended tax subsidy for deductible retirement contributions; in some cases it would even allow the QBI deduction to be used to offset earned income!For that reason, the QBI deduction reduction was introduced: qualified business income is reduced by both half the self-employment tax and by the amount of any deductible contributions made to SEP IRA's and individual 401(k)'s. The owners of passthrough entities thus have to choose: on a given dollar of income, you can either make a fully deductible retirement plan contribution (to be taxed on withdrawal), or a 20% tax cut, but not both.This is sometimes confusingly referred to as making pre-tax retirement contributions only "partially" deductible, but this is incorrect, as the above should make clear: pre-tax retirement contributions are fully deductible at the rate they would otherwise be taxed at. The reason you "only" receive a 19.2% deduction for pre-tax retirement contributions when your income puts you in the 24% tax bracket is that 19.2% is the applicable tax rate, after the application of the 20% QBI. This is a full deduction, at the applicable tax rate.

What's the problem

This is, obviously, a pain in the ass, but any reputable tax software is capable of making the necessary calculations. It does, however, raise two extremely important issues to be aware of.The first issue is the decision between making deductible, pre-tax contributions to retirement plans or Roth, after-tax contributions. That's because Roth contributions do not reduce QBI or the QBI deduction in the way pre-tax contributions do. One way to approach the decision between pre-tax and after-tax contributions is to select a "pivot" point: if your income puts you in the 24% tax bracket, you might decide to make deductible contributions down to the 22% bracket, and Roth contributions after that.But if a 22% tax rate is your pivot point, and the QBI deduction means you're actually paying 19.2%, then 100% of your contributions should go to Roth accounts! Your marginal tax rate is already lower than the point at which you prefer to save taxes today and pay them later.The second issue is the allocation decision between individual retirement accounts and small business retirement accounts, since contributions to traditional IRA's are fully deductible and do not reduce QBI. Before the introduction of the QBI deduction, a business owner could be essentially indifferent between traditional and Roth IRA and solo 401(k) contributions. All traditional contributions were fully deductible, and all Roth contributions were taxable, at the applicable rates.With the QBI deduction reduction in place, these allocation decisions became extremely important, since a $6,000 traditional IRA contribution reduces taxable income by the full amount, while a $6,000 solo 401(k) contribution reduces it by just $4,800. If your IRA contributions have been on autopilot, it's time to turn it off: deductible contributions should always go first into IRA's, and only then should you decide how to split solo 401(k) contributions between pre-tax and Roth accounts.

Conclusion

As tax time gears up, wrangling with these issues has also been an opportunity for reflection, since I have both earned income and self-employment income that put me squarely into the 12% income tax bracket. The advice I would offer a stranger in my position would be to maximize Roth contributions to both their IRA and solo 401(k), paying 12% and 9.6% marginal rates now, and saving them on the presumably much larger balances they'd withdraw 30, 40, or 50 years from now.The problem, of course, is that I'm in the 12% income tax bracket because I'm poor, and this is indeed the entire problem with a retirement system that requires people to make carefully calculated bets each and every year. A $6,000 traditional IRA contribution is worth $720 to me, a $6,000 traditional 401(k) contribution worth $576 more. Do I want an embedded tax asset that I'll redeem decades in the future, or do I want $1,296? Go ahead and guess.It's become fashionable to describe Americans as being "financially illiterate," but I hope someday we get around to acknowledging that the text we're constantly being exhorted to read should never have been written in the first place.Become a Patron!

Why even the perfect income tax can't substitute for a wealth tax

Become a Patron!After they finish hemming and hawing about "constitutional" arguments, opponents of proposals for an American tax on very large fortunes typically make one of two arguments:

• a more-progressive, better-enforced income and estate tax code could achieve the same revenue goals as a wealth tax, or;
• a value-added tax, like those used to fund European social democratic welfare states, would be a better method of raising the same amount of revenue.

I think the arguments for a wealth tax are fairly intuitive to an ordinary American, but since these opposing arguments are made with such consistency, I also think it's worth breaking down the problems with each.

A tax on current income can't fix past errors

One of the most interesting problems in the US income tax code is that no one has any idea what the "correct" income tax brackets and rates are. The brackets in use during the Clinton administration produced two years of budget surpluses, before the original temporary Bush tax cuts, the permanent Obama extension of those cuts for all but the highest earners, and the additional temporary Trump/Ryan cuts went into effect.But perhaps, as Alan Greenspan argued at the time, the Clinton tax code raised too much revenue, and by paying off and thereby depriving the world of secure US debt, our budget surpluses would eventually strangle the global channels of commerce.So, what is the "right" income tax code? Is it the permanent Obama tax rates and brackets, which we'll revert back to in the 2026 tax year? Or is it the Clinton tax rates, which produced a fiscal surplus at the end of the 1990's before Bush's cuts and wars devoured the federal budget?What's even worse, in addition to gutting federal revenue for a decade, the Trump/Ryan income tax cuts made some modest improvements: raising the standard deduction and capping the state and local tax deductions reduced the number of filers who benefit from itemizing deductions, and over time might even put some downward pressure on home prices.Simply reverting to the Clinton tax code would reverse that modest progress; the next round of income tax reform, in addition to raising rates, should instead build on those positive changes by eliminating itemized deductions entirely.The $10 trillion question is, what shall we do about the debt we incurred paying for those tax cuts?

Conservatives are right: it's a mistake to fill the hole with income taxes

People sometimes get upset around here because of my distaste for conservative politicians, but there's no partisan content to the observation that people respond to incentives. When you tax income, you discourage income-earning, and when you subsidize income, you encourage income-earning. Once we agree on this simple observation, we can have all the partisan fights we like.My point here is quite simple: the people paying taxes under the perfect income tax system, whether it is higher, lower, or the same as today's income tax system, will not be the same people who benefitted from the income tax cuts of yesteryear.During the 2000's, a high-earner  saw their top federal income tax rate fall from 39.6% to 35% between 2003 and 2012, rise to 43.4% between 2013 and 2017, and fall again to 40.8% in 2018 and 2019. That means between 2003 and 2019, these policies overall increased the deficit by $410,000 per million taxable dollars in the top tax bracket.But the people in that top tax bracket, in those years, are now 16 years older. The years when the US Treasury was shoving out $27,000 in free money per million dollars in earnings were likely the highest-earning years of their lives. Now, they're retired or nearing retirement, easing out of the workforce, perhaps taking on some light consulting gigs, and carefully managing their estate plans and taxes.It's absurd to say that a high-earner today, whatever the correct calculation is of their fair contribution to their federal, state, and local governments, should also have to pay the share of wealthy individuals who paid too little for the preceding decades!

A VAT is clumsy, ineffective, and un-American

As I mentioned up top, a value-added tax, which is a complicated form of national sales tax, is one answer to this problem: while people may have squirreled away unfathomable fortunes during the low-tax years, we can get them, or their descendants, to pay their share when they eventually spend it. You may have avoided income taxes on the money you use to buy a yacht, but a 10% VAT lets us reclaim the same money on the back end.But a value-added tax is a clumsy solution, for two reasons. First, since it's paid by the poor and wealthy alike, either tax rebates or additional, clumsily-targeted low-income tax cuts are required to make sure it's the wealthy who end up bearing the burden. Second, and even worse, it makes the mistake of assuming that the value of wealth is in the spending, and however popular this belief is elsewhere, it's never had any purchase among Americans. The extremely wealthy are incapable of spending even a fraction of their fortunes, but that does not make them poor — on the contrary, it makes them rich.

Conclusion: a wealth tax surgically targets the beneficiaries of our past mistakes

The idea of a wealth tax is the simplest, cleanest expression of the sentiment that something went wrong. Again, this has no partisan content. Both Democrats and Republicans, every time tax reform is enacted, rush to assure us that actually, ultimately, eventually, we'll raise more revenue, we'll reduce the deficit, we'll grow the economy more quickly.The deficits were real but the growth was fake. And now we're left with the question: who will make up the difference? Should we all pitch in together with a national sales tax? Should we all tighten our belts and agree to cut Social Security benefits? Should we forego infrastructure spending or disaster recovery?Or should we ask the beneficiaries of five decades of folly to agree that we simply made a mistake, and that it's time to make it right?Become a Patron!

How to think about the Spousal IRA deduction gap

Become a Patron!With the end of the year in sight and tax season around the corner, I've been brushing up on the rules for IRA contributions and deductions. Remember IRA contributions can be made for the 2019 contribution year until April 15, 2020. Most large IRA custodians make it easy to designate your contribution for the appropriate year, but if you use an independent broker and make a 2019 contribution next year, make sure they record the contribution properly or you might get an angry letter from the IRS for exceeding your contribution limit in 2020. Today I got to thinking about how and when spousal IRA's can be maximized, particularly when you fall into what I call the "spousal IRA deduction gap."

How spousal IRA's (are supposed to) work

Technically an IRA should only be referred to as "spousal" if one spouse in a married-filing-jointly couple has earned income in excess of the individual contribution limit and the other has earned income less than the individual contribution limit. In this case, contributions can be made to an IRA in the non-earning spouse's name, based on the excess earnings of the earning spouse.That's a complicated way of saying that if the total earnings of a married-filing-jointly couple are at least $12,000 (in 2019), then each spouse's IRA is eligible for the maximum $6,000 contribution, regardless of the distribution of the earnings between the spouses. If the couple's total earnings are less than $12,000, then the amount of earnings can be split arbitrarily; there's no requirement to "fill up" the earning spouse's IRA before contributing to the spousal IRA.I don't know what the original rationale was for this scheme, but it functions as a kind of "breadwinner bonus:" if a worker marries a non-worker, they get to use the non-worker's IRA deduction, a kind of annual tax stipend for bourgeois family values.Of course, most low-income people don't contribute to IRA's, and most married couples consist of two earners, so this intended use case is negligible in the real world. There's one nuance to the spousal IRA rules, however, that has a very real impact: the spousal IRA deduction gap.

Why does the spousal IRA deduction gap occur?

The spousal IRA deduction gap arises because while total contributions for married-filing-jointly couples are limited to the greater of the couple's joint earnings or the annual per-spouse contribution limit, the deductibility of contributions is determined based on the combination of the couple's joint modified adjusted gross income (adjusted gross income after adding back in certain deductions) and each spouse's workplace retirement plan coverage.This is spelled out on page 13 of IRS publication 590-A. Table 1-2 shows that a married-filing-jointly spouse covered by a workplace retirement plan can deduct a traditional IRA contribution if their MAGI is $101,000 or less. Table 1-3 shows that a married-filing-jointly spouse whose spouse is covered by a workplace retirement plan can deduct a traditional IRA contribution if their MAGI is $189,000 or less.That creates an $88,000 gap, where contributions to the non-covered spouse's IRA is still fully deductible, whether or not they have any earnings.

Maximizing the value of the spousal IRA deduction gap

Ideally you'll be maximizing your traditional, Roth, or backdoor Roth IRA contributions each year, but obviously not everyone can, and not everyone who can, will. The spousal IRA deduction gap means that for couples that fall into the gap and aren't able or willing to maximize contributions to both spouse's IRA's, it may be more tax-advantageous to fill up the non-covered spouse's IRA before making contributions to the covered spouse's Roth IRA.

Planning around the spousal IRA deduction gap

Everything above has discussed the deductible IRA rules on the assumption that a couple is already married. However, there's a second payout tucked in Table 1-2: the increased MAGI limit for covered employees when they get married.A single filer covered by a workplace retirement plan with a MAGI of $73,000 is ineligible for any traditional IRA deduction, while a married-filing-jointly filer is eligible for a full deduction up to $101,000 in MAGI.That means the same filer, upon marriage to a non-covered person earning $28,000 or less, will see their taxes fall by $4,987, from $9,235 to $4,248, assuming a maximum traditional IRA contribution of $6,000 (the spouse's taxes, if any, will also fall due to the expanded married-filing-jointly tax brackets, so the total taxes paid by the couple will fall by more than either individual's under most circumstances).Most high-income workers are covered by one or more workplace retirement plans, and those plans are almost always more generous than the IRA deduction. The $19,000 employee 401(k) and 403(b) contribution limit, for example, is so much higher than the maximum IRA contribution that it wouldn't usually make sense financially to choose, between two other-wise identical jobs, the one without a retirement plan purely to maintain eligibility for the IRA deduction.However, few jobs are identical! There's naturally some breakeven point where an increased salary more than makes up for the lack of a workplace retirement plan; that exercise is left to the reader. Furthermore, people are motivated by more than money: a dream job that leaves you eligible for the IRA deduction might, in total, be more attractive than endless drudgery with a nice retirement package.The final important planning situation arises in the case of self-employment. It's tempting to open an individual 401(k) account soon after starting a small business, since they cost virtually nothing to set up and administer, and allow you to manage your taxes through deductible employer and employee contributions, and Roth employee contributions. That's good advice, but in some cases you might consider waiting until you're generating more (or any) income from the business: if you and your spouse are currently not covered by workplace retirement plans, and if you plan to continue working at a non-covered job while you work on your small business.That's because opening an individual 401(k) may trigger the MAGI limits on your joint income, completing eliminating the traditional IRA deduction if your MAGI exceeds $189,000 or thrusting you into the spousal IRA deduction gap. Of course, if you know your MAGI will remain below $101,000, then there's no harm done, since contributions to both spouse's IRA's will remain fully deductible.The same logic applies once a small business has stopped generating income. While closing a 401(k) may seem like too much trouble, keeping it open may cause you to be considered "covered" and limit your IRA deduction. In that case, once you know you won't be making any further contributions, you may be better off simply rolling the balance into traditional and Roth IRA accounts.These corner cases can become extremely complex very quickly; only a fee-only, fiduciary financial advisor can provide advice tailored to your situation.Become a Patron!

The SECURE Act is headed into law; small employers get a few handouts

Become a Patron!I've written extensively about the hilariously-named SECURE Act, which sailed through the House but was frozen in the Senate while Ted Cruz extorted his colleagues to allow wealthy Texans to make tax- and penalty-free withdrawals from their 529 accounts for "homeschooling" expenses. Contrary to some early reporting, that provision does not seem to have made it into the final bill, although the $10,000 student loan double dip did (the changes to 529 plans start on page 642).Since the retirement provisions have been widely covered (and here ridiculed), today I want to focus on a couple features of the bill which are relevant to small employers.

Existing retirement plan startup cost credit

To understand the changes made by the SECURE Act, you need to be familiar with the status quo, particularly section 45E(b) of the Internal Revenue Code. The section provides for a credit of 50% of an employer's "qualified startup costs," up to $500, for each of the first three years of an employer's qualified retirement plan. An employer is disqualified from the credit if they had a qualified retirement plan in any of the 3 tax years preceding the establishment of the new plan.In other words, even if you wanted to hack the current credit, it would mean opening and closing qualified retirement plans every 3 years, for a maximum benefit of $1,500 every 6 years. Obviously, no one should do this, and as far as I know, no one does; the juice isn't worth the squeeze.But the biggest obstacle to claiming the current credit is the definition of qualified startup costs: "any ordinary and necessary expenses of an eligible employer which are paid or incurred in connection with— (i)the establishment or administration of an eligible employer plan, or (ii)the retirement-related education of employees with respect to such plan."I'm not a tax lawyer, and I'm especially not your tax lawyer, but I interpret this as saying that the credit can only be claimed against the actual administrative costs of starting and running the plan for the first 3 years. In other words, it can't be claimed against costs incurred by the employer making contributions to the plan.The difference is important, since starting a 401(k) plan just isn't that expensive, and administering one on an ongoing basis is essentially free (once you exclude the employer's contributions to the plan).I'm not saying it's impossible to qualify for the credit. If you have to hire an outside firm to set up your plan documents, you'll have to pay them, and the credit helps offset that. In theory if your record-keeping is good enough you could probably even claim the credit against the wages paid to an existing employee for setting up a qualifying plan. But since the credit is worth just $500 per year for a maximum of 3 years, we're left with this kind of silly corner case.

Expanded retirement plan startup cost credit

The SECURE Act does not change the definition of qualified startup costs, nor does it remove the 3-years-every-6-years time limitation. What it does do is increase the maximum credit from $500 per year to $5,000 per year (technically the greater of $500 or $250 per employee, with a maximum of $5,000 if you have 20 employees). A $15,000 tax credit might get your attention where a $1,500 credit didn't.It's still hard to spend $30,000 setting up and administering a retirement plan (since the credit is still capped at 50% of startup and administrative costs), but it's not impossible. In particular, I think it's very likely that we will see new financial instruments that charge a certain portion of the ongoing costs of administering a plan to the employer, rather than the employee, in the first 3 years, as an "ordinary and necessary expense."This is completely speculative, but once you consider the possibility, the possibilities are endless. Consider an annuity provider that charges the individual employee accounts of a 20-employee company an average of $3,000 per year for ten years. Under the SECURE Act, they could charge the employer $10,000 per year for three years, while waiving their fees on individual accounts for ten; the insurance company accelerates its payment schedule, and the federal government foots half the bill!Of course, there's no need to take my word for it; once the SECURE Act is signed into law I expect we'll see such products aggressively marketed everywhere.

Credit for auto-enrollment

What isn't speculative is section 105 of the SECURE Act, which offers employers a credit of $500 per year for establishing an auto-enrollment provision, including in existing plans. Business and finance reporters are extremely lazy so you're sure to see this misreported, but the text of the law is crystal clear and blissfully short:Here the eligible period is not determined by the establishment of the retirement plan; it's determined by the establishment of the eligible automatic contribution arrangement. In other words, virtually all small employers, whether or not they have existing retirement plans, should be eligible for this credit if they start an auto-enrollment option any time after January 1, 2020.While the credit doesn't scale up by number of employees as the startup cost credit does, that makes it more valuable for even-smaller employers, almost none of whom include auto-enrollment in their retirement plans.Become a Patron!

Donor-advised funds are in the news, here's why it matters

Become a Patron!Attributing quotes to famous dead people is, as the great Greek poet Homer is said to have once remarked, one of mankind's oldest storytelling traditions. In that spirit, I want to pass along Margaret Thatcher's famous answer when asked to name her greatest achievement in office: "Tony Blair and New Labour. We forced our opponents to change their minds."In the US, this mental revolution took a very specific form: taxes — and tax avoidance — have become the primary engines of public policy. And it's been an unmitigated disaster.

Why are charitable contributions deductible?

Charitable contributions have been deductible for so long it's become difficult for some people to imagine any alternative. Difficult, but worthwhile. There are, I think, two obvious public policy reasons why charitable contributions might be deductible from taxable income:

• Charitable spending "doesn't count." This is a version of the backdoor VAT, which says that only personal consumption should be taxed, not personal income. Even though charitable spending is a form of personal spending (it's directed by the individual, not the state), since it isn't a form of personal consumption (it's the charity's beneficiaries who benefit, not the donor), it doesn't belong in taxable income.
• Charitable spending is a "substitute" for state action. This argument says that individuals are able to direct spending more effectively than the state: while federal emergency aid might rely on crude tools like ZIP codes or satellite imagery, individuals close to the ground will know exactly who is affected and how, and they'll be able to direct their giving in a way that will deliver higher per-dollar benefits than state action.

If you believe either of those things, I won't try to convince you otherwise. I just want to ask the question, if you believe in your heart of hearts that either of those explanations is true, why are charitable contributions only deductible for high-income taxpayers?

The alternatives are obvious

If the state has determined, upon deep reflection, that individuals are better suited to direct the nation's resources towards charitable ends than the state itself is, there are obvious solutions:

• the government could offer matching funds, at any ratio and with any limit. For example, in the 37% income tax bracket, a $1,000 donation generates $370 in tax savings. The federal government could simply offer a 59% match — the same $630 (after-tax) donation would generate the same $1,000 in charitable assets. If you think that's too generous, pick a lower matching rate; if you think it's too stingy, pick a higher matching rate. In either case, the match could be available to anyone with any level of taxable income, since it would be claimed by the charity, not the taxpayer.
• alternately, the federal government could simply assign everyone funds they can contribute to the charities of their choosing. In 2017, the Treasury department estimated $58.29 billion was spent on the deductibility of charitable contributions — roughly $376 for each of the 155 million individual tax returns filed that year. If that's the amount of federal money we're willing to spend on taxpayer-directed charity, then a simple box on each tax return seems like a commonsense way of allocating it. Anyone who's familiar with United Way knows how this works.

Note that neither of these solutions is more complicated than the current system of tax deductibility. In fact, they're both far simpler. The key difference is that they're also more fair: whatever you think the purpose of federal spending on private charities is, there's no logical reason that fixed amount of federal spending should be directed exclusively by the wealthy, the old and the dead.

Donor-advised funds are in the news because no one knows exactly what they are

All this brings me to the news hook for this post: donor-advised funds.I said above that charitable contributions are only deductible for high-income taxpayers, but this isn't exactly true: they're deductible for high-deduction taxpayers. By far the most common itemized deductions are mortgage interest, state, and local taxes (with the latter two currently capped at $10,000, combined).As your mortgage gets closer to repayment, or you consider moving to a lower-tax state, it might occur to you that this is a good opportunity to front-load some charitable contributions: once your house is paid off and Florida zeroes out your income taxes, your first $12,000 in charity will be in some sense "wasted," since taking the standard deduction reduces your taxes by more than itemizing deductions would.On the other hand, making a large donation immediately has its own drawbacks: there's nothing more common than a charity run on a shoe-string budget blowing through your donation this year and then begging for more next year, when your tax advantage is much smaller.Enter the "donor-advised fund:" make an irrevocable contribution to an investment account, take an immediate deduction, and then dole the money out over years or decades to the charities of your choosing.What could go wrong?

You don't own your donor-advised fund, but you think you do

Donor-advised funds are under assault for a very simple reason: large, centralized organizations are easy targets, and rightly so.

• In November, Schwab's fund stopped allowing advisors to direct contributions towards NRA-linked organizations.
• Fidelity's fund was likewise attacked for allowing funds to be paid out towards white nationalist hate groups like the Family Research Council, Center for Immigration Studies, and the New Century Foundation.

An interesting subplot to this story is that conservative con artists actually foresaw this exact development as far back as 1999: Donors Trust is a donor-advised fund that allows funds to flow exclusively to conservative organizations.Irrevocable donations have the advantage of immediate tax benefits, but the disadvantage of irrevocability. What people are discovering far too late, to their chagrin, is what "irrevocability" means. You cannot shift your donor-advised assets from one fund to another. You cannot control what charities your fund allows contributions towards.And the reason is simple: it's not your money. It stopped being your money the second you claimed a tax deduction for it. It's Fidelity's money now, and there's nothing you can do about it, except "advise."

Conclusion: it doesn't have to be this way

On this subject, someone on Twitter responded to me with what, I assume, they thought was an airtight criticism of my position, but which I thought was perfectly correct: "you think DAF custodians want to start to make calls on which legally incorporated charitable organizations meet their standards."The only disagreement we appear to have is that what Joseph describes incredulously is, in fact, the status quo: once a custodian accepts an irrevocable charitable contribution, and the donor deducts that contribution, there is no one else who can be responsible for the final disposition of those funds than the custodian. They cannot be rescinded and they cannot be transferred. They are in the hands of the custodian until they are depleted, and that means the custodian is going to be subject to criticism, sometimes fair and sometimes unfair, about where those funds go.It doesn't have to be this way. We can eliminate the charitable contribution deduction, eliminate "qualified charitable distributions" from IRA and 401(k) accounts, and wait for these donor-advised funds to die of their own accord. But as long as they exist, they're going to be subject to criticism for where they send their money.Because the second you gave it away, it wasn't yours any longer.Become a Patron!

What to watch for as the Senate panics over the SECURE Act

Become a Patron!My readers know that the SECURE Act, passed unanimously out of its House committee and overwhelmingly on the floor of the House, was conjured into existence by the insurance industry in order to increase the distribution of expensive, opaque annuity products in 401(k) retirement plans. It incidentally also includes a few other provisions designed to reduce the taxes paid by the extremely wealthy, like the SECURE backdoor into 529 assets. Throughout 2019 the Act has been held up in the Senate by Ted Cruz, who wants to open the backdoor even further by allowing tax-free distributions from 529 accounts for "homeschooling" expenses.The SECURE Act is back in the news since, with impeachment looming, the Senate's legislative calendar is looking increasingly time-constrained, and the insurance industry's senators are panicking to make sure their masters get what they paid for.Since some version of the Act will likely be folded into end-of-year budget negotiations, here's what to watch for as that process plays out.

What won't change: annuities and RMD's

The core of the SECURE Act, and its companion measure in the Senate, has always been to increase the distribution of annuities in employer-provided 401(k) plans by shielding employers from liability when those plans are unable to make their promised payments. The sop to individual savers to "balance out" that giveaway is an increase in the age, from 70 1/2 to 72, at which minimum distributions are required from pre-tax individual retirement accounts and 401(k)'s.Those two giveaways are the reason the Act exists, and are unlikely to change substantially since they've already been frozen in carbonite by their respective lobbyists.

The 529 backdoor

The House version of the SECURE Act includes the SECURE backdoor into 529 assets, allowing account owners to double dip into their account balance, once by taking a tax-free distribution for higher education expenses covered by a student loan, and then a second tax-free distribution of up to $10,000 in order to repay that loan.The Senate version did not contain that provision, so it remains to be seen whether the final measure will include the backdoor, and if so, whether the House's $10,000 limit will be kept, raised, or lowered.

The "homeschooling" loophole

In the smash-and-grab tax act of 2017, a private schooling loophole was added to 529 plans, allowing for up to $10,000 in tax-free distributions for certain private primary and secondary education expenses. Ted Cruz wants to blow that loophole wide open by allowing for the same tax-free distributions for "homeschooling" expenses, and has blocked passage of the Act in the Senate until he gets his way.Upon even a moment's reflection, this is simply open-ended permission for the wealthy to shield their investments from capital gains taxation. After all, education takes place throughout the year. Who is to say that tennis lessons aren't a form of homeschooled "physical education?" Who is to say that a laptop isn't necessary for homeschooled "computer science?" Who's to say that a month in France isn't a "foreign language" field trip?So far the Senate has had the good sense not to bend on this point, but in the flurry of year-end negotiations, Cruz may end up getting his way.

Changes to "stretch" IRA's

For technical reasons, it's much easier to pass legislation that does not have a budgetary cost than legislation which does, so in addition to its handouts to the very wealthy, the House version of the SECURE Act also included a measure to increase revenue: drastically shortening the period over which withdrawals from inherited IRA's and 401(k) accounts must be taken.Under current law, required distributions from an inherited IRA can be calculated based on the heir's life expectancy, rather than the original account owner's. This allows an heir to both reduce required distributions and strategically time distributions for low-tax years. Under the SECURE Act, all inherited IRA's must be completely distributed within 10 years.This is an extremely important change in the world of tax planning, but obviously not of much interest to the overwhelming majority of people: most people do not inherit anything; most people who do inherit something don't inherit IRA's; and most people who inherit IRA's just withdraw the money immediately, they don't strategically time withdrawals for the next 60, 70, or 80 years.If the SECURE student loan backdoor limit is raised, or the "homeschooling" loophole is added, the budgetary cost of the Act will soar. That may mean the stretch IRA period will be shortened further: a 7-year window raises less money than a 10-year window, since it mechanically reduces the opportunities for strategic withdrawals.It's also possible the necessary revenue will be raised elsewhere in the final bill, or the procedural point of order will be simply be waived.

Conclusion

The SECURE Act is a bad law that should not be passed: the benefits go overwhelmingly to the wealthy in the form of tax savings, and the costs, particularly the ability of annuity marketers to target employers for inclusion in 401(k) plans, will be borne exclusively by the working and middle classes.But since it likely will be passed in some form, eventually, now you know what to watch for.Become a Patron!

The backdoor VAT is an ideological project that must be defeated

Become a Patron!It's a banality among progressives in the United States to observe that we collect too little in taxes, spend too little on government programs, and consequently enjoy the least-generous welfare state, lowest life expectancy, and worst government services among our peer countries. And this is, as far as it goes, true: there's no obvious reason a country with the per capita income of Switzerland should have the life expectancy of Costa Rica.The problem, we are assured, is that while developed social democracies raise 30%, 40%, or 50% of GDP using broad-based value-added taxes, the United States is hobbled by its antiquated income tax system. If we want a European welfare state, we need a European tax state, right?Wrong.

What makes someone rich?

In Soviet Russia, the most beloved humorists were a pair of journalists, universally referred to as Ilf and Petrov, and their most beloved character was Ostap Bender, a con artist. In "The Little Golden Fleece," the second Ostap Bender novel, their hero hears a rumor of a Soviet citizen who has accumulated one million rubles, and he decides to find and rob the man. Without ruining too much of the plot, the hero succeeds, only to realize, to his horror, that there's nothing you can actually do with a million Soviet rubles. Every hotel room is reserved for party functions, every restaurant is reserved for factory employees, every car is reserved for high-ranking officials. He has a million rubles and he can't spend a single one of them.This is a useful frame of reference for thinking about the ideologues of the VAT: a person is not made rich by how much they earn, nor by how much they save, invest, or own. A person is made rich by how much they consume. Just like Ostap Bender, a person who earns a million dollars per year but who only spends $20,000 of it isn't really any better off than a person who earns $20,000 per year and spends all of it.Unfortunately for the ideologues, Americans have never believed this.

Americans believe that what makes you rich is money

At the federal level in the United States, we mostly do not tax consumption. There are exceptions, and I don't want to trivialize them. Tariffs are a form of taxation on the the consumption of imported goods. We have federal excise taxes on gasoline, tobacco, and alcohol, which are obviously included in the prices consumers pay.But the overwhelming majority of federal tax revenue is not raised by taxes on consumption. Instead, it's raised by taxes on profit. That means, unlike in the social democracies of Western Europe, our taxes are based on how much you earn, not how much you spend.At the corporate level, this calculation can be quite complicated, but the underlying principle is that taxes should be paid on "what's left" after deducting all your expenses.At the individual level, for most workers the calculation is a lot simpler, but the fundamental principle is the same: you pay taxes based on how much you earn.This is because Americans understand, in a way that is fundamentally different from the people of many other developed countries, that the thing that makes you rich is having money. Warren Buffett is not rich because he eats caviar every night in a jacuzzi full of champagne while being serenaded by the original cast of "Hamilton;" he's rich because he owns assets worth $100 billion.

The backdoor VAT is swallowing the tax code

Given that Americans do not actually believe in the idea of financing the government with nationwide consumption taxes, you might assume the idea is as theoretical as a North American cricket league. But this would be to underestimate the resiliency of a bad idea.What we have instead is what I have started to call the "backdoor VAT:" a flattening of the income tax code, combined with deductions for an ever-expanding array of expenditures.The flattening of the income tax is no mystery: the Republican Smash-and-Grab Tax Act of 2017 lowered the corporate income tax to 21%, raised the standard deduction, widened personal income tax brackets and lowered the top rates on the highest incomes.But less noticed is the way that tax-advantaged accounts have come to carve out more and more income for permanent tax exemption.In countries financed through VAT's, lots of sectors are naturally excluded from the tax: when you're treated for free at a NHS clinic in the United Kingdom, they don't add VAT to your (nonexistent) bill. When you pay tuition at the University of Lausanne in Switzerland you don't see a separate VAT charge.Tax-advantaged accounts in the United States function identically: they are a way of asserting that certain expenses "shouldn't count" as part of your income. If you're saving for education in a 529 account, that's not "real" income, so you should get a deduction, and your capital gains should be tax-free. If you're saving for retirement, that's not "real" income, so you shouldn't pay taxes on your savings now or ever. If you're saving for medical expenses, it wouldn't be fair to tax you on that income, since you're not spending it on something frivolous, after all. Even money you spend on childcare isn't "real" income, since you're not spending it on yourself; help yourself to a deduction.

There's nothing wrong with VAT's, but they're wrong for us

At this point in the argument, you typically hear that what "really" matters is the overall progressivity of the entire structure of the state, including both taxes and expenditures. A flat consumption tax, which is by definition regressive (since low-income people spend a higher percentage of their income than high-income people), that finances a progressive welfare state can easily wind up being more progressive than a progressive income tax that finances a stingy welfare state.This is correct: the overall progressivity of the state is what "really" matters. But making the federal income tax less progressive mechanically reduces the overall progressivity of the state. It's of course possible to make up that difference through an even more progressive spending agenda: that's the model pursued by our European peers, and God bless them.But to say the only way to raise enough money to provide universal health care, tuition-free higher education, or a carbon-free energy system is to allow the wealthy to keep even more of their money is not just to miss the point, it's downright un-American.A progressive income tax and a progressive welfare state aren't mutually exclusive, they're two great tastes that taste great together.Become a Patron!

California's AB 5 is about benefits, not wages or unions

Become a Patron!I've been following with interest the development and passage of AB 5, California's attempt to end the misclassification of employees, especially at app-based and platform companies including household names like Uber and Lyft.What I found is that there's a high degree of confusion surrounding the need for the bill, whom it will affect and how, and why the implicated companies have been so strongly opposed to it.The key to understanding the issue is that it's not about wages or unions; it's about benefits.

Uber isn't afraid of a union

One common idea people have about the employee classification debate is that it has "something to do with unions." And indeed, it does have something to do with unions! Union leaders in California have spearheaded the drive to end misclassification of platform employees, and the final passage of AB 5 will be a triumphant display of their ability to turn out activists and corral legislators.But it doesn't have anything to do with forming unions. The reason is simple: it's virtually impossible to form a union in the United States, and the distributed nature of platform employees is guaranteed to make it impossible in fact.That's because US labor law is based on the organization of similar workers in specific workplaces. In the mid-20th century that might be all the assembly line workers in a particular GM plant (but not the bookkeepers at the same plant), or all the electricians on a particular construction site (but not the plumbers).The recognition of workers as employees of platform companies will give them the theoretical right to collectively bargain — but only after their bargaining unit has been recognized, and Uber has unlimited tools at its disposal to make that process as onerous as possible:

• First, it will certainly insist that employees who provide rides belong in a different bargaining unit than employees who deliver food, who are different from the employees who repair scooters, who are different from the employees who charge scooters.
• Second, it will certainly insist that the relevant "workplace" is a single city, at the very largest. If you've ever taken a look at a map of "the San Francisco Bay Area" you quickly realize it's not one city, but dozens. Uber will insist its employees organize separately in each city.
• Next, they'll insist that workers will only be included in a bargaining unit if they work at least 20, or perhaps more, hours per week in that workplace, and they'll almost certainly insist that the only hours that count "in the workplace" are hours spent picking up in the relevant workplace. If you drive a passenger from San Francisco to Oakland, and another passenger back, only the outbound ride will count towards your membership in the bargaining unit.

Note that I came up with these obstacles in 10 minutes. Uber will employ the best union-busting law firms in the country to come up with many, many, many more obstacles.It is, of course, possible that there are cities where particularly industrious union organizers will meet all these tests. Unified metropolitan areas (without multiple divisions into separate municipalities) like Detroit would be good candidates.But I want to be very clear: there is no chance more than a trifling number of Uber drivers will ever belong to a collective bargaining unit, and I'd be extremely surprised if the number is ever more than 0, if for no other reason that if a union is ever formed, Uber always has the option to simply leave the market, which is entirely legal under our labor laws (there are a few trivial exceptions but, obviously, Uber will get around them).

Uber isn't afraid of higher wages

Another thing people are understandably bewildered by is that, where Uber drivers have been able to organize into local advocacy groups, Uber has not hesitated to meet with them and has made all sorts of concessions. In August Uber and Lyft even offered drivers in California a $21-per-hour minimum just-don't-call-it-a-wage, far above California's state $12 minimum wage, if they would oppose AB 5.If you thought AB 5 was primarily about wages, this would be extremely confusing behavior. Why would a company offer its workers a wage higher than the minimum wage in order to prevent them from being subject to the minimum wage?

It's all about the benefits

It shouldn't be much of a surprise at this point, since it's right there in the headline, but the reason these so-called "platform" companies oppose properly classifying their employees is that US labor law, for all its shortcomings compared to the rest of the developed world, does offer one nearly-airtight protection: non-discrimination in the provision of tax-deductible employee benefits.In short, this means that with a few exceptions, for an employee benefit to be tax-deductible, it has to be provided on more-or-less equal terms to more-or-less all full-time employees. And the problem with running a hot startup tech company is that if you want to attract talent, you need to offer pretty generous benefits, among the most important of which is health insurance.Under their current "fissured workplace" model, platform companies are able to provide tax-deductible health insurance exclusively to their white collar workforce. Let us very delicately and preliminarily guess that workforce is, on average, younger, healthier, and more educated than their driver and delivery employees.Of course, their driver and delivery employees mostly don't go uninsured. Thanks to the Affordable Care Act, in California the uninsured rate was just 7.2% in 2018. How did California achieve this? Through massive federal expenditures, of course: to expand Medicaid to cover those below 135% of the federal poverty line, and through refundable federal tax credits to cover the cost of insurance purchased through California's ACA exchange.So you can see, it's irrelevant whether Uber does or doesn't "care" whether its driver employees have health insurance or not: rather, it's that Uber wants to offer a generous employer-based health insurance plan to attract the white-collar employees it believes it needs to succeed, while federally-financed ACA exchange plans are "good enough" for its drivers.The misclassification of employees as independent contractors, in other words, is targeted directly at the only real legal protection American workers have: the principle of non-discrimination. You don't have to offer generous health insurance or retirement benefits, but if you do, you have to offer them to all your employees on equal terms — and Uber doesn't want to.

Conclusion: who is flexibility for?

There's a final point I want to make that's somewhat abstracted away from the nitty-gritty of labor and employment law. In all these debates over misclassification the platform company lobbyists and PR goons are always quick to point out that "drivers have the flexibility of deciding when to work." And of course, in a hyper-literal sense this is factually true. Uber cannot force drivers to open their phones and log into the app, so drivers have a choice of whether and when to do so.But while drivers may have control over selecting the hours they're logged into the app, they don't have any control over user demand for rides, or the process of pricing and assigning those rides, and so they don't have any control over the amount they're paid. In this way, they resemble nothing so much as an Applebee's waitress told to clock out and wait in her car outside when business is slow, then clock back in for the dinner rush.Platform companies rely on "flexibility" in order to spin up the availability of workers during periods of high demand. If they couldn't do so, wait times would stretch out of control and users would migrate to other services (or, God forbid, traditional taxis and delivery services). In other words, companies get paid for their worker's flexibility; they rely on it for their very survival, such as it is.But worker's don't get a symmetrical payoff. If a driver's "flexibility" doesn't match up with the company's needs, the driver just doesn't get paid. Again, this isn't unusual across the employment landscape: if you're only available to work at a grocery store between midnight and 5 am, and the grocery store closes at 10 pm and opens at 8 am, you're not going to get hired. Your availability doesn't match up with the store's hours!The platform companies, on the other hand, would appreciate it if you stood outside the grocery store anyway, on the off chance that today is the day they decide to open at midnight instead. There's nothing wrong with asking people to show up even when they're not needed and there's nothing for them to do. But we already have a perfectly good word for those people: employees. And unlike independent contractors, employees still have a few rights left.No wonder Uber is scared.Become a Patron!

Job protection, wage insurance, and universal benefits

Become a Patron!As readers may have observed, I've been doing a lot of research lately on paid family and medical leave policies around the country, and I've found myself frustrated by the way several different ideas are confusingly and unnecessarily combined. Today I want to spell out the relevant issues, and try to explain how they do and don't interact with each other.

Job protection

The most basic protection workers can be provided for family and medical leave is job protection. That's because even if someone can afford to go without pay while recovering from childbirth, bonding with a child, or caring for themself or a relative, no one can afford to do so without knowing they have a job to return to.Currently, the only form of nationwide family and medical job protection is the Family and Medical Leave Act of 1993. For qualifying events, the law provides:

• 12 weeks of leave in a 12-month period;
• to employees who have worked for at least 12 months, and at least 1,250 hours in the previous 12 months, and 
• at private-sector employers who employed 50 or more employees in 20 or more workweeks inthe current or preceding calendar year.

Note that the qualifications are non-transferrable. In order to qualify for job-protected leave, it's not enough to be continually employed for 12 months and work 1,250 hours in the previous 12 months: you have to be employed for 12 months at the same employer. That means workers with working two jobs with 20 hours per week at each will never be eligible for job-protected leave from either employer, since their 1,040 hours of work each 12 months leaves them short of the 1,250 minimum.When we isolate job protection in this way, we can imagine all sorts of possible improvements:

• Increase the quantity of job-protected leave. If we think 12 weeks of leave is inadequate, we might increase the amount of time workers have to return to their jobs after taking family and medical leave. The public health consensus seems to be that about 6 months of leave after having a child is optimal for child and maternal health, so we could increase our job-protected leave from 12 to 26 weeks.
• Make more workers eligible for job-protected leave. The obvious way to do this is linking eligibility to the individual's work history instead of their employment at a specific firm. Instead of requiring 1,250 hours and 12 months of employment at a specific firm, eligibility could be based on total hours worked at all employers over the preceding 12 months. Likewise, the number of hours and required length of employment could be reduced.
• Require more firms to provide job-protected leave. Like many social phenomena, employer size has the curious characteristic that while most workers are employed by large employers, most employers are small employers. Reducing or eliminating the number of employees before a firm is required to provide job-protection is an obvious way of expanding access to job-protected leave.

The reason it's worthwhile to isolate job protection from other features of a family and medical leave policy is that job protection is valuable whether a worker's leave is paid or unpaid. That is to say, there is a difference between going 12 weeks without pay after giving birth knowing you'll have a job to return to, and going 12 weeks without pay after giving birth knowing that you'll be unemployed at the end of the 12 weeks and need to seek out a new employer.

Wage insurance

The second piece of a family and medical leave policy we can isolate is wage insurance, also sometimes called wage replacement, during a period of leave. The argument for wage insurance is that whether or not a worker is entitled to job-protected leave, they may not be able to afford to go weeks or months without a paycheck, and so return to work earlier than would be ideal for their own or their child or dependent's health.The United States has no national system of wage insurance, and consequently a substantial number of new parents return to work without using their full 12 weeks of FMLA leave, even when eligible, because they can't afford to go without a paycheck any longer. Fortunately, as demonstrated in the states operating their own paid family and medical leave systems, wage insurance is extremely cheap to provide. From a recent National Partnership for Women and Families fact sheet, the total employer and employee cost, wage replacement rate, and maximum benefit of each state's program is:

• California: 1% of employee's first $118,371 in annual wages, replaces up to 70% of average weekly wages, up to $1,252.
• New Jersey: up to 1% of employee's first $34,400 in annual wages, replaces up to 85% of average weekly wages.
• Rhode Island: 1.1% of employee's first $71,000 in wages, replaces 60% of average quarterly wages up to $852 per week.
• New York: up to roughly $139.17 per year, replaces 55% of average weekly wage, up to 55% of state average weekly wage (rising to 67% in 2021).
• District of Columbia: 0.62% of wages, replaces 90% of average weekly wage up to $1,000.
• Washington: 0.4% of employee's first $132,900 in wages, replaces 90% of average weekly wage, up to $1,000.
• Massachusetts: 0.63% of wages, replaces up to 80% of weekly wages, up to $850.
• Connecticut: up to 0.5% of wages, replaces up to 95% of average weekly wages, up to 60 times the Connecticut minimum wage.
• Oregon: up to 1% of employee's first $132,900 in wages, replaces up to 100% of average weekly wages, up to 120% of the state's average weekly wages.

Note here again that job protection and wage insurance are conceptually totally unrelated. You can provide wage insurance without providing job protection, and you can provide job protection without wage insurance. Indeed, that's precisely the situation in the 42 states that don't provide paid family and medical leave.Once you've conceptually isolated them, you can suddenly imagine all sorts of combinations: you could leave job protection at 12 weeks and expand wage insurance to 26 weeks. You could expand job protection to 26 weeks and wage insurance to 40 weeks for folks willing to forego job protection.

Universal benefits

There's a final set of benefits that are sometimes pulled into discussions of paid family and medical leave but that are rightly considered separately, and that is universal or near-universal benefits. Universal benefits in this context are those you're eligible for regardless of work or earnings history. The great advantage of universal benefits is they allow us to put the material welfare of people above incoherent attempts at social engineering.Job protection protects only those with eligible jobs and work histories. Wage insurance supplements the income of workers whether or not they are eligible for job protection. Only universal benefits are aimed at ensuring the material well-being of people regardless of their employment status or wage record.The closest thing we have in the United States to a universal benefit is the refundable Child Tax Credit, which increased to $1,400 per year in 2018, or roughly $116 per month per child.The problem with the Child Tax Credit, of course, is that it's only claimed once a year; a parent who gives birth or adopts a child in January won't see any benefit until as late as April the following year, and has to wait a full additional year to receive their next cash infusion. This is an absurd system and, oddly, another better system is already in place: Social Security Child’s Insurance Benefits. These cash payments are available to the minor children of disabled and retired workers, and are received monthly, either by paper check or direct deposit.Besides providing benefits to parents, patients, and caregivers with insufficient work and earnings histories, universal benefits are also capable of reducing the stakes involved in job protection and wage insurance. As indicated above, the maximum weekly wage insurance benefit in most states is around $1,000. Mechanically, a $1,000 monthly universal basic income would allow that maximum wage insurance benefit to fall to just $750, leaving the maximum income of parents with work histories unchanged (at $4,000 per month) but increasing the income of non-working parents from $0 to $1,000.

Conclusion

This post isn't intended to convince you of any one particular policy solution. Personally, I think we need more job protection, more universal wage insurance, and more universal benefits, but I don't know for sure whether we need 26 weeks or 40 weeks of job protection, whether we need 66% or 100% wage insurance, and whether we need fully universal benefits or a mixture of universal benefits and wage insurance and job protection.Rather, this post is meant to help you ask the right questions when your state, your congressperson, or your senator makes a paid family and medical leave proposal: does it extend job protection to additional workers, or beyond 12 weeks? Does it provide wage insurance, and if so, for whom and at what rate? Is it universal or is it means-tested?If you ask the right questions, you at least have a chance at making the policy better. And if you don't know what questions to ask, we'll be stuck with the stingiest welfare state and unhealthiest population in the developed world.Become a Patron!

How the Republican tax heist surgically targeted businesses in progressive states

Become a Patron!This post gets pretty deep in the weeds, but it's an issue that was brought to my attention by someone who works on family and medical leave policy and I was shocked to discover that it may disqualify certain employers from claiming the temporary paid family and medical leave credit included in the CPA Full Employment Act of 2017.I've written at length about that credit, which is set to expire at the end of 2019, so first pop over to my earlier post to get caught up on what it is and how to claim it.

Only benefits in excess of state requirements are eligible for the paid family and medical leave credit

The 8 states and the District of Columbia which have enacted paid family and medical leave typically administer it through the state's existing temporary or short-term disability insurance program, through a separate state-run program, or through private insurers. Some states, like New York, also allow businesses to self-insure.These insurance policies are funded either through employee contributions (as in New York State), employer contributions (like in the District of Columbia), or a combination of both (in Washington State).This puts firms in states that require paid family and medical leave at a severe disadvantage, because the IRS has announced that "[a]ny leave paid by a State or local government or required by State or local law is not taken into account for any purpose in determining the amount of paid family and medical leave provided by the employer" — and this is true whether or not the leave is paid for by the employer!This creates the absurd situation where virtually identical employers are treated completely differently by the federal tax code. An employer in Connecticut that provided 55% wage replacement for all their eligible employees in 2019 for all Family and Medical Leave Act purposes would receive a tax credit for 25% of the replaced wages; an identical employer in New York would receive nothing, simply because the benefit is required by state law.In the specific case of New York, you might think this makes sense, since family and medical leave insurance premiums are, by default, paid for by employee payroll deductions; since the employer doesn't pay anything, they aren't entitled to a tax credit for the resulting benefit. But New York also allows employers to pay their employees' insurance premiums (just like employers can pay for insurance in any other state), and even employers who pay in full for their employees' leave are not entitled to the tax credit, unlike their competitors on the other side of the Long Island Sound.

Conclusion

If you squint just right at the rules around the tax credit, you can see the kind of broken-brained Congressional logic at work here: the tax credit is intended to encourage additional employers to provide paid family and medical leave. Firms which are already required by state or local law to provide paid leave by definition don't need any additional encouragement.But that logic has the deranged result I described above: two firms with identical payroll and identical paid family leave policies will face different federal tax rates based solely on whether their paid family leave policy is or is not required by state law.In other words, a tax credit intended to encourage firms to adopt paid family leave policies has the perverse consequence that New York State could increase the amount of federal tax credits flowing to its businesses by repealing its paid family leave policy, which would immediately deny access to paid family leave for millions of New Yorkers.Fortunately, the paid family and medical leave credit is currently set to expire at the end of 2019. For all our sakes, let's hope we get it right next time.Become a Patron!

Are there 529 plans so bad they aren't worth their state's income tax benefits?

Become a Patron!A lot of financial planning and advice can start to seem pretty routine over time: maximize contributions to tax-advantaged savings vehicles, invest in a basket of diversified, low-cost assets, and periodically (but not too often!) rebalance.I'm always interested in identifying places where that kind of routine advice breaks down, and the other day, I got to thinking: many states allow certain state income tax deductions for 529 college savings plan contributions, but only when contributions are made to plans sponsored by the state where you take the deduction. Since the fees and expenses of 529 plans can vary considerably, I wondered if there are states where the costs of using the in-state plan instead of a cheaper alternative exceed the value of the state income tax benefits.

Deductions, credits, and rates

To investigate this question, I had to isolate several different dimensions:

• Does a state offer a tax deduction or a tax credit? Four of the 35 states offering state income tax benefits offer a tax credit for contributions: Indiana, Utah, Vermont, and Minnesota. The rest allow for contributions to be deducted from state income instead.
• What are the limits on the state tax benefit? Colorado, New Mexico, and West Virginia allow taxpayers to completely eliminate their state income tax liability through 529 contributions. The remaining states place a cap on the amount that can be deducted.
• What are the state income tax rates? A deduction is more valuable in a state with high income tax rates than in a state with low ones. I used the lowest and highest non-zero income tax brackets for each state to identify the range of potential values of a state income tax deduction.
• Does the state only allow deductions for in-state plan contributions? Seven states allow income tax deductions for contributions to out-of-state plans: Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.
• And finally, what is the cheapest appropriate investment option in each plan? For this comparison, I selected the lowest-cost broad US equity option in each plan, which was typically a US large cap, S&P 500, or total stock market fund.

Whether or not you're interested in my particular research question, you might find the resulting spreadsheet useful on its own, and you can find it here.

Reminder: state tax benefits are worth less to federal itemizers

Before I go on, I want to remind folks who choose to itemize their federal deductions that state tax credits and deductions are worth less to them, since reducing their state income taxes mechanically reduces their state and local tax deduction and increases their federal income taxes.Take, for example, a South Carolina resident in the 7% state income tax bracket who owed exactly $10,000 in state income tax and no other state or local taxes in 2018. If they chose to itemize their federal deductions, for example due to a large deductible charitable contribution in 2018, then the $10,000 is also deductible from their taxable federal income.Since South Carolina allows 529 plan contributions to be deducted against an unlimited amount of state income, the taxpayer can save $10,000 in state taxes by contributing a bit over $100,000 to a South Carolina 529 plan. But this will reduce their state and local tax deduction by the same $10,000, increasing their federal income tax liability by up to $3,700.Such corner cases cover only a tiny number of taxpayers, but it's something to be aware of in case you happen to be one of them.

First impressions

Taking a look at the spreadsheet, the first thing that should jump out at you is that these plans are all over the place. Investment costs start as low as 0.035% (for Rhode Island residents to invest the "U.S. Stock Portfolio"), and run as high as 0.65% (for Mississippi's "U.S. Large-Cap Stock Index Fund Option"). Note that these are the lowest-cost equity investment options in each plan — fees for other investment options can run much, much higher than this.The second noteworthy observation is that some of these supposed tax benefits are trifling. Rhode Island will give a married couple with over $145,600 in taxable income a deduction worth a little less than $60 for contributing $1,000 to their in-state plan. For a low-income single filer, the deduction is worth less than $20. What exactly is the point supposed to be?At the high end, the state tax benefits can be considerable. In addition to the states with unlimited deductions I mentioned above, high-income married taxpayers in Alabama, Connecticut, Idaho, Illinois, Indiana, Iowa, Mississippi, Nebraska, New York, Oklahoma, and Vermont can all save $500 or more by making contributions to in-state plans. Single filers have it tougher, but can still save more $500 or more in Mississippi and Oklahoma state income taxes.

If you're just maximizing state tax benefits, don't diversify!

This is a corollary of what I wrote above: since I chose the lowest-cost equity option in each plan as my benchmark, if you don't use that option, you will likely end up paying more in fees. For your primary 529 account, you should have an appropriately diversified portfolio that scales back risk as your beneficiary nears enrollment. For your tax-scam 529 account, just put however much money you need to maximize the state tax benefits into the cheapest equity fund and forget about it.If you're lucky enough that your primary account is also your tax-scam account (Utah, I'm looking at you), then feel free to disregard this warning.

It's almost always worthwhile for non-zero rate payers to maximize their in-state tax benefits

Remember the original question we started with: are there states where the cheapest investment option is so expensive it outweighs the state income tax benefits?And the answer, to a first approximation, is no. What I was looking for is a state with a very low income tax benefit, like Rhode Island, and very high investment costs, like Mississippi or North Dakota. But those states mostly don't exist: for taxpayers with any state income tax liability at all, making the maximum deductible contribution to the cheapest in-state 529 investment option will almost always create a greater reduction in state income taxes than the increased expenses compared to the cheapest 529 plans available.There are two exceptions: in states with fixed account maintenance fees in addition to investment costs, low balances may incur much higher proportional expenses, in the same way that fixed fees on origination can increase a loan's APR far above the stated interest rate.The second exception is folks without state income tax liability. If you aren't taking advantage of your state's tax benefits for in-state plan contributions, don't feel compelled to make in-state plan contributions: find the cheapest plan with the best investment options and use that instead.Become a Patron!

The manufactured "kiddie tax" crisis, explained

Become a Patron!There's a simple rule I like to remind people of whenever a business or finance story emerges from the business section of the paper into the news section or into public consciousness: business journalists are the laziest people in the country. I would call business journalism "stenography," except for the serious injustice that would do the patient, skilled, and honorable work hard-working stenographers do every day.Business journalism is far worse than stenography: it's fiction. Today's entry in the genre is the manufactured "kiddie tax" crisis that snuck its way into the "Politics" section of the New York Times.

What is the "kiddie tax?"

Formally the "Tax for Certain Children Who Have Unearned Income," the kiddie tax is a section of the tax code that applies to unearned income received by certain children, specifically children:

• who do not file a joint return;
• who have a living parent;
• who are under the age of 18;
  • or who are between 18 and 24 and are full-time students and receive less than half their "support" through earned income.

The kiddie tax is reported on Form 8615, which only needs to be completed for a certain child if that child's unearned income exceeds $2,100.Note one thing here: the test above is not whether a child is claimed as a dependent, but the stricter standard of whether a child may be claimed as a dependent, so the kiddie tax can't be avoided simply by having a full-time student file their own tax return (unless they meet the 50%-earned-income support test).

How and why did Republicans change the kiddie tax?

Until the 2018 tax year, Form 8615 required a complicated calculation based on their parents' tax rates, with special rules for divorced and separated parents. Republicans changed that calculation so that all children subject to the kiddie tax pay trust-and-estate rates on their unearned income in excess of $2,100.This somewhat simplified the calculation by not requiring reference to the parents' income, although as the Journal of Accountancy helpfully explains, "While many complexities of the old kiddie tax were eliminated, new complexities were introduced."But obviously simplifying the tax code wasn't the point of the change, since the Republican law made the tax code vastly more complicated, introducing as it did 6 new schedules to replicate information that used to be provided on Form 1040. The reason the change was made is that the budget authorizing the law to be passed through the reconciliation process only permitted Republicans to raise the federal deficit by $1.5 trillion over 10 years. Since they wanted to cut a far bigger hole in the federal budget than that, they needed to find offsetting revenue anywhere they could, including the much more famous changes to the standard deduction and the cap on the state and local tax and mortgage interest deductions.And it turns out, now they want to call backsies.

Policymaking by anecdote: students-and-orphans edition

That brings us to today's news, that the Republican authors of the tax reform bill, with control of both chambers of Congress and the White House, "accidentally" raised taxes on certain sympathetic populations, and want "to correct drafting errors and other technical issues on a bipartisan basis." Let's take a look under the hood.Financial aid for post-secondary students is treated by the tax code in distinct ways based on a number of factors:

• grants (including merit-based, need-based, and discretionary awards) are completely tax-free up to the amount of mandatory tuition and fees charged by the institution, plus books, supplies, and equipment required for courses;
• student loan interest is deductible from income in the year it's paid, whether or not you otherwise itemize deductions;
• work-study income is taxable as earned income but exempt from FICA taxes during the school year (FICA taxes apply if you continue to work over the summer, for instance);
• grants in excess of mandatory tuition, fees, and expenses are taxed as unearned income.

This treatment of "excess grants" as taxable income is one reason virtually no institutions provide scholarships covering room and board: a dollar of tax-free scholarship spending goes further than a dollar of taxed scholarship spending, so institutions naturally prefer to "fill up" the bucket of untaxed scholarships before they start issuing taxable ones. Student loans, work-study awards, and family contributions are expected to make up the difference in the cost of attendance.I want to draw special attention to one piece of sleight of hand the Times' journalists dutifully copied down from whichever lobbyist fed them this story:

"In the past, a student from a household with a joint income of $50,000 who was awarded a scholarship that covered $11,500 in room and board would be taxed at their parents’ rate of 12 percent. Under the new law, that money would be taxed up to 35 percent."

Did you catch it? Reread the paragraph one more time, I'll wait here."In the past" there was no 12 percent income tax bracket!In 2017, a married couple with one dependent making $50,000 would have owed $2,840 in income tax on $25,150 in taxable income, and the $9,400 in unearned income in excess of $2,100 would have been taxed at the parent's marginal income tax rate of 15%, for a "kiddie tax" of $1,410, and a total tax bill of $4,250.In 2018, the same couple would owe $2,739 on $26,000 in taxable income and $1,927 in kiddie tax, for a total of $4,666. In other words, the catastrophic mistake Republicans are rushing back to fix cost this family a grand total of $416 per year, raising their average tax rate from 8.5% to 9.33% during the years their child is enrolled.But of course even this overstates the consequences for the family because they'll continue to enjoy the Republicans' lower income tax rates after their child leaves school (and increased child tax credit in the years prior to that, if applicable). Assuming their income remains the same for the 10 years the personal income tax cuts are in effect, the changes to the kiddie tax will cost them a total of $1,664 while the lower personal income tax rates will save them $1,001, meaning the total cost to this family over 10 years is $663 on $500,000 in income, or 0.13% of the total.The point is, Republicans needed to find additional sources of revenue in order to make the numbers work on their enormous deficit-financed tax cut. Complaining about the new sources of revenue in isolation without taking into account the enormous tax cut is always going to make it look like taxes went up, instead of down, because you're only looking at one half of the equation.

Conclusion: politics ain't beanbag

Making predictions is hard — especially about the future. If you ask me honestly what I think will happen to this provision, I'll tell you I think Democrats are going to get rolled on it, because Republicans are better at this than Democrats are. There's going to be a steady stream of these stories planted in the business press, where the laziest journalists in America take in press releases, process them, and uncritically pass them along to the public. Long lines of sobbing athletes, scholarship students, widows, and orphans will parade past television cameras until Democrats cave and shovel another billion dollars into the furnace.And look: I don't care one way or the other if room and board scholarships are taxed as unearned income, earned income, or are completely untaxed. My point is that in a world with a competent financial press, Democrats would be in a much better position to extract concessions from the people who single-handedly created this manufactured crisis before throwing them a lifeline to get out of it.Become a Patron!

What would total employer-employee collusion look like?

Become a Patron!I've lately been researching some employer-side tax benefits and binge-listening to an organized-crime-themed comedy podcast, which I'm not going to name because it's so vulgar that I strongly discourage anyone with a weak stomach or guilty conscience from listening to it (e-mail me if you're interested), and the two eventually crystalized in my mind the following question: how would you organize a business with the explicit goal of maximizing the total benefits made available to the collective pool of both owners and employees?This is an interesting question because the employer-employee relationship is traditionally treated as adversarial. Employees ask, beg, plead, and strike for higher compensation and benefits, and employers hire strikebreakers and scabs, enlist the National Guard, and sue, delay, and terrorize in order to pay as little as possible in compensation and benefits.But there are other models. In the FIRE blogging community, it's de rigueur to "employ" your kid as a "model" so you can start making Roth IRA contributions while they're still in the womb, or at least as soon as they have a Social Security number.And likewise, anyone who has watched the entire run of the Sopranos more than once knows that Tony needs his W-2 from Barone Sanitation. While it observes the forms of an employer-employee relationship, it's what Baudrillard might call a simulation or simulacrum of employment: an imitation or a replica of an original that has long since ceased to function as designed or imagined.That eventually made me ask the question: if many of our public programs are designed around an adversarial employer-employee relationship, what would complete employer-employee collusion look like? In other words, if the total pool of profits were shared between everyone at the company, how would you organize the company to maximize the amount of benefits the entire collective received?

Workplace benefits

This may seem obvious, but it's important: there is a wide range of methods to distribute profits to employees in ways that are not taxable to either the employer or the employee.

• Dependent Care Flexible Spending Accounts. While many people associate FSA's with health insurance, Health FSA's are not available to the employees of firms that don't offer health insurance. Fortunately, Dependent Care FSA's are, and have higher contribution limits ($2,500 if married filing separately, $5,000 otherwise). These accounts can only be used to pay for dependent care (not healthcare) expenses, but that includes a wide range of childcare costs for children up to the age of 13, and dependent adults. Anyone with either kind of dependent will no doubt find it easy to find $5,000 in eligible expenses per year, but note that like health care FSA's, dependent care funds expire at the end of each calendar year.
• Workplace retirement accounts. Our employer-based welfare state affords enormous advantages to employees whose employers happen to offer workplace retirement plans. Obviously, if you have complete collusion with your employer, you'll both want to maximize your contributions to those plans. Employer contributions unfortunately have to be made into pre-tax accounts, but employee contributions (up to $19,000 in 2019) can also be made into after-tax Roth accounts, semi-permanently shielding the income from taxes on interest, dividends, and capital gains.
• Paid family and medical leave credit. I wrote up this benefit in detail on Tuesday, but the short version is that if an employer adopts a written policy offering 100% wage replacement for up to 12 weeks to all employees making up to $72,000 per year for all Family and Medical Leave Act purposes, the federal government will provide a tax credit credit of 25% of that wage replacement. Without total collusion, this simply offsets the cost of having to accommodate an employee's absence. With total collusion, the collective can get a tax credit of up to $4,150 per year, per employee earning up to $72,000 (25% of 12 weeks at 100% wage replacement). There is no limit on the number of years or number of times the leave can be taken to be eligible for the credit (up to 12 weeks per year).

Tailor payroll to family size

Because of the way our benefits system privileges employment income, under conditions of total collusion it's essential to report the lowest possible wage eligible for the highest possible benefits. I've written about these "minimax" conditions before, but to review, the most important benefits are:

• Earned income credit. The federal EIC phases in based on both tax filing status and number of dependents, meaning the optimal amount of earned income for each employee is highly dependent on the exact composition of the employee's household, ranging from (in 2018) $6,800 in income and a $519 credit for a single adult with no dependents to $14,300 in income and a $6,431 credit for a filer with 3 children.
• Child tax credit. The new $2,000 child tax credit doesn't require as much careful calculation as the EIC, but it still phases in and out, so under conditions of total collusion you'd want to make sure each employee with children has at least enough income to trigger the entire $2,000 credit. The key thing to keep in mind is that $600 of the credit is only refundable against tax liability, so you need to make sure each employee with children has at least $600 in tax left over each year to claim the entire credit.
• Supplemental Nutritional Assistance Program. SNAP, the successor program to "food stamps," is phased in and out like the earned income credit, and is based on family size like the child tax credit, but has additional employment requirements. Under conditions of total collusion, you'd want to make sure each employee was recorded as working at least 20 hours per week in order to satisfy SNAP's work requirement.
• Medicaid / Affordable Care Act subsidies. This is one of the most important areas of collusion, because it interacts in such a complicated way with the others. In Medicaid expansion states, it's essential to keep each employee's income below 138% of the federal poverty line for that employee's family size, while in non-expansion states, it's essential to make sure their income is just above 138% of the poverty line, so they'll be eligible for the maximum ACA subsidy.

You need a patsy

There's one big problem you run into right away when developing a conspiracy to maximize the transfer benefits of the welfare state on behalf of a collective: you need an employer. This isn't the end of the world, but it's also not trivial: several of the benefits I described above aren't available to the owners of companies and so-called "highly-compensated employees." This has some odd knock-on effects under conditions of total collusion.The highly-compensated employee test is complicated, but a truly committed crime family could find workarounds. For example, if the collective distributed 4.9% ownership to 20 totally unrelated people, then none of those people would meet the 5% ownership test. But, until your collective expands to that many people, you have the problem of assigning ownership to someone who won't, for example, be able to benefit from Dependent Care FSA's or certain employer-side 401(k) contributions. That's fine, but ideally you'd want to rotate the role among people who would be eligible for the fewest work-related benefits. If an "owner" gave birth, for example, you'd want to shift ownership to someone who wasn't incurring present-year dependent care expenses.

What do you do with the money?

This is sometimes treated as the most complicated part of the conspiracy, but it's actually the simplest. After all, once the business has completed its payroll, and once the "owner" of the business has taken the distribution of profits, the owner is free to do with that money whatever they wish.Now, it would certainly be illegal, and I would never encourage or even suggest, that the "owner" of a business "distribute" the "profits" of a "collective enterprise" to its other members as compensation for their labor. Those would be wages, and would need to be reported to the appropriate authorities, with appropriate state, local, and federal payroll taxes deducted and withheld.But hypothetically, under conditions of total employer-employee collusion, whomst amongst us has not made periodic transfers to our friends, relatives, and co-workers? And whomstsoever amongst us has ever even pretended to pay taxes on those transfers? The fact is, once money has been flushed out of a business through payroll or the distributions of profits, we can do anything we want with it. Even give it to our friends.Become a Patron!