The least-understood benefit of the 529 scam

I have written a lot about 529 college savings plans, the grotesque transfer of millions of dollars of additional wealth to the richest people in the country, which were expanded and made even more valuable in the Smash-and-Grab Tax Act of 2017 when qualified "higher education" expenses were expanded to include up to $10,000 per year in tuition at private elementary and secondary schools.In an exchange with reader calwatch in the comments to an earlier post, I touched on one of the most misunderstood elements of 529 plans, and realized it really deserved its own post.

The difference between tax-free and penalty-free withdrawals

I've gone over the basic conceit of 529 plans many times before: contributions are made with after-tax income (although some states allow tax deductions if you contribute to the plan in your state of residence), compound internally tax-free, and can be withdrawn tax-free for qualified "higher education" expenses (now including up to $10,000 in private elementary and secondary school tuition, as I mentioned above).It's essential to understand three types of withdrawals that can be made from a 529 plan:

• withdrawals for qualified higher education expenses paid out of pocket or with student loans are completely tax-free;
• withdrawals for qualified higher education expenses covered by grants and scholarships are penalty-free, but subject to income tax on the earnings portion of the withdrawal;
• and withdrawals for non-qualified higher education expenses are subject to income tax on the earnings portion of the withdrawal and a 10% penalty on the earnings portion of the withdrawal.

The key difference between tax-free and penalty-free withdrawals is this: tax-free withdrawals must be made in the year the qualified educational expenses are paid (or billed), while penalty-free withdrawals can be made at any time and "attributed" retroactively to the grant or scholarship.For folks who choose to enroll in high-deductible health plans eligible for tax-free health savings accounts, this should sound familiar: withdrawals from HSA's must be "attributed" to a qualified health expense, but they don't have to be made in the same year the health expense is incurred. Indeed, they can be made years or decades later, as long as you keep good records.

A well-timed penalty-free withdrawal is a tax-free withdrawal

What this allows you to do is time penalty-free, taxable withdrawals for years when you have low taxable income, for example if you stop working before age 70 but want to take advantage of the Social Security magic trick. During years in which you don't earn any ordinary income, you can "fill up" the bucket of your $12,000 or $24,000 standard deduction with 529 plan withdrawals attributed to decades-earlier grants and scholarships, and then meet any additional income needs with withdrawals from Roth accounts or taxable capital gains in the separate 0% capital gains tax bracket for those transactions.

Conclusion: yes, I'm trying to kill this loophole

Tax-advantaged programs like 529 accounts, while offering hilariously small benefits to the middle class and no benefits at all to the poor and working classes (who for obvious reasons are not saving anything at all) offer preposterous tax incentives to the rich, the very rich, and the ultra-rich.The answer is waiting for us whenever we're ready for it: shut down the 529 scam once and for all.

The more unrealistic your goals are, the more of them you need

I got to thinking the other day, as I so often do, after seeing somebody toss off a joke on Twitter. The gag is an asset manager being told by a prospective client, "I need real, net of fee returns of 8%, so I don’t think you are a fit." The asset manager drily replies in .gif form, "Correct." My immediate response was not to the "realistic" or "unrealistic" element of an 8% return, net of fees. My response was to the idea of "needing" one return or another.

What return do you need?

If you want to operate a private space program like Jeff Bezos or Elon Musk, you need many billions of dollars. For the sake of argument, let's say ten billion of them. Now, ten billion dollars sounds like a lot of money, but it's not an impossibly large amount of money. According to Forbes's (always-suspect) list, there are about 150 people in the world with fortunes that large. The formula is simple: you start a company (or, like Eduardo Saverin, be roommates with someone who starts a company, sue him, renounce your US citizenship, and move to Singapore), hire some competent managers, wait for the stock market to get frothy, go public, and presto, you're worth $10 billion.The trouble is, there's no point in operating half a space program. That means if your managers are a little less competent or the stock market is a little less frothy, you might only walk away with $5 billion — not nearly enough to land a man on Mars. If you don't want to strand Matt Damon halfway there, then you need a different goal. For example, the University of California system budgeted the collection of $3.15 billion in tuition and fees in 2016-2017, meaning with $5 billion you could pay the tuition and fees for every student in the University of California system for a year (and still hang on to almost $2 billion).The point is not that financing public education in California is a less worthy goal than sending Matt Damon to Mars. The point is that you can't afford to send Matt Damon to Mars, so you need a backup goal.And indeed, this is a perfectly common situation to find oneself in. On a visit to a steakhouse you might prefer the $150 cut of meat to the $45 cut, but choose the $45 piece anyway because you can't afford the $150 option. It doesn't make your choice "less authentic" or "worse" in any meaningful way; it simply means you've arrived at a particular balance of your preferences and your constraints.

Your goals don't need to be realistic if you have enough of them

At this point you might object that there's a big difference between a $150 steak and a reusable rocket that can land on a platform floating at sea. But I don't see any difference at all: to afford the steak you need another $105, to afford the rocket you need another $9,999,999,955. In both cases, your ability to meet your goal depends on your starting assets, your income, your savings rate, and the return on your investments.Personal finance advice often ends up eliding this by saying the only goal worth thinking about is to acquire "as much as possible." Traditionally, that's been used to mean as much money as possible. "The Millionaire Next Door" became a classic of the genre by observing that even a middle-class income allows healthy white people to accumulate millions of dollars if they live frugally enough. In our own time, the FIRE community turns this logic on its head and says the goal is to acquire as much freedom as possible, i.e. working the least possible amount of time required to liberate oneself from the drudgery of work.If "as much (money, freedom, whatever) as possible" is the only way you know how to think about your goals, then you end up with more or less identical advice: earn as much money as possible, spend as little money as possible, and invest in the most aggressive portfolio you will be able to stick with through market volatility.But acquiring "as much as possible" is obviously not the only way to set goals. Most significantly, it takes all potential goals that decrease your net worth off the table. Giving away a million dollars may feel good for a moment, but it also reduces your net worth by a million dollars, which makes it theoretically indistinguishable from buying a new car, renovating your kitchen, buying organic groceries, or sending your kids to private schools.

Have enough goals to accommodate reality

Fortunately for them, but much to the consternation of personal financial columnists and bloggers, in the real world people seem to have no trouble organizing their lives around multiple goals. People do buy organic groceries, even though they could invest the difference in price. People do renovate their kitchens, even if the renovations cost more than any higher final sale price of their house. People even send their kids to private schools, unfortunately.While I find people are in general extremely effective at forming and executing goals within their means, they don't pay nearly enough attention to "upside risk:" the possibility that their income, savings, and return on investments will dramatically outpace their goals. Of course, setting unrealistic goals is, by definition, unrealistic. You don't want to commit to donating $1 million in 10 years, only to discover that a job loss, unexpected medical expenses, or global financial crisis leaves you with just $250,000.But you also don't want to commit to donating $250,000 and find that your investment has swollen to $1 million, leaving you with $750,000 you can't fathom what to do with. Is that a better problem to have than the reverse? Of course. But there's no such thing as a good problem, and if you find yourself suddenly on the spot trying to figure out what to do with $750,000, you're vulnerable to two serious errors.First, you might simply spend the money foolishly, or not at all. If you check your brokerage statement the same day you get a mail or phone solicitation from the Wounded Warrior Project, you might ship the money off to them to be spent on their lavish headquarters and advertising budget. Worse in its own way is simply choosing not to spend it and passing the problem on to the next generation.But the second problem is one I consider almost as dire: a big part of the pleasure of setting goals is working towards them, and experiencing satisfaction and disappointment as you draw nearer and farther away from them. In my other career as a travel hacker, I see my loyalty program balances rise towards the values I need to book the trips I want to take. Money's not entirely like that: there will always be things to spend as much or as little money as you like on. But the principle is the same: working towards a goal has a satisfaction independent of actually achieving it.

Conclusion: set unrealistic goals!

Most people have a sense of what they will do if their investments end up returning 5% instead of 8%. They'll move to a smaller house, they'll replace the car less often, they'll take fewer vacations, they'll leave less money to their children. But fewer people know what they'll do if their investments end up returning 11%, or 20%, or 100%, instead of 8%. Thinking about that problem sooner, rather than later, gives you more time to formulate the right goals and more time to relish getting closer to them, whether or not you ever end up getting Matt Damon to Mars. 

Everyone should have access to the federal Thrift Savings Plan, but not for you reason you think

Shortly before his humiliation and expulsion from public life, Florida Senator Marco Rubio resurrected the idea of allowing some non-government employees to invest in the Thrift Savings Plan, which is the federal equivalent of private-sector 401(k) and non-profit 403(b) plans. The proposal got some sympathetic attention from lazy personal finance journalists, and some critical responses from bloggers serving the federal workforce.

The lazy reason to support TSP-for-all: lower costs

The narrow reason financial journalists latch onto in support of TSP-for-all is administrative costs, and it's true that TSP charges less in overhead and fund management fees than virtually all private retirement schemes, between 0.032% and 0.033%, depending on the fund.

Let me be clear: costs matter, and that's a lower cost than, for example, a Vanguard mutual fund held in a Vanguard 401(k).

But, as opponents of TSP-for-all are quick to point out, those costs are subsidized in part by fees paid by employing agencies. Universal enrollment in TSP might provide some economies of scale, but would also introduce a large number of non-subsidized workers into the system, dragging up average costs even if the final cost is lower than most workers pay today.

For that reason many TSP-for-all proposals involve replicating a second pseudo-TSP for non-federal-employees, so federal employees continue to enjoy their agency subsidies and lower costs, while non-federal-employees are shunted into a parallel system with higher, unsubsidized costs.

With costs as low as they already are in the private mutual fund industry, this strikes me as the least convincing argument for TSP-for-all.

A decent reason to support TSP-for-all: simplicity and universality

An argument for TSP-for-all that I'm more sympathetic to is that decisions over the availability of tax-advantaged retirement savings shouldn't be made by employers at all. If the federal government decides it's willing to let people shield $25,000 in earnings from income tax in 2019 ($6,000 in IRA contributions and $19,000 in workplace contributions, plus catchup contributions in both), why should your boss get to decide whether you are able to take advantage of that benefit or not? It's as nuts as companies running their own private health insurance offices.

Providing everyone, with or without their employer's permission, with access to the total retirement savings benefit they're entitled to, is a commonsense measure, although as I've said in the past, my preference would be to simply eliminate workplace retirement savings plans entirely and increase and universalize the contribution limits for individual retirement accounts (which isn't mutually exclusive with TSP-for-all).

TSP-for-all is also sometimes praised on the grounds of simplicity, and here the argument is fair enough as far as it goes. It's somewhat shocking even to me, but the "best retirement plan in the country" has just 5 investment options (plus "Lifecycle" funds that blend the 5 in different proportions): US large-cap, US small-cap, US bonds, international developed stocks, and the TSP's proprietary "G fund."

The first four are fairly standard low-cost market-capitalization-weighted index funds, while the G fund is unique in that it offers interest income based on intermediate-term US treasury rates, but with the principle guaranteed so that the fund can't lose money when interest rates rise. A neat trick!

I think between them these are excellent components in a retirement savings portfolio, and wouldn't have any serious objection if they were the only options available in a TSP-for-all plan. But there are perfectly reasonable objections to this fund lineup as well: emerging markets are completely absent, as are international bonds. Do those asset classes have a role in every portfolio? Of course not. Should they be categorically excluded from investments? That depends on the trade-off you want to make between simplicity, versatility, and diversification.

The best reason to support TSP-for-all: a simple national supplemental annuity

The primary source of retirement income for Americans is not traditional defined-benefit pensions, and it's not defined-contribution retirement plans like 401(k)'s and 403(b)'s. It's Social Security's old-age benefit, a federal program that guarantees retirement income based on your recorded earnings paid into the program during your working lifetime.

One problem with our current jerry-rigged retirement system is that under our laws, annuities are not investments at all: they're insurance contracts, sold on a commissioned basis by state-licensed agents and state-regulated for-profit companies.

If, instead, we want voluntary savings to accumulate and supplement workers' Social Security income in retirement, then there's no better solution than a federally-guaranteed annuity, available nationwide, based on a worker's balance in the federal Thrift Savings Plan.

The Thrift Savings Plan already offers a free calculator showing how your retirement savings can be converted into a single lifetime, joint lifetime, or inflation-indexed annuity (and even a few more exotic options related to non-spouse beneficiaries), and I haven't been able to find another company offering better terms. However, those annuities are still technically issued by the private MetLife corporation, and subject to state law (and bankruptcy court).

But since the federal government already runs a guaranteed income program for retirees, the greatest promise of TSP-for-all is the ability to convert accumulated savings into a supplemental Social Security benefit, guaranteed by the federal government to last as long as you do.

What do we want from our retirement system?

Nothing could be simpler than our retirement system as it exists today: the rich do what they can, while the poor suffer what they must. But this rule is not written in the stars, it's the product of very specific decisions made in the development of our retirement policy:

• Employers are allowed to decide the retirement savings options available to their employees, so low-wage employees have less access to tax-advantaged savings vehicles than high-wage employees;
• Social Security contributions are capped so high-income workers have more disposable income to contribute to tax-advantaged plans than low-income workers do;
• Low-income workers who are able to save in individual retirement accounts can be lied to by financial advisors who are not required to act in their best interests.

A simple, cheap, universal, federal Thrift Savings Plan won't solve every problem in the world. But no one defending the current system is even pretending that it's doing an adequate job providing for income security in retirement.

So how about we try something different?

The SEC offers free financial planning tools. Are they any good?

This is a funny thing I was unaware of until I saw someone mention it on Twitter the other day: the SEC hosts a website offering free financial planning tools. I was surprised, since I think of the SEC as having a "hands-off" approach to investing: they don't want people to commit too much fraud or anything, but they're mostly indifferent to whether you invest well or poorly and make good or bad decisions with your money.Financial planning is a totally different animal because financial planners really do make right and wrong decisions. For example, SPICX is an S&P 500 mutual fund with an expense ratio of 1.31%, 33 times more than Vanguard's equivalent fund. That's not something that bothers the SEC (assuming the expense ratio is properly calculated and reported), but it's something that should bother a financial planner.So, I decided to find out: are the SEC's free financial planning tools any good?

401(k) and IRA Required Minimum Distribution Calculator: 3/10

The 401(k) and IRA Required Minimum Distribution Calculator is functional, but primitive. It asks for just two pieces of information: your account balance at the end of the previous year and your age at the end of the current year. From that, it calculates your "withdrawal factor," which is the reciprocal of the percentage of your assets you need to take as required minimum distributions. Finally, it calculates that amount. There are two main design problems with the tool that earn it such a low rating:

• It doesn't help you calculate the relevant year-end account balances or help you interpret the rules around them. For people with multiple IRA's, 401(k)'s, and 403(b) plans, with some Roth balances and some traditional balances, it would be helpful if the tool had multiple fields to enter each balance separately and apply the relevant rules to each account type. For example, someone with multiple 401(k) accounts and multiple traditional IRA accounts may not know that 401(k) RMD's have to be taken from each account separately, while IRA RMD's can be combined and withdrawn from a single account. And while they mention IRA and 401(k) plans, they don't even ask about 403(b) balances, which have their own slightly different rules.
• It doesn't calculate RMD's for people using the joint-life-expectancy exception. If the owner of a retirement account has a spouse more than 10 years younger, they're able to calculate their RMD's using their spouse's joint life expectancy instead of their own. The tool acknowledges this, but merely says "Note: If your spouse is more than ten years younger than you, please review IRS Publication 590-B to calculate your required minimum distribution." But the joint life expectancy rules aren't subjective, they're just a math problem — precisely the kind of math problem a tool like this should be able to solve. It also doesn't help that the site they link to is barely functional (the actual publication is here if you're curious).

Compound Interest Calculator: 8/10

The Compound Interest Calculator is pretty good and well-designed, with the one advantage over the Moneychimp calculator I normally use (because it's the first Google hit) that it is able to display 3 growth rates simultaneously.The only minor tweaks I would make is providing some default suggestions of what kinds of contributions and earning rates are realistic. For example, the IRA contribution limit of $5,500 (increasing to $6,000 in 2019) works out to about $458 a month, which they could offer as a suggested monthly savings rate.Likewise, what's a realistic interest rate, and what's a realistic range of interest rates around it?Finally, I've never seen a tool that incorporates inflation rates on both the contribution and earnings side. Someone who diligently maxes out their IRA every year will contribute $5,500 in 2018 and $6,000 in 2019...and perhaps $15,000 in 2038. Anchoring is an important feature of human psychology, and I suspect quite a few people anchor their IRA contributions on the maximum allowable contribution. It would be nice for a tool to try to reflect that.But these are quibbles. Overall, the Compound Interest Calculator is fine.

Savings Goal Calculator: 5/10

The Savings Goal Calculator suffers from the same problems as the Compound Interest Calculator, while adding no additional value. If these are financial planning tools then they need more inputs than you can get from a basic finance calculator. What is an appropriate savings goal? What is it based on? I'm not asking for the SEC to predict health or transportation expenses 30 years in the future, but a simple approach would be to look at the median savings amount of retirees today and apply a range of inflation expectations.I understand why they don't want to do this: they don't want people to say "the SEC told me I'd be alright if I saved such-and-such an amount!" But if you're going to offer a "Savings Goal Calculator," you've got to take some responsibility for its calculations.

Ballpark E$timate: 0/10

The less said about Ballpark E$timate, the better. First of all, it's not actually operated by the SEC like the previous 3 tools. Second, it requires even more speculative assumptions about the future. Why do the people who design these tools think that a person who needs an online tool to decide how much to save will have an accurate guess about future inflation rates? Whatever you think about the ability of experts to predict future inflation rates, you should have much, much less confidence in the ability of the average person to do so.

Social Security Retirement Estimator: ?/10

I have no idea if this tool works because the Social Security Retirement Estimator will only return a result if you already have 40 Social Security credits (at least 10 years of covered work earning the maximum 4 Social Security credits per year). The plus side is that it's based on your actual earning history, so should be somewhat more accurate than the back-of-the-envelope calculations I'm typically forced to use.

Mutual Fund Analyzer: 3/10

Another external tool, this time offered by FINRA, the Fund Analyzer works ok, but has some serious flaws. To test the Fund Analyzer, I plugged in the high-cost Invesco S&P 500 Index Fund (SPICX) and the low-cost Vanguard 500 Index Fund Admiral Shares (VFIAX) to see what the Fund Analyzer was able to conclude. Feel free to plug in the same funds so you can follow along with this analysis at home.

• Fund Analyzer correctly observed that SPICX would cost 30 times more over a 10-year holding period: $1,574.28 versus $51.45 for the Vanguard fund.
• Frustratingly, Fund Analyzer did not point out that if you sold SPICX within 12 months, you'd be hit with a 1% back-end load fee. To identify that, I had to reduce the holding period to 1 year, and suddenly the fee materialized. Since how long you will ultimately hold an investment is obviously a matter of speculation, those contingent fees should be displayed much more prominently.
• The annual operating expenses are not compared on a like-for-like basis. This apparently comes from the fact that Vanguard filed their fund as a "Growth" mutual fund, while Invesco filed theirs as a "Growth and Income" mutual fund. Remember, these are both S&P 500 index mutual funds.
• The visual "expense ratio bubble" graphic depiction of mutual fund expenses is useless because there's no way to zoom in and tell them apart. It also includes funds that are closed to new investors or only available through proprietary products like target retirement date funds.
• The data is out of date. FINRA still reports that VFIAX has a $10,000 minimum investment, when in fact Vanguard recently lowered the minimum investment for most of their index fund Admiral Shares to $3,000.

529 Expense Analyzer: 0/10

The final financial planning tool recommended by the SEC is the 529 Expense Analyzer, also provided by FINRA. This tool, as far as I can tell, is worthless. The instructions are:

"You can find the information you will need to input into the analyzer in the plan's program disclosure statement, program brochure or plan description. If the plan invests in mutual funds, you may also need the prospectuses for these funds. If you don't have copies of these documents, you can find electronic copies on most 529 plan websites. The College Savings Plans Network website provides links that take you to each state's 529 plan website. If you are having difficulty locating a disclosure statement or plan description on the state's website, it may be included with the 'enrollment information.' Once you download the document, check the Table of Contents for a section on fees and expenses (unlike a mutual fund prospectus, this data is often not presented in a fee table)."

This reminds me of nothing so much as the folk story "Stone Soup." FINRA makes a seemingly outlandish promise: they'll calculate the expenses of any 529 plan in the world. Intrigued, you ask what you must do to receive this extremely valuable gift. And FINRA explains: all you have to do for FINRA is one little favor. Go to the website of every 529 plan, download all the enrollment and investment documentation, carefully input it into a spreadsheet, and presto! FINRA does the rest.

Conclusion: do better, SEC

Let me be clear: I'm not trying to make some kind of abstract argument about the futility of replacing human financial planners with automated tools. On the contrary, I think it would be easy to produce online tools that actually perform the financial planning functions the SEC describes!Vanguard, for example, already has a pretty great tool showing a lot of the information you need to select the right 529 plan for you, including essential information like state-level tax benefits. The key difference is that they don't require you to hunt down the information on your own: they actually did the work to create a useful tool to help people draw correct conclusions.But you can't design useful tools with a view from nowhere. You actually have to make judgment calls, and those judgment calls might be wrong. In a mutual fund low fees are better than high fees. In an index fund, less cash on hand to meet redemptions is better than more cash on hand (the SPICX fund mentioned above has 7% of its net asset value in cash — you're paying 1.32% for someone to manage cash for you!). Lower tracking error is better than higher tracking error. Except when it isn't!A tool that tells you how much you need to save needs to have reality-based estimates of investment returns and inflation in order to produce useful conclusions, even though those estimates might be wrong. Asking people off the street "what do you think the inflation rate will be for the next 30 years?" relieves you of responsibility for the accuracy of your estimates, but it also prevents your tool from providing useful information.There are lots of potential solutions to these issues: Monte Carlo simulations, historical evidence, fundamental analysis, etc. Some of those solutions might work better than others, or perhaps a combination of them would work best of all. But if all do is throw up your hands and say "figure it out for yourself," you haven't provided a financial planning tool, you've provided a 9th grade math exercise.

The risks of specialized knowledge

The other day, I received an invitation to an event at the Brookings Institution called "The new American dream: Retirement security." This seemed right up my alley, so I clicked through to see the event details. The description starts off with some generic language:

"The American dream has drawn millions to the 'land of opportunity' and long encapsulated the idea that every citizen has the right to improve their lives. Yet, the current state of the U.S. retirement system may threaten the ability of some to fully achieve the American dream by ensuring their health and quality of life in retirement."

I naturally found myself nodding along, since the inadequacy of our old age insurance programs is a subject near to my heart. The description continued:

"The traditional three-legged stool of retirement—social security, pension, and retirement savings—is transforming into a wobbly one-legged stool,"

so far, so good,

"with personal savings and investment providing the only retirement security."

Wait, what?

Social Security is the only source of income security in retirement

It's been a while since I've written about Social Security, so let's do a quick refresher on how the program works:

• any time between age 62 and age 70, you can claim an old age benefit based on your income in the highest 35 wage-inflation-adjusted years for which you reported earnings;
• the longer you wait after turning 62, the higher your benefit is;
• your benefit will never fall;
• and your benefit is adjusted upward for inflation each year.

Because the benefit is paid in US dollars by the United States federal government, the system can never go bankrupt. This is retirement security.

Personal savings and investment provide income, not security

What is the difference between income and security?First, income fluctuates. If your savings are in a savings account then the interest rate might fluctuate monthly or quarterly. If they're in a CD ladder, then each time a CD matures you're forced to reinvest the principle at the currently prevailing interest rate. If they're in stocks, bonds, or mutual funds, then the dividends and coupon payments you receive will likewise fluctuate along with interest rates and economic conditions.Second, income is risky. If you don't have control over when you sell your investments, you risk selling them at depressed prices, permanently impairing your ability to generate additional income in the future.Finally, income is vulnerable to inflation. The very safest federally insured deposits may pay little or nothing in excess of inflation, meaning to generate real income you need to draw down your principal or invest in riskier assets.No one in their right mind should confuse personal savings and investment for retirement security. So why did the Brookings Institution?

The risks of specialized knowledge

If you said to me, "Social Security succeeded in lowering the elder poverty rate from 35% in 1965 to 10% in 1995, but some elderly people are still in poverty," I would say, "that's because Social Security benefits are too low and the minimum benefit needs to be raised so no seniors live in poverty."If you said to me, "many children in the United States live in poverty," I would say, "that's because children don't earn income, while requiring adult supervision, and we need a universal child allowance that reflects that fact."Specialized knowledge, the kind of knowledge possessed by scholars at the Brookings Institution, makes it very difficult for people to identify problems and propose solutions that address them directly. Once you know that 401(k) accounts exist, but that most people don't have access to them, and most people who do have access to them don't participate in them, then it's the most natural thing in the world to find yourself talking about how to expand access to 401(k) plans, how to increase participation, how to increase the quality of the investment options, how to ensure people are getting unbiased investment advice, etc, and calling that a set of solutions to "retirement security."But those questions are all downstream from, "how do we provide retirement security to elderly Americans?" That's a question we already know the answer to: bigger Social Security checks.Likewise, once you know the Social Security Administration collects more money than it spends and saves that money in a "trust fund" that will be used to pay benefits once outlays begin to exceed FICA tax revenue, and that the "trust fund" will be "exhausted" in 2034, then it's natural to start frantically wondering what combination of benefit cuts and payroll tax increases will be necessary to make the program "solvent."But if all you want to know is "how will the federal government pay for Social Security benefits in the future?" then the answer is obvious: the same way it pays all its other bills, a combination of corporate and individual taxes, estate taxes, licensing fees, seignorage, and debt. My preference would be fewer wars, higher taxes, and less debt, while if you're a Republican your preference might be for more wars, lower taxes, and more debt, but there's no use pretending Social Security benefits pose some unique threat to the Republic. That is the risk of specialized knowledge.

What's the optimal amount of self-employment income?

Because of the antipathy of American politicians to low-income people, who mostly don't vote and mostly don't make large campaign contributions, we've been blessed with a fractured and dysfunctional welfare state, designed to make income support as cumbersome and difficult as possible to receive, even or perhaps especially for those people who are, in fact, entitled to it.One of the worst manifestations of that dysfunction is that programs have different, overlapping rules for eligibility: the earned income and child tax credits phase in, plateau, and then phase out, while the Supplemental Nutritional Assistance Program starts high and begins dropping almost immediately with each additional dollar of income you earn.While this creates certain benefit cliffs, for example between eligibility for Medicaid and eligibility for Affordable Care Act exchange subsidies, it mostly just creates confusion: will an extra dollar of income increase your earned income credit by more or less than it decreases your SNAP benefit?While employees may have little or no control over their annual income, and in fact may not even know their annual income in advance depending on how predictable their assigned hours are each week or month, people reporting self-employment income may be able to dial in their reported income to the dollar to maximize the available state and federal benefits.While Jared Kushner has a team of lawyers and accountants working tirelessly to help him maximize the benefits of the tax code, you just have me. So here we go!

The four primary federal anti-poverty programs

Federal income support is composed of four primary programs, which I want to split up to make them easier to digest:

• Supplemental Nutrition Assistance Program (SNAP). Monthly benefits begin at $192 and increase by $161 for the second household member, $152 for the third, $137 for the fourth, and so on. For most beneficiaries (excluding those with unusually low housing and utility costs), benefits decrease by roughly $24 per month for every $100 in additional income you earn above roughly $900 per month. Unlike benefits administered through the tax code, the number used in SNAP benefit calculations is your net self-employment income before income or self-employment taxes are deducted. That means $900 in monthly self-employment income will pass through to your 1040 as $10,800 in business income, from which you'll deduct $763 in self-employment taxes, resulting in $10,037 in adjusted gross income.
• Earned income credit. The EIC is one of the original "trapezoid programs," with a rapid phase-in, a benefit plateau, then a gradual phase-out. The EIC is maximized for single childless filers with "earned income" between $6,650 and $8,350, for married childless filers between $6,650 and $13,950, for couples with one child between $10,000 and $18,350, and for couples with two or more children between $14,000 and $18,350. Every additional $100 in self-employment income in the phase-out period reduces childless filers' EIC by $7.11, filers with one child by $14.85, and those with two children by $19.57. Note that for the self-employed, earned income is calculated based on your net self-employment income after deducting half your self-employment taxes.

Let's take a breather here and consider how you would maximize your benefits if these were the only two federal income support programs, since we'll have more moving pieces later.Childless adults, whether single or married, have an incentive to absolutely minimize their reported earnings, while remaining eligible for SNAP. This is because the earned income credit phases in too slowly for these filers: an additional $100 of self-employment income increases their self-employment taxes by $14.13, while increasing their earned income credit by just $7.11. Since SNAP benefits begin to phase out at $10,800 in self-employment income, single childless filers are best off keeping their reported earnings below that level, since each additional dollar they earn costs them more in taxes than the amount they receive in income support.The picture is different for filers with one child: here, the optimal self-employment income is $10,760 for married couples with one child, producing earned income of $10,000. Why? Because for filers with children, the earned income credit phases in faster than SNAP benefits are phased out. Each $100 in additional self-employment income increases the EIC by $31.60, while reducing SNAP benefits by just $2 and increasing taxes by $14.13, leaving such filers with $15.47 more disposable income.The same logic would apply to married couples with two children: maximizing SNAP benefits requires $10,800 in self-employment income, while maximizing the EIC requires $15,064 in self-employment income. Again, we need to compare three values: the phase-in rate of the EIC, the phase-out rate of SNAP, and the marginal tax rate: $100 of additional self-employment income increases the EIC by $37.57, decreases SNAP by $2; and increases self-employment taxes by $14.13, leaving you with $21.44 more in disposable income.Since $100 of additional self-employment income increases disposable income by $21.44, the optimal amount of self-employment income is the EIC-maximizing value of $15,064. Reporting income above that point decreases SNAP benefits and increases self-employment taxes without generating any additional benefits.Simple enough? Unfortunately, we've still got two more anti-poverty programs to go.

• The reformed 2018 child tax credit is another trapezoid program for households with children. Families can begin claiming the credit when their self-employment income reaches $2,690, and each $100 in self-employment income above that level produces a credit of $13.94 per child, up to a maximum credit of $1,400 per child when self-employment income reaches $12,732.
• Medicaid is the final keystone of the American welfare state, and there are very important income restrictions to keep in mind, depending on your state. In Medicaid expansion states, virtually all low-income people are eligible for Medicaid, while in most non-expansion states, most self-employed people are not eligible (Wisconsin is an exception, since they did not expand Medicaid but reached an agreement with the federal government to extend exchange subsidies to the Medicaid-expansion population). Since the Affordable Care Act was designed to make Medicaid expansion universal, in most non-expansion states households aren't eligible for subsidies on the private health exchanges until their income reaches 139% of the federal poverty line, based on household size. That means if you live in a Medicaid-expansion state, you need to keep your income below that threshold to qualify for Medicaid, while if you live in a non-expansion state, you need to make sure your income is above that level to qualify for the maximum ACA subsidy.

The child tax credit doesn't affect our calculation for married couples with one child, since each additional $100 in self-employment income above $10,760 will increase their self-employment taxes by $14.13 and decrease their SNAP benefits by $2, while only increasing their child tax credit by $13.94 and leaving the earned income credit flat, leaving them with $2.19 less in disposable income.In the case of a married couple with two children, however, we see $100 in increased self-employment income raising the child tax credit by $27.88, and the earned income by $37.17, swamping the $16.13 in increased taxes and lost benefits. That means the optimal self-employment income for married couples with two children rises all the way to the EIC-maximizing value of $15,064, at which point their total federal picture will be:

• $2,800 child tax credit;
• $5,616 earned income credit;
• $6,708 SNAP benefit;
• while paying $2,142 in self-employment taxes.

Their next $100 earned above this point will increase their self-employment taxes by $14.13 and decrease their SNAP benefits by $2, but have no effect on their child tax credit or earned income credit, leaving them with an effective marginal income tax rate of 16.13%.

Conclusion

So there you have it. If you have complete control over the amount of self-employment income you report each year, the amounts that optimize your federal income support benefits are:

• For childless adults (single or married): $10,800 or less. SNAP is the primary income support benefit for these households, so be sure to report 20 or more hours of self-employment per week.
• For parents of one child: $10,760. The EIC phases in more quickly than SNAP phases out, so your decreased food-only SNAP benefits are offset by a higher and more flexible EIC. Above that level, the increased child tax credit doesn't fully offset your higher taxes and lower SNAP benefits.
• For parents of two children: $15,064. At this level, the EIC and child tax credit are both fully phased in, so any earnings above this point increase your taxes and lower your SNAP benefits without providing any additional benefits.

Something finally happened in the stock market. What did you do?

It's been a boring year in the stock market. If you bought Vanguard's S&P 500 ETF on October 16, 2017, and held it until this last Friday, you would have earned a mere 10% in price appreciation, and a mere 2-4% in dividends (I can't be bothered to look up the exact historical dividend yield at the moment). If you assume 2% inflation (and no, I don't know why people assume 2% inflation), you've earned "about" 10% in real returns on your investment over the last 12 months. That's a little bit above the historical average, and a lot below truly breakout years like 1933, 1954, or 2013.But it's been an interesting week in the stock market! So let's talk about it.

All of this has happened before and will happen again

The same Vanguard S&P 500 ETF has lost 3.9% of its value this week (and 5.6% of its value since September 20). Some people get upset by price swings like this, but I have exactly the opposite view: price volatility is absolutely essential, not for any economic or financial purpose, but rather as an opportunity to learn something about your own reactions to price volatility.Let's be clear about one thing up front: most Americans have virtually no assets invested in markets of any kind. The price movements of the stock market are of concern to a small number of people beginning with the upper middle class and stretching all the way up to the oligarchs, and matter not at all to workers who experience, if anything, glee when their boss's savings are wiped out.Having said that, among the sliver of people with assets invested in the stock market, it's easy to identify at least three very different reactions to price movements like this week's:

• Total indifference. My partner participates in a workplace retirement savings plan, which is invested entirely in the Vanguard LifeStrategy Growth fund (the same fund my solo 401(k) is invested in). If her payroll cycle happens to coincide with a market downturn, she buys the dip, and if it coincides with an all-time high, she buys the peak.
• Greedy buying. I don't know what path the price of the stock market will carve over the next 30 years, but I have a high degree of confidence that, with dividends reinvested, a stock market investment today will be worth between 5 and 6 times more 30 years from now. This is not a one-year prediction: a year ago, I would have been off by a full 50% (the stock market returned twice my estimated 6%). In any case, for long-term investors dips are obviously better times to buy than peaks, so one thing you might do when prices fall is use the opportunity to buy stocks you intend to hold for the long term.
• Panic selling. The only real mistake you can make when stock prices fall "dramatically" (a 5.6% decrease in a month is not, in any objective sense, dramatic), is to sell your stocks in a panic. The mistake is not selling your stocks — the mistake is selling them in a panic. The price of your stocks will fall 50% or more at least once in your lifetime. If you can't handle a 50% or more fall in the price of your stocks, you own too many stocks, and are right to sell them. But you're wrong to sell them in a panic.

A modest proposal for finding out what your "risk tolerance" really is

It's standard for investment advisors, whether you're talking about the sales teams employed by the big banks, fee-only fiduciaries, or roboadvisors like Betterment, to pose a series of standardized questions to identify your "risk tolerance," so they can recommend an asset allocation. I'm sure a lot of work goes into formulating and processing those questionnaires.But they all suffer from the same problem: they capture your "risk tolerance" at a particular moment in time. If stocks have been sailing smoothly higher, I can bet your "risk tolerance" will be pretty high. After a 50% drop in the stock market, I'm certain your "risk tolerance" will likewise be in the doldrums.Thinking about this problem led me to a modest proposal for a way to assess the amount of stocks a person should actually hold: the investment attention journal. For a period, even a period as short as a week, carry around a pad and jot down every single time you think or do anything about any of your investments. How many times a day do you check stock prices? How many times a week do you buy or sell your investments? How many times a month do you reallocate your investments?If at the end of a week, or a month, or a year, you have a blank page in front of you, you've shown yourself perfectly invulnerable to stock market movements, and might want to invest even more of your portfolio into volatile assets (which you'll never check the value of).If at the end of a day, or a week, or a month, you have a page full of timestamps showing how meticulously you track the price of all your assets, you might be too heavily invested in assets that are too volatile.

Sell down (or buy up) to the sleeping point

There's a cliche in the asset allocation field that the right place to invest your assets is the "sleeping point:" where what happens to your investments isn't keeping you up at night. The cliche usually goes, "sell down to the sleeping point." But I'm so neutral on the question that I'm willing to entertain the flip side: there are people who are sleeping too well, and need to scale up their exposure to volatile investments!In other words, your "risk tolerance" is not, or should not be, how you happen to feel about the stock market at a particular moment in time. It's how you consistently, reliably, and verifiably react to movements in actual market prices.

It's October, time to shuffle around your high-interest accounts

As I wrote last month, my favorite high-interest checking account, the Free Rewards Checking account from Consumers Credit Union, has dropped the maximum balance eligible for their highest interest rate tier from $20,000 to $10,000 (while raising that rate up to 5.09%). While the account is still more than worthwhile (it also offers unlimited worldwide ATM fee reimbursement), there's no reason to hold more than $10,000 in your account anymore, which means you may suddenly have some extra underperforming cash lying around.Here are a few suggestions for what to do with it.

Kasasa Checking

I'm not going to lie and say I know exactly who or what a Kasasa is. If I had to guess, I'd say it's a way for smaller banks and credit unions to pool their deposits and earn higher interest rates on them, part of which they pass along to their depositors in the form of higher interest rates.How high? This high:

• First Financial Bank: 4.07% APY on up to $15,000
• Park City Credit Union: 4% APY on up to $10,000
• Marshall Community Credit Union: 3.75% APY on up to $15,000
• Leighton State Bank: 3.56% APY on up to $15,000
• Texomo Community Credit Union: 3.51% APY on up to $10,000
• One American Bank: 3.5% APY on up to $10,000

All these accounts have slightly different calendar schedules and monthly requirements for triggering their interest rates, so be sure to read through the requirements carefully to make sure you will be able to trigger the advertised rates before opening an account.

Other Rewards Checking Accounts

Two additional non-Kasasa options are:

• Department of Commerce Federal Credit Union Performance Checking: 3.47% APY on up to $20,000
• and Heritage Bank eCentive Account: 3.33% APY on up to $25,000.

What to do with the rest of your cash

I love cash for its two great virtues: it doesn't go down in price (although of course it may go down in value due to inflation), and it can be exchanged for goods and services. Those are virtues I'm willing to pay something for, but I'm not willing to pay an unlimited amount for. That's why I would think twice before deciding to hold onto cash that was earning less than the 3.33% APY offered by Heritage Bank.So, what are your other options?

• Certificates of Deposit. I'm not generally a huge fan of CD's, simply because most people willing to apply a little elbow grease can get higher interest rates from rewards checking accounts. But if you've already exhausted the rewards checking accounts you're eligible for, there are a few places you can get decent rates on CD's. People's Community Bank, United States Senate Federal Credit Union, and KS StateBank all offer medium-term CD's paying between 3.37% and 3.63% APY.
• Pay down debt. If you financed a car or house at the depths of the Great Recession, you may well be paying less in interest than you can earn on the high-interest-rate accounts. But once your savings exceed the eligible balances on those accounts, you can convert your additional cash savings into savings on interest by aggressively paying down those loan balances.
• Low-cost bond funds. While I've been focusing on investments of cash that are federally guaranteed to maintain their value and liquidity, interest rates have gradually crept up enough that there are finally opportunities worth considering in the bond market. Vanguard's Short-Term Corporate Bond Index Fund (VSCSX) currently has an SEC yield of 3.41%, their Intermediate-Term Investment-Grade Fund (VFIDX) yields 3.64%, and Intermediate-Term Corporate Bond Index Fund (VICSX) yields 4.08%. The essential thing to keep in mind when investing in bond index funds is the relationship between duration and return: an intermediate-term bond fund is more volatile than a short-term bond fund over the short term, which means its higher yield can be more than outweighed by its sensitivity to interest rates if you need to sell your shares within a year or two. If you need a short-term investment, you should buy a short-term bond fund!

Conclusion

No one of these options, or any one combination of these options, will be right for everybody. But it's equally true that most Americans are not earning as much as they could be on their savings, and I'd like to help them get started.Politicians often cast the failure of Americans to save as the fault of individuals for not making sufficient contributions to their workplace retirement accounts, or not saving enough in IRA's, or HSA's, or 529 plans. My Councilmember has an insane plan to encourage people to save by deferring their tax refunds and earning a "bonus match" or some such nonsense.But it's all ridiculous. What you need to do to make your savings grow is earn as much interest as possible on your savings. High interest rates encourage people to save, low interest rates discourage people from saving, and that's the whole ballgame. If you save more money than everybody else, at higher interest rates than everybody else, you'll end up with more money than everybody else.So why not get started today?

What goes into a good active savings strategy?

A headline passed across my Twitter feed yesterday that seemed like a good bank account signup bonus: "$500 Bonus for New Money Market Account at Capital One." $500 is a lot of money, so I clicked through to check out what the requirements were. As usual, there were some deposit requirements, in this case a $50,000 deposit of outside money, held in the account for 6-8 weeks (until the signup bonus posts). $50,000 is a lot of money, certainly more money than I have, so I moved along.But, a few hours later, I circled back and started thinking: what is the right way to think about these signup bonuses, and how should you incorporate them into an active savings strategy?

How much cash do you have, and why?

I love cash. It's considered fashionable among some financial advisors to talk about how your cash is constantly losing its value due to inflation, it's not earning a high enough rate of return, it's not backed by gold, whatever. But actual people understand the great thing about cash is that it's cash. You can use it to buy things, you can give it away, you can invest it, you can do anything you want with it! Cash is great, and anyone who tries to convince you cash isn't great is probably trying to sell you something.But as great as cash is, it isn't everything. On the contrary, cash is always and everywhere a substitute for something. If you have a mortgage, car loan, or credit card debt, cash is a substitute for paying down those balances. It might be a good substitute (you might be able to earn more on your cash balances than your current mortgage interest rate) or it might be a bad substitute (unless you have a promotional rate, your credit cards are probably charging more interest than what you can earn on cash deposits). Likewise, up to the relevant balances, cash might be a good substitute for short-term bonds, but a bad substitute for long-term stock investments.

How active is your active savings strategy really going to be?

It doesn't matter how lazy you think you are, it matters how lazy you actually are.Consider the Capital One money market account I mentioned above. It offers a $500 bonus after 8 weeks, and 1.85% APY, which roughly works out to the equivalent of 8.35% APY for the 8 weeks it takes the bonus to post — a high interest rate by anyone's standards. However, it only offers that interest rate for 8 weeks. If you leave your money there for 16 weeks, your blended APY will be 5.1%. At 24 weeks, it'll be 4.01%. If you leave it there for a full year, you'll earn just 2.85% APY.Commenter Kim pointed out last week that Heritage Bank's eCentive account earns 3.33% APY on balances up to $25,000 (she also said she had three of them), while my favorite Consumers Credit Union rewards checking account earns up to 5.09% APY on up to $10,000 (starting in October).In other words, if you only muster up the initiative to actually move your cash savings or your direct deposit from bank to bank once per year in order to trigger a bonus, you're probably earning less than if you simply sat on the cash in the highest-earning accounts you have access to year-round!

Where are you getting the cash?

One tempting option is to say that instead of having a pool of cash you're constantly chasing bank account signup bonuses with, you're going to selectively target just the highest signup bonuses that come around.While it avoids the problem of decaying interest rates I described above, the problem with this strategy is that the cash still has to come from somewhere. If you already have a large cash balance, then the problem is easy to solve by moving the cash from one account to another and back again, but in that case your profit is only the difference between the bonus-inclusive APY and the basic interest rate you earn year-round. That may still be worth doing on a case-by-case basis, of course.Alternatively, you could combine chasing signup bonuses with a more comprehensive strategy of harvesting losses in taxable brokerage accounts. If you have a taxable portfolio with $50,000 in assets showing a loss, then you can sell those assets, realizing a deductible loss, then instead of immediately reinvesting the assets, deposit them in bank accounts offering the highest current signup bonuses. Since bank account bonuses typically take at least 30 days to post, this is also a convenient way to avoid the "wash sale rule," allowing you to reinvest your cash into the same investment you had originally sold (just be careful that ongoing contributions aren't being made to that investment or you're going to run into all kinds of trouble come tax time).Finally, you could borrow the money to chase bank account signup bonuses. While this may or may not be more expensive than the other two options, it's not strictly speaking "riskier." The simplest example would be funding a new account using a credit card, waiting for the bonus to post, then paying off the credit card with money from the same account. A more complicated option, popular back when money market accounts were paying 6% APY or more on liquid deposits, is to open a credit card with a 0% introductory APR and no balance transfer fees to spin up lots of cash that can be invested across a variety of accounts for the entire introductory period.

Conclusion

I love robbing banks and encourage anyone and everyone to get in on the action to the degree it makes sense for them individually. However, there are real risks to trying to dive into the signup bonus game without thinking through a strategy ahead of time:

• how active are you willing to be? The less work you put into your bank account signup strategy, the more your lived interest rate will decay compared to the advertised rate.
• how much is your cash costing you? Do you have other debt that cash could be used to pay down at a higher interest rate than a bank account signup bonus earns?
• are you integrating your cash holdings into a comprehensive investment strategy? If you have $100,000 invested in a 60/40 equity/fixed income portfolio and another $50,000 held in cash, you have just 40% of your investable assets in equities. Does that correspond to your long-term investment goals?

Once you've answered those questions to your satisfaction, there really are opportunities to get outsized returns on short-term deposits, and those opportunities are well worth considering.

Winners and losers from changes to Consumers Credit Union Free Rewards Checking accounts (and why it matters)

I've been an enthusiastic fan of high-interest checking and savings accounts ever since you could earn 6% APY on your PayPal account balance back in the early 2000's (unfortunately I was in college at the time and barely had two quarters to rub together at 6% APY). The boring reason is that the more work your risk-free assets are able to do, the less work your riskier investments have to do in order to meet your long-term financial needs.That made me immediately concerned when I saw Doctor of Credit report some Consumers Credit Union Free Rewards Checking accountholders had received notification of changes to the conditions required to qualify for elevated interest rates. Now that I received my own notification, I want to dig into the details.

Background

As long as I've been a member, Consumers Credit Union has offered three interest rate tiers for qualifying Free Rewards Checking accountholders. While the exact interest rates have bounced around a little, the basic rules were:

• Tier C: 12 signature debit transactions per month and a direct deposit or ACH credit of $500 per month to your account, plus signing up for electronic statements.
• Tier B: Tier C requirements plus $500 spent on a Consumers Credit Union credit card.
• Tier A: Tier C requirements plus $1,000 spent on a Consumers Credit Union credit card.

The three key changes they've made, starting on October 1, 2018, are:

• the debit transactions no longer have to be signature-based, i.e. they can be PIN-based instead;
• the 12 transactions must total $100 or more per qualifying period (previously no minimum);
• and the increased interest rates are only available on deposits up to $10,000 for all three tiers (previously $15,000 for Tier B and $20,000 for Tier A).

Winners: high-interest, low-balance savers

If you were already triggering the Tier B or Tier A requirements each month, but had $10,000 or less in your Free Rewards Checking account, then congratulations! Your interest rate is being raised from 3.59% to 4.09% or from 4.59% to 5.09% APY. On a $10,000 balance, you just got a $50 annual raise.And if you were stuck at Tier B, you just got another nudge to qualify for Tier A instead each month!

Losers: high-interest, high-balance savers

On the other hand, if you were holding $20,000 in your Free Rewards Checking account and meeting the Tier A requirements, your annual interest income is dropping from $918 to $529 (5.09% on the first $10,000 and 0.2% on the second $10,000).

Losers: low-cost automators

I've found that Consumers Credit Union has been pretty good about treating my microtransactions as signature purchases. For example, $0.50 Amazon balance refills and $1.00 Plastiq bill payments have all counted towards my 12-transaction requirement. On the other hand, I've had a misfire or two, like buying $0.50 in Kiva credit, which was processed as a PIN-less debit transaction and did not count towards my qualifying transactions.The new puzzle for low-cost automators is how to get to 12 total transactions with those transactions totaling to at least $100. The first 11 transactions can still be automated using a service like Plastiq, especially if you have access to fee-free dollars (you earn $500 Fee-Free Dollars when you sign up and make $500 in payments, and $1,000 Fee-Free Dollars when someone signs up with your referral code), but if you're making $100 per month in payments (eleven $1 payments and one $88.01 payment), then you'll end up paying something like $0.99 in fees (or using $100 in Fee-Free Dollars). Not ideal!The obvious solution for most folks will be to automate the first 11 transactions and then set up a monthly $89+ payment to a recurring biller like a cable or phone company. I don't have any bills that high, so come October I plan to set up my 12th payment to my student loans until I run out of Fee-Free Dollars.

Why it matters

Folks with workplace 401(k) or 403(b) plans, IRA's, HSA's, mortgages and car loans find my interest in these high-interest opportunities a distraction. But I think there are two reasons everyone should care about maximizing the return on their FDIC-insured savings.

• First, most people have no investment or retirement savings at all. For many US workers, the balance on the prepaid debit card their paycheck is deposited to is the entirety of their "savings." Simply moving from a high-fee prepaid debit card to a high-interest Free Rewards Checking account is the single most important thing most workers can do to maximize the value of their savings.
• Second, even folks who do have a comprehensive, well-rounded investment strategy should be aware that integrating a high-interest, FDIC-insured account into that strategy increases the investor's ability to take risk in the other parts of their portfolio.

To illustrate a stylized version of the second point: if someone has $20,000 of investable assets and wants to achieve the exact return and volatility of a 50/50 investment of $10,000 in US equities and $10,000 in fixed income, they could invest $10,000 in VTI and $10,000 in BND, Vanguard's total stock market and total bond market ETF's.However, substituting their $10,000 of fixed income exposure with a higher-interest FDIC-insured checking account allows them to either increase their equity exposure in order to expose more of their savings to riskier assets and try to achieve a higher overall return with the same volatility, or reduce their equity exposure in order to achieve the same overall return with fewer assets exposed to equity volatility.

Conclusion

If you consider volatility the cost you pay for investment returns, then you should try to reduce that cost just as hard as you try to reduce the costs you incur through expense ratios and trading commissions.High-interest, FDIC-insured rewards checking accounts are one of the lowest-volatility, highest-interest fixed income investments available to most people, and most people would be better off substituting them in to the degree possible for their more expensive fixed-income investments.

Index construction is the most important, least understood part of the indexing revolution

Modestly improved investor education and extensive marketing have made investors today more conscious of the costs of their investment decisions, and helped promote the use of index-tracking mutual funds and exchange-traded funds as opportunities to reduce expenses and allow investors to keep more of their investment returns.While cost-consciousness is a clear positive for investors, the move to indexing has created another source of risk investors rarely hear about: index construction.

How much exposure do you want to South Korea?

My favorite example of the risks of index construction is the FTSE and MSCI definitions of "developed" and "developing" countries outside the United States. They're almost identical, except FTSE places South Korean equities in the "developed" bucket and MSCI includes them in the "developing" index.This is fine if you're invested entirely in funds from issuers tracking the same indices: iShares' core developed (IDEV) and developing (IEMG) market funds both track MSCI indices, so South Korea's inclusion in one and exclusion from the other doesn't affect your exposure. Likewise, Vanguard's developed (VEA) and developing (VWO) market funds both track FTSE indices, so if you only own Vanguard funds you're still able to get exactly the exposure you want.The flip side of that is someone who for whatever reason invests in a developing market fund provided by one company and a developed market fund provided by another. Owning a FTSE developed market fund and a MSCI developing market fund gives you exposure to South Korean equities in both funds, while owning a MSCI developed market fund and FTSE developing market fund leaves you without any exposure to South Korea in either fund.I'm not trying to exaggerate the importance of South Korea to global capitalism (although South Korea has certainly played an important role in the development of global capitalism). I'm trying to say that if your goal is to invest in indexed mutual funds in order to reduce your need for ongoing supervision and maintenance, you need to put in more time up front to figure out exactly which indices your funds are tracking.To put a little more meat on this bone, the MSCI-tracking IEMG has returned an average of 3.86% annually since October 2012, while the FTSE-tracking VWO has returned an average of 3.27%, while the MSCI-tracking IDEV has too short a history to be very interesting, but has slightly underperformed the FTSE-tracking VEA since inception.

Fidelity launched US and international index funds that track...something

That brings me to the news hook for this post: Fidelity made a splash this summer by introducing two funds with 0.00% expense ratios. The funds are only available to Fidelity customers, so you can't buy them in Vanguard, Merrill Edge, or other brokerage accounts, but if you have some reason to invest through a Fidelity brokerage account, they're certainly the cheapest funds available to you, charging as they do no fees on the amount invested in the funds.Some people have suggested that these 0.00% expense ratio funds are being offered as a "loss leader," but that's not exactly right. In fact, they're an experiment in charging people nothing in order to invest in Fidelity's own bespoke indices, which they have the luxury of paying little or nothing for.Here's what Fidelity has to say about the "Fidelity ZERO International Index Fund:"

"Geode normally invests at least 80% of the fund's assets in securities included in the Fidelity Global ex U.S. Index and in depository receipts representing securities included in the index. The Fidelity Global ex U.S. Index is a float-adjusted market capitalization-weighted index designed to reflect the performance of non-U.S. large-and mid-cap stocks."The fund may not always hold all of the same securities as the Fidelity Global ex U.S. Index. Geode may use statistical sampling techniques to attempt to replicate the returns of the Fidelity Global ex U.S. Index. Statistical sampling techniques attempt to match the investment characteristics of the index and the fund by taking into account such factors as capitalization, industry exposures, dividend yield, P/E ratio, P/B ratio, earnings growth, country weightings, and the effect of foreign taxes."

And here's what they have to say about the "Fidelity ZERO Total Market Index Fund:"

"Normally investing at least 80% of its assets in common stocks included in the Fidelity U.S. Total Investable Market Index, which is a float-adjusted market capitalization-weighted index designed to reflect the performance of the U.S. equity market, including large-, mid- and small-capitalization stocks."Using statistical sampling techniques based on such factors as capitalization, industry exposures, dividend yield, price/earnings (P/E) ratio, price/book (P/B) ratio, and earnings growth to attempt to replicate the returns of the Fidelity U.S. Total Investable Market Index using a smaller number of securities."

Emphasis mine.

A bad fund can track a good index

Today, you could buy any of the following three ETF's, all based on versions of the S&P 500 index:

• SPY tracks a market-cap-weighted S&P 500 index;
• RSP tracks an equal-weighted S&P 500 index;
• RVRS tracks an inverse-market-cap-weighted S&P 500 index.

All three options require you to decide whether the S&P 500 is a "good" index or a "bad" index. If it's a bad index, you shouldn't buy any of them!But even once you've decided it's a good index, you aren't relieved of your responsibility. The existence of the three funds means you also have to decide what the best strategy is for investing in the companies that make up that index.SPY has an expense ratio of 0.09%, RSP has an expense ratio of 0.20%, and RVRS has an expense ratio of 0.29%, so even if the funds have identical performance of their underlying assets, you'd be 0.11-0.2 percentage points per year ahead using SPY. However, in order to maintain their equal and inverse-market-cap weights, the latter two funds also have to do much more trading, incurring additional costs that aren't reported in the expense ratio. That means your confidence in the investment strategy needs to be "somewhat higher" than the difference in expense ratios.

Conclusion

I'm sure Fidelity's bespoke indices are fine, I'm sure their ZERO funds will track those indices very closely, and I'm sure they'll perform similarly to the low-cost market-capitalization-weighted index funds offered by their competitors.But my point is broader: you aren't a passive investor just because you invest in low-cost, passively-managed mutual funds or ETF's. You're still making at least three very important, very active decisions:

1. which indices to track,
2. how to track them (market-capitalization, equal-weighted, inverse, leveraged, etc.),
3. and how to allocate your assets between them.

You can carefully research those decisions, you can shrug those decisions off, or you can let me or the Bogleheads forums make them for you, but careful research, indifference, and reliance on the advice of others are all decisions too.As the saying goes, it's turtles all the way down.

So-called "personal finance education" is a distraction

About a year or so ago I noticed a cliche spreading among a certain set of prominent investors and money managers: that a key obstacle to success among young people today is a lack of personal finance erudition. Today's entry in the genre came from Ben Carlson at Ritholtz Wealth Management, who wrote:

"I wish high schools and colleges would teach personal finance. They could show young people things like how to do their taxes, which it seems like maybe 3-4% of the population knows how to do (and that’s being generous)."The U.S. federal tax code is around 4 million words and almost 75,000 page long. To say it can be confusing would be an understatement. Changes from the latest tax overhaul throw another wrench into this equation because now people must figure out how it affects them."

This is an unusually clear example of the role "personal finance education" plays in this ideology. You can clearly identify a problem (people can't do their own taxes), you can clearly identify the cause of the problem (the tax code is too complicated), but instead of demanding that the cause of problem be solved, and the tax code simplified, you demand that teenagers receive specialized education in tax preparation!

"Personal finance education" dodges all the hard problems we face

The beauty of the personal finance education meme is that it allows you to acknowledge real-world problems, without having to undertake any of the effort required to solve them:

• wages are too low;
• housing is too expensive;
• health insurance is too expensive, and leaves even insured individuals vulnerable to catastrophic medical expenses;
• Social Security's current financing stream is inadequate to pay out its present benefits, let alone the benefits that would be needed to permanently eliminate elder poverty;
• the Family and Medical Leave Act covers too few workers, with too few protections, for too little time;
• occupational licensing regimes pose too many obstacles to entry for too many professions.

These are problems with solutions. But a higher minimum wage, more housing construction, single payer health insurance, higher and uncapped FICA taxes, comprehensive family leave, and occupational licensing reform are hard.There are interests on the other side who will do everything in their power to fight against efforts to solve these problems. Businesses want to pay low wages, homeowners want to keep housing scarce, insurance companies want to keep earning record profits, high-income individuals want their FICA taxes low and capped, and every licensed occupation wants to minimize the number of new entrants.So why would a genteel financial advisor, money manager, or financier want to take on those fights? High-income homeowners with occupational licenses are the bread and butter of the upper-middle-class economy! They already have workplace retirement plans, gold-plated health insurance, and generous family leave."Personal finance education," on the other hand, is easy. Sure, it might take a few classroom hours away from actual education, but that's the teacher's problem, not your problem. Plus, once it's up and running you might even be able to sell your consulting services on the side to school districts that, for obvious reasons, don't want to hire a full-time "personal finance educator," because there's no such thing.

Conclusion

Let me be clear about one thing: ignorance is also a problem. Educating people about how things really work is an important and valuable service, indeed one I try to perform here to the best of my limited abilities.The fact that IRA's, for example, are privately marketed means there's an incredible scope for abuse by savvy marketers, with both the victims and the government ultimately paying the price. An education campaign about what to look for in an IRA would be at least as good a public service as the "National Responsible Fatherhood Clearinghouse." Even better would be strict limits on the kinds of assets eligible to be held within IRA's.But "personal finance education" is just a savvy marketing technique for inaction, insisting that we need do nothing to fix the actual problems we face, because the problems were inside us all along.

Why I like tax-free internal compounding, and why you might (and might not)

Last month I wrote about a range of available non-retirement investment accounts and broke down some advantages and disadvantages of each. When it came to 529 college savings accounts, reader flyernick had some objections to my math:

"On one hand, you’re arguing that at withdrawal, you get to exempt $12000 in gains because of the std. deduction. Then you compare that, 'In a taxable account, meanwhile, you’d owe taxes annually on every dividend and capital gain distribution'. But, you get that same $12000 exemption every year on annual distributions. And of course, 'taxes on the sale of the asset itself' would only apply to (un-distributed) cap gains. Your example here fails to convince me that paying an additional 10% tax 20+ years down the road is a useful strategy."

I want to address flyernick's specific objection and also expand on my logic to show why I think tax-free internal compounding is valuable enough that it's worth paying some amount for under the right circumstances.

529 accounts are uniquely valuable because of the option of tax-free withdrawals

I know my readers have heard this a thousand times already, but let's do a quick rundown of the benefits of 529 plans again:

1. limited, state-dependent tax benefits;
2. unlimited tax-free internal compounding;
3. unlimited tax-free qualified withdrawals.

The state tax benefits are typically not very interesting, but high-income folks in high-tax states should certainly maximize their home-state benefits before contributing to a low-cost plan like Utah's My529 (formerly UESP) or Vanguard's Nevada-based plan.The tax-free internal compounding is a feature shared by 401(k)'s, 403(b)'s, IRA's, and even variable annuities — more on this in a moment.But the ability to make tax-free qualified withdrawals of both your contributions and your earnings turns 529 plans into super-charged Roth accounts for anyone who may ever spend money on anyone's higher education expenses: they have preposterously high contribution limits, no income limits, tax-free dividends and capital gains, and tax-free withdrawals.This is a crime against the American taxpayer, but as long as the crime is being committed for the benefit of the wealthiest people in the country, it would be irresponsible for the rest of us not to join in.

What is the value of tax-free internal compounding?

With that out of the way, we can focus on nickflyer's specific question: what is the value of tax-free internal compounding, and how much should you be willing to pay for it? Let's take two stylized, but true, historical examples.

• Between July 1, 2009, and June 30, 2018, Vanguard Total Stock Market Investor Shares had a price appreciation of about 200%: $100,000 invested at the beginning of the period would have turned into $301,900 at the end of the period, and this appreciation would be tax free under any circumstances, as long as you held your shares for the entire period, since we don't tax capital gains until they're realized. But you also would have received $32,212 in dividends and capital gains distributions, and those would have been taxed along the way. Capital gains tax rates have bounced around a little bit but if you were in the highest capital gains tax bracket (23.8%) for the entire period, you would have owed a total of $7,667 in taxes over the 10-year period. In the lowest long-term capital gains tax brackets, you would have owed nothing on those distributions.
• Between July 1, 2000 and June 30, 2009, Vanguard Total Stock Market Investor Shares had a price appreciation of negative 32%: $100,000 invested at the beginning of the period would have turned into $68,639 at the end of the period. During the same period, you would have received $12,349 in dividends and capital gains distributions, and paid a top federal tax rate of 20%, or $2,470.

Importantly, in these examples it doesn't matter if you reinvest your dividends and capital gains; the taxes are owed no matter what you do with the money.Using the same two time periods, with the same $100,000 invested in the same mutual fund, but with dividends and capital gains reinvested and allowed to compound tax-free, the corresponding final values would be $356,174 and $79,522, respectively. With the investment made in a 529 plan or other account with tax-free internal compounding, the investor has so far saved $7,667 or $2,470 in federal taxes owed, plus whatever rate their state levies on capital gains and dividends.What happens when we try to get the money out of the 529 plan? For the 2000-2009 investor, this is not a problem at all: they're allowed to withdraw their entire balance, including dividends and including capital gains, tax- and penalty-free, because the amount of the withdrawal is lower than the amount of their contribution. The 529 plan "wrapper" has saved them $2,470 in federal taxes with no downside at all (except the opportunity to harvest capital losses). Obviously they'd prefer if their decade of investing had a positive, instead of a negative, return, but that's what you get when you invest at the peak of a stock market bubble and sell at the bottom of a global financial crisis.What about the investor who put $100,000 to work in July, 2009? Sure, they've saved $7,667 in taxes along the way, but now they're facing an account balance that is 72% gains ($256,174 of their $356,174 balance). For simplicity, say they convert their Vanguard Total Stock Market Investor Shares to cash at the end of the period, so they'll face a total of $25,617 in penalties whenever they withdraw that balance: 10% of the gains on the account, plus of course their ordinary income tax rate on the share of the gains they withdraw.Based on our stylized example, we can now easily see four possible outcomes:

• The account falls in value, and non-qualified withdrawals are completely tax- and penalty-free;
• The account maintains its value, and withdrawals are completely tax- and penalty-free regardless of whether they are qualified or non-qualified;
• The account increases in value, and non-qualified withdrawals are taxed and penalized;
• The account increases in value, and qualified withdrawals are tax- and penalty-free.

Only in one of the four cases, where you have an appreciated account with non-qualified withdrawals, does the 529 account have any downside compared to the same investment in a taxable account. In the case of accounts that fall in value or maintain their value, withdrawals remain tax- and penalty-free while dividends and capital gains compound internally tax-free, and in appreciated accounts used for qualifying expenses dividends, capital gains, and price appreciation are permanently tax-free.

Conclusion

I've assembled these facts not to give nickflyer a definitive answer to his question, but to reframe it slightly.A person who has certain knowledge about the future trajectory of the stock market should invest in the stocks that are going to go up the most. In that case, tax loss harvesting, tax-deferred accounts, and other opportunities to game the tax code are a sideshow compared to the business of buying the stocks that are going to go up and selling the ones that are going to go down.But if you have no idea which stocks are going to go up and which are going to go down, then 529 plans give you the opportunity to make lop-sided bets: if they go down, you're allowed to withdraw your principle, your dividends, and your capital gains tax-free. If they go up, you only have to pay taxes and penalties on your earnings, and only for non-qualified distributions. And if you're able to make qualified distributions, your earnings, dividends, and capital gains are permanently tax-free.The 10% penalty and ordinary income taxes levied on non-qualified distributions has to be weighted by the likelihood and magnitude of non-qualified distributions of gains. And as I mentioned in the original post, you can make those odds even more lop-sided by opening multiple accounts and horse-racing them against each other: make qualified withdrawals from the most appreciated accounts, and non-qualified withdrawals from accounts that have fallen in value, maintained their value, or appreciated the least, while all your accounts compound internally tax-free.

Differences between non-retirement investment options

If you're in the right mood, there's something a little bit depressing about the subject of investing: how boring it is. An easy way to think about this is that if you make the maximum contribution to a 401(k) and IRA every year, for 20 years, at the end of that 20 years, you'll be rich. How rich you'll be depends on a lot of factors, but the fact you'll be rich doesn't depend on anything except the steadiness of your contributions and the amount of time they're allowed to compound.$24,000 in annual contributions for 20 years turns into a million dollars at 6.6% APY. If you can only manage 6% APY, it takes a year longer, and at 7% APY a few months less. But all anyone has to do to become a millionaire is max out their 401(k) and IRA contributions for around 20 years.I don't mean to say that's easy. You can't contribute more than 100% of your income to a 401(k) or IRA, so if you make less than $18,500 you can't maximize that contribution (although you can contribute your first $5,500 in income towards both accounts). I'm just saying it's boring. Max out your contributions, wait 20 years, and you'll fall somewhere in the top 10% of households by net worth.The flip side of that fact is that as long as you make your retirement accounts as boring as possible (my solo 401(k) is invested in a single Vanguard mutual fund), you can do almost anything you like with the rest of your money without posing much if any risk to your chances of ending up rich. I've written a lot in separate posts about different kinds of non-retirement investments, so I thought I'd pull those different pieces together in one place.

Taxable brokerage accounts

Pros: no withdrawal penalties, opportunities to manipulate income, cheap or free, $11.2 million estate tax exemption and stepped-up basisCons: taxable (at preferential rates), may affect financial aid eligibility, limited control over dividends and capital gains distributionsTaxable brokerage accounts have two huge advantages and a slew of disadvantages.On the plus side, you can access your money at any time for any reason. It's true you may owe taxes on any appreciated assets, but as I like to say, if you're afraid of paying taxes you're afraid of making money — you only owe capital gains taxes on capital gains, after all. Additionally, simply having a bunch of uncorrelated assets in a taxable account is a tool for managing your tax liability, since you're able to top up your income with long term capital gains in low-income years ("capital gain harvesting"), and sell losers in high-income years to reduce your taxable income by up to $3,000 in losses per year ("capital loss harvesting").The disadvantages are important to consider, however: mutual funds that are forced to pass along capital gains can trigger tax bills even if you don't sell your own shares. Unpredictable dividends can make it difficult to dial in your income precisely, for example if you intend to qualify for premium subsidies on the Affordable Care Act exchanges. If you or your kids are applying for federal financial aid using the FAFSA, you don't need to report qualified retirement savings, while assets in taxable brokerage accounts will reduce your assessed financial need (under some circumstances).One other thing taxable brokerage accounts are perfect for is gambling. If you walk into a Vegas casino and lose $500 playing roulette, you're out $500. If you buy $500 of Enron stock and it drops to $0, you might be out as little as $250, depending on your federal and state income tax situation.

Variable Annuities

Pros: tax-free internal compounding, asset protectionCons: gains taxable as ordinary income, inherited assets fully taxable, very expensive, early withdrawal penaltyI wrote relatively recently about variable annuities so I won't belabor the point here, but one point that reader Justin brought up in the comments to that post is that depending on your precise situation, annuity assets may be protected from creditors in a civil judgment or bankruptcy filing. This is, obviously, not protection afforded to taxable brokerage assets, and I think in certain circumstances an annuity might be worth considering for this reason alone.However, if your primary goal is asset protection, you should first consider shopping around for an umbrella insurance policy, since the management fees and tax consequences of a variable annuity might be substantially higher than the annual cost of comprehensive liability insurance. However, this would not apply if you're contemplating bankruptcy in a state that protects annuity assets from creditors.

529 College Savings Plans

Pros: low-cost, state-dependent tax benefits, tax-free internal compounding, flexible beneficiary designation, tax-free qualified withdrawalsCons: non-qualified withdrawal penalty, contribution limitsLong-time readers know that 529 plans are a crime committed in broad daylight against the American people. But that doesn't mean they can't still be useful. It's useful to think of 529 plans in two ways:

• qualified withdrawals are completely tax-free;
• pro-rated gains on non-qualified withdrawals are taxed as ordinary income with a 10% penalty.

While my main problem with 529 plans is the tax-free transmission of wealth between generations, it's trivial to conceive of an even simpler hack to achieve both tax-free internal compounding and tax-free withdrawals. Since 529 plan beneficiaries can be changed without any tax consequence to immediate (and not-so-immediate) relatives of the current beneficiary, who does not need to be related to the account owner, all you need to do is find a family with a bunch of kids and designate the oldest (or smartest) as the beneficiary of the account.Whenever they have any qualified educational expenses (which, thanks to Zodiac Killer and Republican Senator Ted Cruz, now include up to $10,000 in private and religious K-12 expenses per year), you can issue a qualified, tax-free distribution to the school and be reimbursed by whoever would otherwise pay their tuition.To be clear, this is completely illegal. But if you think that's stopping our plutocrats from doing it, I've got a tax-advantaged infrastructure investment in Brooklyn to sell you.The other reason to consider 529 plans as an alternative savings vehicle is that the penalty on non-qualified withdrawals just isn't that harsh. Here's an example using the 20-year investment horizon I described earlier:

1. Contribute $100,000 to the Vanguard Total Stock Market Portfolio in Vanguard's (Nevada-sponsored) 529 plan;
2. Using a 5% APY average return after fees, in 20 years the account's value will be about $265,000, representing $165,000 in gains, or roughly 62% of the account's value.
3. Assuming a standard deduction of $12,000, you can withdraw $19,354 per year without owing any income tax: 62% of the withdrawal will be taxable as ordinary income and 38% will be a tax- and penalty-free withdrawal of your original contribution. You will, however, owe a 10% penalty on the gains, or $1,200.

In a taxable account, meanwhile, you'd owe taxes annually on every dividend and capital gain distribution as well as taxes on the sale of the asset itself. Under the right circumstances, the 10% "penalty" can be lower than the taxes you've avoided on internal compounding, and over even longer time horizons that's even more likely to be the case.In other words, over long enough time horizons, 529 college savings plans function like variable annuities with substantially lower management fees and expenses, and the opportunity for completely tax-free withdrawals. In Vanguard's case, compare the 0.18% all-in fee for their 529 Total Stock Market Portfolio to the 0.42% for the same portfolio in their variable annuity product. The key point is that the higher management fees and expenses are charged on the entire variable annuity portfolio, while the 10% withdrawal penalty is only charged on the gains in the 529 portfolio.This technique even allows you to replicate the old "horse race" strategy of IRA recharacterizations. Since the gains in each 529 account are calculated separately for the purpose of non-qualified withdrawals, you could open one Vanguard 529 plan invested entirely in the Total Stock Market Portfolio, and one My529 plan invested entirely in the Vanguard Total International Stock Index Fund (and another state's plan invested in the domestic bond market, and another state's plan invested in the international bond market, etc.). Since non-qualified distributions are taxed and penalized on an individual account basis, you would always have the option of making non-qualified withdrawals from the account with the most (or least) gains, depending on your tax situation in a given year.And this, unlike the "sell your 529 plan assets" strategy mentioned earlier, is 100% legal. Hell, it's practically encouraged.

Non-traded investment scams

Pros: high "expected returns"Cons: expensive, illiquid, obviously doomedToday there are a million crowd-funded investment options, from old-school players like Prosper and LendingClub to newfangled bill brokers like Kickfurther. But the investment that most naturally lends itself to crowdfunding is real estate. Real estate is expensive (so you can raise a lot of money), it's illiquid (so you can lock investors' money up for years), and it's opaque (so no one has any idea if you're getting a "good" or "bad" price on the real estate you acquire or the management fees you charge).I have a lot of respect for these scams. They charge huge upfront fees and huge management fees for an investment they have no control over the performance of. Fundrise is one of my favorite examples: one thing you could do if you identified a promising piece of real estate is to take out a loan and buy it. Alternately, you could raise money from a group of investors who would then share ownership of it. But Fundrise has an even better idea: collect money from strangers, issue them unsecured claims on a future stream of revenue, charge your expenses against that stream of revenue, then return their money minus your own healthy share of any eventual profit.If you want to invest in a mutual fund, you ought to invest in a mutual fund. If you want to invest in real estate, you ought to invest in real estate. But if you want to get ripped off by some Silicon Valley dweebs who paid $300 for a graphic artist to design a sleek website, Fundrise is for you.

Rental real estate

Pros: generous tax treatment, stepped-up basisCons: expensive, illiquid, volatileAs a leveraged bet on the cost of housing, owning rental real estate doesn't have any advantages over simply buying a residential REIT on margin. You have all the risks of declining real estate prices, rising vacancy rates, and property damage, and none of the benefits of spreading that risk across hundreds or thousands of properties.All the advantages come from the special tax treatment real estate receives. While you own a rental property, you're allowed to deduct the interest on any mortgage you took out to buy it. You're allowed to deduct the property's depreciation. And you're allowed to sell the property and make a "like-kind" exchange for another property (in the US) without triggering taxes on the sale. Finally, like other taxable assets, your heirs will receive the property with a stepped-up basis, meaning they won't owe taxes on the appreciation of the property during your lifetime.This is especially valuable in the case of real estate if the original owner was deducting depreciation and reducing their own basis in the property: a property purchased for $200,000 whose owner deducted $100,000 in depreciation, but is worth $400,000 when inherited and sold, avoids capital gains taxes on $300,000 that would have been owed if sold during the original owner's lifetime.

Collectibles

Pros: interesting conversation piecesCons: losing all your moneySome people think the problem with "greater fool" assets, whether it's bitcoin, Beanie Babies, or Hummel figurines, is that you'll run out of fools, but I don't think that's quite right. If you try hard enough, you'll likely always be able to find someone, at some price, to take your junk off your hands. The problem isn't finding a fool, it's finding a greater fool — someone willing to pay more for your trinkets than you did.Note that there are strict rules on the tax treatment of hobby losses, so consult a lawyer and/or CPA  (again, I am neither) before starting to gamble in any of this stuff.

Start a business

Pros: preposterous tax advantages, higher Social Security benefits, larger 401(k) contributionsCons: unknownI'm here to promote entrepreneurs and entrepreneurship, so obviously I'm a bit biased. Nonetheless, the advantages of starting a business are undeniable, whether or not you also work as an employee elsewhere.First, if you don't hit the Social Security earnings cap through any other work you do, self-employment allows you to raise your annual contribution and increase the old age and disability payments you're entitled to. For folks who spent a long time unemployed or in higher education due to the late-2000's breakdown in global capitalism, the only way to make up for those missing years is higher contributions during the remaining years before retirement.Second, while your voluntary employee-side 401(k) contributions are capped at $18,500 in 2018 across all your employers and your self-employment, each employer — including yourself — has a separate cap on the amount they're able to contribute to an employer-side 401(k). That means you can take advantage of any employer matching program at your day job and make additional employer-side contributions into a solo 401(k) subject to a totally separate cap.Finally, the 2017 Republican tax heist added an additional 20% discount on the taxable income of many small businesses. This is an extremely confusing topic so, again, consult a CPA if you have any questions about whether your small business qualifies, since certain industries and legal structures are excluded under certain circumstances.

Thinking about Vanguard's no-transaction-fee ETF announcement

The finance blogosphere has been ablaze the last week with Vanguard's announcement that they'll be eliminating trading fees on an enormous swathe of ETF's that currently cost $7 to buy and sell. Reducing transaction fees is an unalloyed good for investors, but I think there are some interesting additional consequences of the change to think about.

What's happening

On July 2, Vanguard announced that "nearly 1,800" ETF's would be offered with no transaction fees through the Vanguard platform, beginning "in August."Vanguard already offered its own ETF's commission-free, so this seems like an attempt by Vanguard to move more non-Vanguard ETF trading onto their own platform; folks who used Vanguard to trade Vanguard ETF's, but used a Fidelity or Merrill Edge account to trade non-Vanguard ETF's, like iShares and SPDR's, may be tempted to move more of their assets into a single Vanguard brokerage account.

Aside: Why ETF's?

People who invest in taxable accounts sometimes prefer ETF's to mutual funds because when mutual funds see investor redemptions they're sometimes forced to sell their underlying holdings and pass along any accrued capital gains tax liability to the remaining shareholders, while ETF's use a financial engineering process called "creation and redemption" to avoid passing along capital gains to shareholders. I don't think this is very interesting but people who distribute ETF's think it's incredibly interesting, so I want to make sure you're aware of it.

This could be a Robinhood-killer

I like using the Robinhood iPhone app to trade individual shares of stocks and ETF's without commissions. But with commission-free ETF's through Vanguard, there's no reason to use Robinhood to buy and sell those shares, so Robinhood will get a smaller percentage of my recreational trading business [Disclosure: I own one share each of WisdomTree's DHS, iShares' QAT, ERUS, and TUR, and two shares of Cambria's TAIL].Robinhood has two key problems as an investment platform: it only offers taxable brokerage accounts, and it doesn't offer the benefits of a full-service taxable brokerage account. While Vanguard allows you to easily identify specific shares for sale, making it possible to harvest capital losses in some years, gains in others, or both to offset each other, Robinhood just doesn't have that functionality, at least not yet.On the flip side, while Vanguard's full-service taxable brokerage platform makes it easy to maximize the tax benefits of price fluctuations, they also charge transaction fees for non-Vanguard ETF's, meaning every time you harvest a loss or gain, or simply make a periodic contribution to a non-Vanguard ETF, you're surrendering some of the benefit of the platform back in transaction fees.

Using Vanguard as your primary taxable brokerage account is going to make more sense

While Vanguard offers a wide range of ETF's, understandably they don't offer very many overlapping, tightly correlated ETF's, which is one of the fundamental principles of tax-loss harvesting.When you sell an asset in a taxable account that has declined in value, if you want to maintain exposure to the asset class, you need to find a not-substantially-identical asset to buy in order to avoid the "wash sale" rule. But within a single fund family, those are relatively rare. Vanguard offers VTI (Total Stock Market) and VOO (Vanguard S&P 500), for example, but they don't offer a foreign total-market and foreign large-cap ETF, or emerging market total-market and emerging market large-cap ETF.What the addition of no-transaction-fee non-Vanguard ETF's brings is the ability to do far more such matching trades in taxable brokerage accounts. For example, the Vanguard FTSE Emerging Markets ETF (VWO), as you'd expect, tracks the FTSE emerging markets index, while the iShares MSCI Emerging Markets Index (EEM) tracks the MSCI index. The main difference is the exclusion of South Korea in the former and its inclusion in the latter. Since they're not substantially identical (South Korea's a big country!), they make a great tax loss harvesting trade.I don't think taxes are that interesting so I don't think you should spend too much time obsessing over this stuff, but for those who are willing to put in the work these fee-free transactions potentially offer a lot of opportunities to harvest losses during choppy markets without the friction of transaction fees.

Vanguard doesn't offer custodial services to advisors

One reason folks in the finance world have been spilling so much ink over Vanguard's announcement is that Vanguard doesn't have a full-service custodial platform for financial advisors, which creates a dilemma: in order to take advantage of opportunities to harvest losses and rebalance portfolios, advisors want to have a full-service trading platform, but in order to best serve their clients, they also want to have a low-cost trading platform.There's no one right solution to this problem, but hopefully Vanguard's aggressive move will encourage the existing custodial platforms to lower or eliminate trading fees for ETF's on their own platforms.

No-transaction-fee ETF's in qualified retirement accounts

So far I've been talking about the tax benefits of access to more no-transaction-fee ETF's in taxable brokerage accounts, but of course most people have the majority of their financial assets in qualified retirement accounts where things like capital gains distributions and tax loss harvesting are irrelevant.In those accounts I think there's opportunity for both mischief and profit. If no-transaction-fee ETF's cause people to buy too many, too-expensive ETF's from too many issuers, they're going to end up with something that looks a lot like the market's performance, minus the additional expenses paid to their menagerie of funds.On the other hand, if investors want to pursue a specific investment thesis, or execute a specific hedge, in their retirement accounts then being able to do so without the friction of transaction fees could save them tens or hundreds of dollars per year.

Conclusion

To be clear, lower transaction fees are an unalloyed good, for the obvious reason that transaction fees cost money, and the more money you spend on transaction fees, the less money you have left afterwards.But whether you, in particular, should be jumping all over no-transaction-fee ETF's starting in August instead of making steady contributions to a portfolio of low-cost mutual funds depends on your specific situation.In other words, just because you can trade for free doesn't mean you should trade for free.

3 questions about Americans and money

It's a slow, rainy Sunday around here, which is as good an occasion as any to contemplate the mysteries of life. In that spirit, here are three questions I genuinely don't know the answers to about Americans and their financial habits.

Why don't Americans save in other currencies?

I'm fascinated by currency risk and have written before about exposure to currency risk in the context of long-term investing. But even outside the context of long-term investing, as far as I can tell Americans have no easy access non-dollar-denominated accounts, and even less interest in them.Why would you want to save in euros, pounds, or yen? Well, because you plan to spend euros, pounds, or yen! If you're planning a trip to the United Kingdom in June, 2019, you know for a fact that you'll have to spend pounds for your accommodations, meals, transportation, and souvenirs. What you don't know is what the exchange rate will be in June, 2019, so you have no idea how many dollars you'll need to cover those expenses.The sensible solution is to save not in dollars, but in pounds. This is perfectly legal, and it's even possible, but only at great cost and inconvenience. For example, a nearby mall has a Travelex currency exchange booth where they'll happily sell you pounds in exchange for dollars. But what then? You've got a stack of pounds you've got to do something with, and your bank doesn't accept pound-denominated deposits.The main thing I want to stress is how unusual this is. Every bank I know of in Russia allows customers to open accounts denominated in US dollars, euros, or Russian rubles. In Poland people took out home mortgages denominated in Swiss francs. There's no technical or administrative barrier to denominating assets and liabilities in any currency you please; it's a purely cultural barrier.In principle I understand that it "feels" riskier to save in a different currency. You might lose money if the exchange rate moves against the currency you're saving! But you might also end up having to take a shorter vacation, eat worse meals, and buy fewer souvenirs if the dollar drops against the currency in your destination. Ordinarily, that's the kind of risk it makes sense to hedge against, and Americans don't have a convenient way to do so.As a travel hacker in my day job, I feel compelled to point out that it's travel hackers and miles-and-points enthusiasts who really do "save" in a currency besides their home currency. The relative "stickiness" of hotel pricing in each hotel chain's loyalty currency means you can relatively predictably know how many points a stay will cost: if the destination currency moves higher against your home currency, it's unlikely the price in points will immediately react, while if the destination currency falls in value, you can pay with dollars instead (of course, "relatively" is doing a lot of work here; hotels move around in redemption cost all the time).

Why do Americans debt-finance everything?

This morning I came across a very strange story in the Washington Post, titled "The latest blow to struggling family farms: Rising interest rates."Broadly speaking, there are three ways to finance a business:

• raise money with debt;
• raise money with equity;
• and reinvest retained earnings.

There are of course variations on these themes, like mutual aid societies, Islamic finance, or rotating savings clubs, but the general idea is that you can either pay a fixed rate of interest for access to money, you can sell a share of your future profits, or you can reinvest the business's profits instead of withdrawing them to spend.While there is a theorem in economics that capital structure is "irrelevant" we know this is not true in the real world, and for obvious reasons: a firm that is certain of its success is likely to use debt financing in order to preserve as much profit as possible for its owners, while a speculative enterprise is more likely to use equity in order to put as little of the founders' capital at risk as possible.What is baffling to me, and what the Washington Post article above illustrates clearly, is that Americans are way, way too reliant on debt financing.This is not entirely irrational. For example, under conditions of accelerating tuition and decreasing state support for higher education, debt financing ("student loans") is a sensible response, since college students don't typically have any prior earnings they could use to pay tuition, and the extremely wide distribution of incomes in American society means they would have to sign over an unacceptably high percentage of their lifetime income to raise equity financing.Likewise equity financing of car purchases makes little sense, since virtually all cars are used for the same morning and evening hours so few people would want to share ownership of a depreciating asset (although there's no reason coworkers couldn't share ownership of a vehicle they are all able to carpool to work in).All of this brings me back to the plight of the family farmers in today's Washington Post. It seems obvious to me that they've made a simple mistake: they used debt financing instead of equity financing for an incredibly speculative enterprise. They thought they would be able to buy seed and equipment, and pay their farmhands, using borrowed money, then repay the borrowed amount with interest while turning enough of a profit on the sale of their crops to make withdrawals that meet their own personal spending needs.Why did they think this? I have no idea.Farming is a complex enterprise, forcing farmers to deal with a multitude of factors, but the one thing that isn't complex about it is that commodity prices fluctuate, meaning each growing season's profits is entirely out of the farmer's hands. In other words, it's a perfect candidate for equity financing, or financing out of retained earnings.Someone who raises equity financing and promises to pay out profits in proportion to the ownership stake of their investors never needs to worry about rising interest rates. Someone who saves their profits in profitable years never needs to worry about lower commodity prices or rising interest rates, as long as their savings hold out.Maybe the savings won't hold out! But that's a consequence of your inability to run a profitable business, which is obviously not something that rises to the level of national emergency.

Why do Americans take financial advice from commissioned salespeople?

In a whole range of commercial activities, Americans are some of the most skeptical people on the planet. We know used car salesmen are con artists, we know "extended warranties" are scams, we know "travel insurance" is a racket, we know rental car insurance is a joke.But when it comes to financial advice, Americans are still rubes. Of course it's not as bad today as when you would call up "your" stockbroker and ask what he (and it was almost always a he) thought was going up and what he thought was going down, send him your money, and cross your fingers.But it hasn't gotten a whole lot better.Part of the problem is surely the famous "fear of missing out," which means people are reluctant to "merely" earn the market rate of return on their savings as long they're reading every day about bitcoin millionaires, venture capitalists, and private equity.But it's nonetheless true that smart, educated, professional people (the only people these days who have any excess income to invest) fall for the most preposterous scams imaginable, whether it's variable annuities, actively-managed mutual funds, or whole life insurance policies. And I don't have a good answer why our natural skepticism breaks down when confronted with a sufficiently analgesic Powerpoint presentation.When it comes to insurance Americans at least have the excuse that it's literally illegal to sell policies on anything but a commission basis. But that does nothing to explain the love affair of American investors with stock brokers who are paid to rip them off.

Why do so few people use non-conflicted financial advisors?

I was listening to the latest episode of the "Animal Spirits" podcast with Michael Batnick and Ben Carlson, and they mentioned a statistic in this (paywalled) Wall Street Journal article: just 2% of the 285,000 professionals giving financial advice in the United States are fee-only financial advisors, who are held to a fiduciary standard that requires them to put the interests of their clients first.An ocean of digital ink has already been spilled over the Department of Labor's aborted fiduciary rule requiring advisors on retirement accounts to act as fiduciaries, and the SEC's decade-long refusal to impose a similar rule on all financial advisors, so I'm not going to repeat that history here.Instead, I think it's worth considering why so few investors who, in principle, are the ones that should be most interested in ensuring their assets are invested with their best interests in mind, use fee-only financial advisors. No one would go to a doctor they knew was being paid by a pharmaceutical company to prescribe a certain drug, or a lawyer they knew was being paid to file in a certain jurisdiction, so why do investors go to financial advisors being paid to work contrary to their interests?

There aren't very many fiduciaries

Unless you stop to think about it, you might not notice just how many "financial advisors" are out there.I didn't think about it until I recently drove through a struggling area of central Illinois, and even in a town with blocks of empty storefronts, burned-out buildings, and crumbling houses, there was an Edward Jones office offering "retirement" services. Of course the only "retirement" services they offer are high-cost, variable fixed income annuities with big commissions for the agent who closes the deal.How is the average investor in central Illinois supposed to even find out how abusive these products are, and that there are financial advisors who put the investor's interest first? Google? All they'll find there are another thousand agents trying to sell variable indexed annuities!Almost every Chase, Bank of America, Citi, US Bank, and Wells Fargo branch in the country has a desk with a little sign next to it saying "financial advisor." That's what financial advice means to the overwhelming majority of individual investors.

They're not accepting new clients

My buddy George Papadopoulos (not that one, the other one) is a fee-only planner in Michigan. He seems skilled and conscientious, and his clients seem satisfied with his work. And he hasn't accepted new clients since 2017.It's not his fault: providing skilled, conscientious, fiduciary advice is hard work. Why would anybody do any more of it than they absolutely have to?By contrast, nobody's ever been turned away from a Chase branch because the branch "has enough clients already." Make an appointment (or don't!) and somebody will be able to see you the same day, they'll have all the forms ready for you to move your assets over, and you'll be on your way in no time.

They have transparent fees

The most common argument made by the non-fiduciary crowd is that sure, they might churn accounts a little bit than they should, they might buy and sell securities that aren't strictly speaking in the best interest of the client, but if they weren't allowed to do that, then investors wouldn't get any advice at all because investors aren't willing to pay for it.And anyway, the products still have to be "suitable," and maybe sometimes they'll even outperform the market!Compare that to a fee-only financial advisor who gets paid directly by the client, instead of through commissions, marketing fees and sales charges. It's a lot less fun to pay a fee you're billed directly than one that's extracted one trade at a time whenever your broker has a hot new investment idea.I think unbiased financial advice is worth paying for (if you're willing to take it), but it never feels good to pay for something, especially when down at the bank they're telling you that all of their fees are "included."

They're boring

Since the correct thing to do with your investments in 99.9% of circumstances is nothing, the client of a fee-only advisor often finds herself in the bizarre situation of paying someone to tell her not to do anything, and that everything will be fine.Meanwhile, a commission-based advisor can't wait until the next big market downturn, or upturn, or increase in volatility, or decrease in volatility, so they can tell you the market environment has completely shifted and it's time to incur another batch of trading commissions.Yield curve flattening? Better do something. Dollar weakening? Better do something.But a fiduciary who puts your interests first should know better than to chase performance, overtrade, and overpay for active management that's almost certain to underperform low-cost mutual funds (and ETF's, if you're so inclined) over the medium and longer terms.

Quality is tough to measure

A fee-only advisor acting as a fiduciary can't accept the legalized bribes that non-fiduciary advisors accept. But it's not enough for a doctor to free of conflicts with the pharmaceutical industry, you'd also like them to be a skilled medical professional. It's not enough for a lawyer to be unconflicted, you'd also like them to win your case.Likewise, a financial advisor without any conflicts at all can still give bad advice, and for someone without any investing experience bad advice sounds pretty much the same as good advice.Just like buying socks, toothpaste, or contact lenses, if you don't know how to distinguish good products from bad products in advance, you can either buy the more expensive version (hoping that price does the work for you) or the cheapest (hoping that you save more in cost than you lose in quality).Unfortunately, when it comes to financial advice, the question of whether it's good or bad depends just as much on you as it does on the person doing the advising. A fee-only, fiduciary financial advisor is perfectly free to advise a strategy of building a highly-leveraged real estate empire, a fleet of lobster boats off the coast of Maine, or a pile of gold in a safe deposit box in Switzerland. They just can't be paid by anyone else to suggest it.If you don't know what kind of investor you are (or want to be), it's almost impossible to identify a financial advisor that's able to help you meet your goals."Fee-only" is used as a kind of talisman by the financial planning industry, but you should think of it as a necessary, not sufficient, requirement for your financial advisor.

Basics of IRA recharacterizations

Like aircraft flying at very low altitudes, the US tax code does strange things when very low incomes are involved. Most people know about, or have at least heard of, the earned income credit, which phases in quickly as "earned income" (which includes wage and self-employment income) rises, then phases out somewhat more slowly.I think that's bad program design, since it creates a weird higher marginal tax rate in the phase-out range, which then drops again when the credit is fully phased out, and I think the tax code should feature steadily rising marginal tax rates, not ones that bounce around all over the place, but economists like these "phase-outs" and the economists won.If the earned income credit has an unfortunate design, it's nothing compared to the retirement savings contributions credit, which has two abrupt adjusted gross income thresholds that reduce the value of the credit by 60% and 50% at $18,501 and $20,001, respectively, for single filers, before being eliminated completely at $31,001 in adjusted gross income. Those cutoffs have no economic rationale, but presumably they reduce the cost of the program since low-income folks tend to have more volatile income and will bounce around between the income bands.These cutoffs mean fine-tuning your adjusted gross income can make an enormous difference to your total tax liability, and IRA recharacterizations are a great way to fine-tune your adjusted gross income.

The 2017 tax reform did not affect recharacterizations

This gets a bit confusing, since there was a change in the 2017 tax bill that affected a particular tax planning strategy involving IRA's. That strategy involved transferring a tax-deductible traditional IRA balance into an after-tax Roth account, then reversing the transaction if the account fell in value before the tax filing deadline, a sort of heads-I-win-tails-I-win method of managing current and future income tax liability.That strategy was eliminated by Congress in the 2017 tax reform bill by stipulating that Roth conversions cannot be reversed: if you convert a traditional IRA to a Roth IRA, you are liable for income taxes on the amount of the conversion whether the Roth account rises or falls in value.All of this is made even more confusing by the fact that people use the terms "conversion" and "recharacterization" interchangeably. In this post I'm calling converting an existing traditional IRA balance into a Roth IRA account a "conversion" and redirecting an IRA contribution to a different account type a "recharacterization."And there was no change to the ability to recharacterize contributions, which can be done in either direction: contributions to a Roth IRA can be recharacterized as contributions to a traditional IRA, and vice versa (subject to Roth IRA income limits).

Recharacterizations were intended for high-income taxpayers

Since Roth IRA contributions can only be made by taxpayers with modified adjusted gross incomes below a relatively low limit ($133,000 for single filers in 2017), but many people (in my view, rightly) make weekly, biweekly, or monthly contributions throughout the year, there needed to be some mechanism for taxpayers whose income turned out to be above the contribution threshold to correct their mistake.That mechanism is the recharacterization, whereby a contribution (legal or illegal) can be recharacterized from one account type to the other. In a recharacterization, both the original contribution and any earnings or losses on the contribution are transferred, meaning it's irrelevant which account type you contribute to during the year: whether it gains or loses value, in a recharacterization everything is calculated as if you had made the contribution to the other account type in the first place.

Recharacterizations are great for fine-tuning low incomes

Low-income workers are the biggest beneficiaries of Roth IRA's, since the "post-tax" contributions they make to them are generally "post" a tax of $0. That means they feature the enormous benefit of tax-free contributions, tax-free internal compounding, and tax-free withdrawals. A good deal!But due to the "ground effects" of the retirement savings contribution credit I described above, it can be extraordinarily valuable to fine-tune the income of low-income workers, since the difference of a dollar in adjusted gross income can mean the difference between a credit that covers your entire tax liability and one that leaves you owing $418!That means a low-income worker's "core" retirement savings account should be a Roth account, but with a traditional IRA on the side to fine-tune their AGI before filing their taxes each year.

My 10-minute recharacterization call with Vanguard

I made very slightly more money in 2017 than I did in 2016, and when I plugged my numbers into Free File Fillable Forms my adjusted gross income was about $4,900 over the $18,500 threshold needed to claim the maximum retirement savings contribution credit.This was a purely unforced error. I have a solo 401(k) for my self-employment activities, into which I split contributions 50/50 between the pre-tax and Roth subaccounts. If I had made only traditional contributions, I would have been just a few bucks away from the $18,500 target and could have just topped up the traditional account with retroactive contributions, which is what I've done in previous years.But five grand is a lot of money, and I'm poor, so it was time to learn about recharacterizations.Once I'd identified the precise dollar amount I needed to recharacterize, I called Vanguard, where my Roth IRA is held. After the security questions, I told the agent what I needed to do and he immediately understood. Since I didn't have a traditional IRA with Vanguard, he told me to open one online while he waited. After I reached the confirmation screen, he refreshed his view and saw the account.After I told him the amount of the 2017 contribution I needed to recharacterize, he plugged it into his computer and immediately returned with the amount of earnings on that amount (2017 was a good year).Note that you have the option to identify specific contributions to recharacterize. I had 52 (give or take) contributions in 2017 so didn't bother with specific identification, but it's an option that's available if you want to recharacterize only the most-appreciated or least-appreciated contributions (most-appreciated if you're recharacterizing to Roth, least-appreciated if you're recharacterizing to traditional).Then he asked me which securities in my Roth IRA I wanted to move. Vanguard moves securities in-kind internally, so you don't have to sell to cash before recharacterizing. I told him to move all my TIPS and take the remainder from my Vanguard 500 holdings.Since I held Admiral shares of the Vanguard 500, he warned me that Vanguard would eventually downgrade them to higher-cost Investor shares unless I topped up the balance to the $10,000 minimum.The entire call, including opening a new traditional IRA account, took 10 minutes.

Conclusion

As I'm fond of saying, the overwhelming majority of financial advice is targeted at people who can afford it and don't need it, rather than people who need it and can't afford it.The retirement savings contribution credit is the major tax benefit available to filers who make too much to qualify for the earned income credit, and claiming the maximum benefit is the easiest way most low-income filers have to increase the amount of their federal income tax withholding returned to them as a refund each year.IRA contribution recharacterizations are an easy way to maximize the amount of your retirement savings permanently shielded from taxes, while also giving your savings as much time as possible to work in the markets.

Is this the next high interest savings opportunity?

My go-to resource for high-interest savings and checking accounts has long been depositaccounts.com, which has a pretty good list of accounts offering unusually high interest rates on deposits when you meet certain requirements, usually connected to either debit or credit card spending activity, or both. Such accounts are great; what's not to love about high-interest, FDIC- and FCUA-insured deposits?When people complain about low interest rates on savings, I usually point to these accounts and argue that this is precisely how we'll see higher interest rates trickle through the economy: through products offered by regional banks and credit unions that are confident they'll be able to deploy the deposits profitably within their service areas.But I stumbled across the subject of today's post in a totally different way.

Somebody has sold the nation's credit unions on "round-up savings" accounts

Like many folks with my areas of interest, I have accumulated quite a few memberships in regional credit unions over the years, and today I opened my mail to discover an unusual offer. One of my credit unions has launched a product called "Round-Up Savings."The program works like Bank of America's "Keep The Change" program, rounding up each debit card purchase to the next dollar and depositing it in a savings account. Via Henry Fung on Twitter, I learned that program used to match contributions up to $250 per checking account — a good deal!This Round-Up Savings program works slightly differently: instead of matching your savings contribution, it pays 20% APY (through February) and then a "high interest rate" thereafter.Knowing that virtually all credit unions deal with the same traveling salespeople, it occurred to me to look around to see if any other credit unions had bought into this scheme.They had.The best one I found on the first couple pages of Google search results is a credit union in Kentucky which offers:

• a 100% match for the first 90 days;
• a 5% match thereafter (the two matches are capped at a combined $250, I believe);
• a 5% APY dividend rate (oddly the dividend is paid annually instead of monthly, but it's advertised as APY which in principle is supposed to control for compounding frequency).

How do you fund these accounts?

Every Round-Up Savings account I found allows the account to be funded exclusively through round-up transactions; you can't just deposit your life savings into your new 5% (or 20%!) APY account.What you have to do is make purchases with your linked debit card that end in as small a cent figure as possible, ideally while minimizing the dollar figure — $0.01 purchases would be ideal, for example.Assuming the best case scenario, that you have access to a tool that lets you charge $0.01 to your linked debit card an unlimited number of times, you're then faced with a grim reality: such a transaction only deposits $0.99 into your account. One thousand (1,000!) such transactions would only result in a deposit of $990.So the opportunity is throttled by your patience, the tools you have available, and the willingness of your credit union to entertain your antics. That's going to dissuade virtually everyone from pursuing these high-interest accounts aggressively.And that's the real reason arbitrage opportunities last as long as they do.

What is a 30-year fixed-rate mortgage?

The title of this post may sound like a rhetorical question, but I assure you I don't mean it that way. It's a question I've been pondering for a while as I come across weird datapoints from the history of home financing around the world. A 30-year fixed-rate mortgage is maybe best defined by what it is not: it's not a one-year floating-rate mortgage.

What would a one-year floating-rate mortgage look like?

There's no mechanical reason a one-year floating-rate mortgage couldn't exist. At the beginning of the first year, a home-buyer would take out a loan for the purchase price of a house, secured by the house as collateral. They'd make payments throughout the year at whatever the prevailing interest rate was (the borrower and lender could agree on whether payments would fluctuate or whether payments would be fixed and the amount of interest and principal paid would fluctuate), and then at the end of the first year, the home-buyer could either repay the remaining principal or take out another one-year floating rate mortgage to repay the balance of the original one.While there's no mechanical reason such a system couldn't exist, it has some obvious drawbacks:

• Vulnerability to changes in house value. In a rising housing market, such a system would be the equivalent of annual cash-out refinancing. In a falling housing market, it would be an annual cash call, since the borrower would have to pay the previous year's lender the amount borrowed, even if the next year's lender was unwilling to lend the full amount given the lower value of the house in year 2.
• Uncertain total repayment term or uncertain payments. In a period of rising interest rates, each year the borrower would repay less and less of their loan's principal (or face rising monthly payments). That means it might take many more than 30 years to fully own a home, even if at the beginning of each year you intend to pay off one thirtieth of your remaining principal. Uncertain monthly payments also would make it difficult to plan your expenses in advance.
• Borrower credit risk. Even if economy-wide interest rates remained steady, the interest rate an individual borrower might be forced to pay could vary from year to year as their personal credit profile changes. A higher income might lower their monthly payment in one year, while a lost job might make it impossible to roll over their loan at all — even if they have the next year's worth of payments saved up in cash!
• Lender risk. In case of an economy-wide shock to the credit market, it might not be possible to refinance a loan at all, even for the most credit-worthy borrowers. Mass foreclosures and evictions based on banking sector malfeasance would be a constant risk in an economy of one-year mortgages.
• Huge transaction costs. Presumably such a system would create streamlined refinancing offers (perhaps even interest rate discounts after a certain number of years) but verifying the credit and income of a borrower and the value of a home each year would still require an enormous amount of work, and create enormous scope for human error.

That said, there are some obvious advantages as well, for both borrowers and lenders:

• Lower interest rates. If lenders didn't have to squint at the horizon and forecast the future trajectory of interest rates, they would be able to offer much lower interest rates today. You can see this in the interest rate differential between 30-year and 15-year fixed-rates mortgages. It would be reasonable to expect the rate to be even lower for one-year floating-rate mortgages.
• Less prepayment risk. When a lender makes a mortgage loan today, they're forced to take into account the risk that if interest rates fall their customers are likely to repay their loans early and refinance into a lower-rate mortgage. That creates an unpredictable, one-way risk for the lender and for the buyers of mortgage securities. Rolling one-year loans would drastically reduce that risk, since few people would be willing to go through the hassle of refinancing a loan mid-year.
• Reduce borrower debt. Since each year borrowers would only borrow the amount they needed to repay the balance of the previous year's loan, they could use annual savings to reduce the amount borrowed each year. This is the same logical process as accelerating payments on a 30-year mortgage, but the annual refinancing process might provide a sense of immediacy or urgency to the process, or simply given borrowers a chance to look at their household assets and expenses.
• Increase home equity. Lenders would presumably insist on large down payments in order to shield themselves from the risk of a decline in the house's value between the time they make a loan and the time the borrower seeks another. Much higher home equity might contribute to fewer foreclosures and evictions in general.

A 30-year fixed-rate mortgage is a one-year floating-rate mortgage with a bunch of riders

That brings me back to the question, what is a 30-year fixed-rate mortgage? In the same way that a delayed variable annuity is an immediate fixed annuity with a bunch of riders on the contract, I think of 30-year fixed-rate mortgages as one-year floating-rate mortgages with a bunch of riders:

• instead of a floating interest rate, a fixed interest rate;
• instead of variable payments, fixed payments;
• instead of annual credit assessment, assessment just once at the beginning of 30 years;
• instead of having mandatory cash calls for any change in your home equity at the end of each year, never having a cash call for declines in your home equity;
• instead of being vulnerable to changes in the supply of credit, being guaranteed the same terms as long as you stay current on your payments.

Of course, just as with a delayed variable annuity, each of these riders comes at a cost, generally in the form of higher interest rates.

Once you know you're paying for each rider, you could decide which ones are worth paying for

What got me thinking about this most recently was seeing the statistic that the median length of tenure in single-family owner-occupied housing is 15 years (6 years for multi-family condo owners). In other words, 50% of single-family homeowners move before spending 15 years in their home. But between 85% and 90% of mortgages are for 30 years. That means 35-50% of home buyers are paying for riders they don't use: fixed interest rates and payments and credit insurance for the second 15 years of their mortgage.That begs the question: do the 50% of homeowners who move within 15 years know in advance they'll move within 15 years? If so, they're overpaying for those 15 years; they'd be strictly better off with a 15 year mortgage (even if that meant a balloon payment in year 15, by which point they plan to sell the house anyway). If not, what they're paying for is an insurance policy so that if they end up belonging to the 50% that stays longer than 15 years, they won't have to renegotiate new terms and be susceptible to intervening changes in the credit market.That insurance is worth something, without a doubt. But the price is higher interest payments and lower principal payments during each of the first 15 years. By saving that money instead, home buyers could "self-insure" against the same risk, with the potential upside of being able to keep the savings if they do, in fact, move before then.

The problem with the federal housing finance agencies is that they subsidize one particular set of riders

On the one hand, the idea of securitizing standardized mortgages and making it possible for investors to select the particular borrower and loan characteristics they are looking for while freeing up bank capital to underwrite and issue new loans is a fairly reasonable idea. On the other hand, the private sector has demonstrated absolutely no interest in doing so, and it was left up to the federal government to create the so-called "government-sponsored enterprises," or GSE's (the failure of the GSE's in 2008-2009 suggests one possible explanation of the reluctance of the private sector to undertake this enterprise).The problem is not that the government has decided to subsidize homeownership. The problem is that doing so has made offering unsubsidized mortgages uneconomical, since mortgages that don't qualify for sale and securitization have to be held on the lender's books or privately securitized (i.e. without an implicit government guarantee), tying up that capital until the loan is repaid, while qualified mortgages can be immediately sold and the same money lent again to another borrower, with a new set of origination fees piled on top.Freddie Mac has this fairly hilarious document signed by their "VP Chief Economist" Sean Becketti explaining that:

"The considerable benefits of the 30-year fixed rate mortgage to consumers are beyond question. However, this type of mortgage isn't a natural fit for lenders. All the features that benefit the consumer—long term, fixed interest rate, and the option to prepay the loan without penalty—create serious headaches for lenders. As a result, the federal government created Freddie Mac and other institutions that allow lenders to hand these headaches over to the capital markets, where sophisticated portfolio managers have the tools and expertise to manage the investment risks of the 30-year mortgage."

Now, 15-year (and shorter) fixed-rate and floating-rate mortgages are still available, and under the right circumstances may even be qualified mortgages for securitization purposes. But balloon loans, which require repayment or refinancing in the final year of the mortgage, are decidedly verboten. In other words, for a mortgage to be qualified for GSE securitization, it has to be repayable in equal payments over the term of the mortgage, which in practice forces people who have no intention of staying in their home for 30 years into 30-year mortgages — and paying the correspondingly higher interest rates for each of the years they actually remain in the home.

Disclosure

I own 50 common stock shares of Freddie Mac and of Fannie Mae. I've lost about $150 on them since I bought them, but remain hopeful that the current administration will sell out the American public by allowing the GSE's to recapitalize and start paying dividends again, in which case I'll make a fortune.