That's not how any of this works, Amazon edition

The recent debacle in New York over Amazon's plan to open an office there under the hilarious marketing slogan of "HQ2" (or maybe HQ1.5, or maybe HQ2.14159?) gave finance journalists, who I've long insisted are the laziest people on earth, the opportunity to cluck their tongues about the poor state of "financial literacy," and gives me the opportunity to debunk a few of the more absurd claims that are consistently trotted out when cities and states, and now even the federal government, offer tax incentives to attract business activity to particular areas.

Yes, economic development subsidies are a "real" cost

State and local economic development programs typically have three components:

1. the government undertakes a massive buildout of infrastructure in order to make the site suitable for development. Sometimes this also includes regulatory waivers, like the environmental and labor regulation exemptions around the Wisconsin Foxconn plant (which, as a reminder, will never open). In the case of the Amazon office complex, "rather than going through the city’s extensive land use review process, known as ULURP, the state will take the lead and override local regulations on the lot, currently zoned for manufacturing space."
2. the target of the economic incentives then usually (but not always!) uses its own money to build out the commercial use of the site.
3. finally, once the site is operational, the costs of the subsidies are supposed to be eventually "recouped" through payroll, income, and sales taxes generated by the new economic activity.

A lazy financial journalist looks at these three components and says, "economic development subsidies do not have a real cost, and stopping them does not save money, because they are provided against economic activity that does not currently exist and would not exist without the subsidies."But Indy Finance readers aren't lazy financial journalists, so they ask some obvious follow-up questions:

• If a massive buildout of infrastructure is required in order to make a site suitable for development, why hasn't it been done yet? If an area of one of the richest cities in the world does not have adequate water, sewage, or transportation connections to make it possible for businesses to open in that area, it represents a serious failure of governance that has nothing to do with any individual business's willingness to operate there. An enormous number of people are eager to live and work in New York City, so leaving areas of the city underserved by public services is an active, ongoing harm that should be eliminated as quickly and efficiently as possible.
• If zoning and environmental regulations are preventing businesses from opening in an area, then they should be carefully considered to make sure the regulations are achieving their goals and are not needlessly obstructing development with little or no public benefit. This is true, obviously, regardless of whether any individual business is interested in operating there. After review, bad policies should be repealed and good policies should be retained.
• Once appropriate infrastructure is in place, and once appropriate zoning and environmental regulations have been decided on, why should policymakers care what (legal) businesses operate in the area? This is sometimes, wrongly, split into the idea of "good" (well-paid, college-educated, predominantly white) jobs and "bad" (poorly-paid, high-school educated, minority) jobs but this is not a distinction that makes any sense from the point of view of the government or the economy. Well-paid workers are well-paid because their employer finds it worthwhile to pay them well, poorly-paid workers are poorly-paid because employers can get away with paying them poorly. If an area supports well-paid jobs, the employees will be well-paid, and if it supports only poorly-paid jobs, the employees will be poorly paid.

At this point it becomes clear why economic development subsidies are a "real" cost. With or without economic development subsidies, the government can pay for a massive infrastructure buildout. With or without economic development subsidies, the government can right-size environmental and zoning regulations. But in one case, businesses choose to open in the area based on the commercial appeal of the area and pay their taxes in full, while in the other case, one or more subsidized businesses opens in the area based on the subsidies provided and pays just a fraction of the taxes they'd otherwise owe.The difference between the "taxes-in-full" regime and the "subsidized taxes" regime is the real-world cost to the public of the economic subsidies, and it's a real, budgetary cost that has to be paid with higher taxes, reduced public services, or increased debt.But finally, and I know you saw this coming, the "subsidized taxes" regime serves as an additional tax on all the businesses that would love to operate in Long Island City but don't get Amazon's sweetheart deal. It doesn't matter whether you're a dry cleaner, a livery cab operator, a restauranteur, or a venture capitalist: New York wanted to set aside the land it had prepared, at taxpayer expense, for commercial use for a single business it had decided upon in advance. Everyone else who wants to open a business in Long Island City would have to pay their taxes in full, and compete for workers and resources against a $2.988 billion head start.

Conclusion

If New York City's infrastructure is too bad, improve it. If New York City's zoning regulations are too strict, loosen them. If New York City's taxes are too high, cut them. But don't tell me you can get a free lunch by subsidizing a single business promising to hire 25,000 people, when millions of people around the country and the world are dying to move to New York to live, work, start businesses — and pay their taxes in full.

Let's all go to the movies

When Ronald Reagan needed to explain to the American people the outlandish claims of his voodoo economists, he would often reach back into his remaining intact memories of his first career, as a Hollywood star. Who could forget such iconic roles as "The Gipper," "The Gipper: Tokyo Drift," and of course "2 Gipper 2 Furious?"Reagan patiently explained to his lead-damaged voters that high marginal income tax rates on actors meant that after getting paid for two films per year, leading men and women would take the rest of the year off, knowing that each additional movie would be worth just pennies on the dollar to them.The logic is airtight: if a blockbuster takes 2 weeks to film, an actor considers two weeks of work worth $200,000, and their studio considers the actor's work worth $400,000, then at 50% tax rates the actor is willing to work but at 70% tax rates they'd rather chase starlets around the pool at the Chateau Marmont.Between 1981 and 1987, Reagan got his wish, unleashing unimagined productivity in the acting industry by reducing the marginal tax rate on top incomes from 70% to 38.5%. Or did he?

Methodology

Due to my unfortunate literal tendency, I got to wondering: if 70% marginal tax rates were keeping actors from taking on a third film each year, did lowering top marginal tax rates to 38.5% increase the number of films top actors were willing to take on?Since tax rates fluctuated wildly between 1981 and 1986, this gives us a natural disjuncture point. For each of the 25 years ending in 1980, and the 25 years beginning in 1987, I looked at the top-billed and second-billed actor in the highest-grossing film of the year, and asked a simple question: how many films did that actor appear in? There are a few obvious problems with this methodology: if actors are paid the year principle photography occurs, but the film is released in a different year, the wrong actors might be selected for a given year. Additionally, surprise hits, particularly independent films, might have high box-office receipts but not have needed to compensate their actors correspondingly. I don't think these problems should matter much, but if you do, you can do your own analysis.

Results

Having put all this data together (you can check it out for yourself), I wanted a way to easily visualize it. In each charts the number of total film credits by the top-billed actor in the highest-grossing film of that year is shown in blue, with the number of total film credits by the second-billed actor in the highest-grossing film stacked on top in red.Here are the 25 pre-reform years:And here are the 25 post-reform years:Another approach is to look at some statistical values. Pre-reform, the average number of films by both top-billed and second-bill actors was 1.8, with a range of 1 to 5 (props to Gene Wilder in 1974) and standard deviation of 0.65 and 1 for top-billed and second-billed actors, respectively.Post-reform, the average number of films dropped slightly, to 1.72 (top-billed) and 1.68 (second-billed), with a range of 1 to 4 (Sam Neill in 1993 and Billy Bob Thornton in 1998). The standard deviation rose slightly for top-billed actors to 0.94 and fell slightly to 0.85 for second-billed actors.Using the sum of both top-billed and second-billed actors, as I did in the charts above, yields a fall in the mean from 3.6 to 3 films per year, and a slight rise in the standard deviation from 1.26 to 1.29 films per year. Using the combined data, the median and modal number of films by each year's pair of actors is identical pre-reform and post-reform, as is the range, with 2-7 films being made by each year's pair, with 3 films per year remaining the most common total value.

Why did the Reagan tax reforms fail?

From the perspective of encouraging our highest paid actors and actresses to produce more films for our entertainment and enrichment, the verdict is clear: the Reagan reductions in top marginal tax rates were an abject failure. A tax reform that reduced revenue by roughly 1.1% of GDP in order to incentivize increased economic activity at the highest end of the income scale instead left that activity slightly lower than it was pre-reform!One key to understanding why is the interaction of what we can call "wealth effects" and "income effects." To clarify the difference, consider a simple case of interest rates on plain-vanilla savings accounts. If interest rates are currently at 10%, what happens if they fall to 9%?On the one hand, this will make saving marginally less attractive. You may be willing to deposit $1,000 if it will earn you $100 in interest per year, but if it only earns you $90 per year, you may prefer to spend all or part of the $1,000 instead. This is the income effect: the less net income you receive from an activity, the less incentive you have to do it. It's also the effect voodoo economists choose to emphasize.But a second effect is working in the opposite direction: the wealth effect. If your goal is to accumulate a total of $2,000, then a reduction in interest rates from 10% to 9% will not lead you to save less, but instead cause you to save more, since your previous savings will no longer let you achieve your goal in the same time frame.Likewise, the wealth effect of a higher interest rate is not increased thriftiness, but the opposite: you need to save less money to achieve your wealth goals at an 11% interest rate than at a 10% interest rate, leaving you more money to spend rather than save.Once you understand the income and wealth effects, you can see one reason why Reagan's efforts were doomed. The income effect means that post-1987, actors got to keep a far higher share of their income, increasing their incentive to work as much as possible, but the wealth effect means that it took far fewer films to accumulate the kind of wealth that puts you comfortably among the rich and famous. Not every actor struck the same balance, but a glance at the data shows that for highly-paid actors on the whole, the two effects almost perfectly canceled each other out.

Conclusion: wage slavery or capital strike?

This exercise, and generally taking income and wealth effects seriously, isn't supposed to suddenly grant you some special insight into the correct marginal tax rate on high incomes. Instead, it's meant as an invitation to think about what, exactly, we want our tax policy to achieve, and how.To give a simple example, if we believe that investment banking is a good and worthy activity that improves the peace and prosperity of the world in one way or another (allocating capital, hedging commodity prices, whatever), then should we prefer to have a large number of investment bankers working reasonable hours and making reasonable incomes or a small number of investment bankers working inhuman hours and making preposterous incomes?In the one case, high marginal income tax rates might reduce the willingness of investment bankers to work long hours in order to earn higher and higher incomes, forcing firms to hire more of them at more reasonable wages and hours. If investment banking is, instead, as specialized an activity as Guild Navigator, then perhaps lower tax rates are necessary to encourage the very highest specimens to achieve their full potential.But as The Gipper made clear, it's not enough to say that we'll "let the market decide," for the simple reason that "the market" is a product, not an input, of public policy.

Reminder: the buyback debate is about taxes, not corporate finance

Long-time readers know that the way to tell if a financier is lying about stock buybacks is to check if their mouth is moving.But since buybacks are back in the news, meaning lies about buybacks are back in the news, I thought I'd offer a quick refresher.

If buybacks and dividends are identical, why do buybacks at all?

The lie about buybacks always starts the same way: "from a corporate finance perspective, share buybacks and dividends are identical." This concept of identity is extremely important to people lying about share buybacks.The logic goes that a firm with more cash than it is able to productively invest in operations should return some or all of that cash to its shareholders. Since a single share contains the value of the firm's productive capacity and any cash and marketable securities it has on its books, minus debt, buying back shares (increasing the proportional ownership of the firm's productive capacity for the remaining shareholders) and issuing dividends (moving cash from the books of the company to the individual accounts of shareholders) should have the same effect as buybacks on the company (less cash) and the shareholders (more cash for the shareholders who participate in a buyback, or a greater ownership stake in the operating business for the shareholders who don't). Hence, the identity that's so important to people lying about buybacks.So if this identity holds, if share buybacks are absolutely identical in every way to dividend distributions, why all the fury around banning them?

Stock buybacks are about managing individual shareholder tax liability

The fury is because dividends and share buybacks aren't identical: when held in taxable accounts, dividends are taxed in full in the year they're distributed, while only people who participate in share buybacks incur a tax liability, and only if their shares have increased in value since purchase.That means dividends create a "blended" tax rate across all shareholders (a 0% rate for tax-free institutions and individuals, a 23.8% rate for high-income individuals), while share buybacks allow shareholders to determine their own tax liability.In a stylized example, a firm issuing a $1 per share dividend on 1,000,000 shares is virtually guaranteed to distribute some of it to untaxed institutions or individuals in the 0% capital gains tax bracket, some to individuals in the 15% tax bracket, some to individuals in the 20% tax bracket, and some to individuals in the 23.8% tax bracket, while a firm buying back $1,000,000 worth of shares might not create any individual tax liability at all, if only untaxed institutional shareholders participate in the buyback.

Should wealthy shareholders decide for themselves whether to pay taxes?

This is the whole ballgame. Since only the very wealthy hold shares in taxable accounts at all (as opposed to workplace retirement, IRA, or HSA accounts), the entire propaganda operation around share buybacks is focused on allowing them to manage their individual tax liability. A lifetime of carefully selecting companies that maximize their share buybacks and minimize their dividends leaves a multi-millionaire paying virtually nothing in taxes, then passing along greatly appreciated shares with a stepped-up basis to their heirs.As I explained in my earlier post, 364 days a year financiers have no trouble explaining this in fine detail to their wealthy clients. But on the 365th day they begin to rant and rave about how there's absolutely no difference between dividends and buybacks.But the debate over share buybacks has never been about corporate finance. The debate is about whether the wealthiest people in the country should get to decide for themselves if they'll ever owe taxes on their investment returns, or whether those returns will be passed from generation to generation tax-free.

"Opportunity Zones" are a terrible idea, poorly implemented, but big ambitious policies can and do work

Over the course of 2018 we've seen increasing clarity about the so-called "Opportunity Zones" included in the Republican smash-and-grab tax heist of 2017. Over at Alpha Architect they have an excellent breakdown of the tax advantages of these investment vehicles, so I'll stick to the roughest possible outline:

• taxable capital gains (e.g. from the sale of an appreciated security in a taxable account) can be rolled into an "Opportunity Fund;"
• those rolled capital gains are untaxed for between 5 and 7 years, then are taxed at a preferential rate depending on the holding period;
• any gains within the Opportunity Fund itself are completely tax free after a 10-year holding period.

The one thing I would add to Alpha Architect's otherwise-comprehensive post is that they actually understate the advantages of Opportunity Funds: there are three separate discounts that should be applied to the initial taxable capital gains rolled into the Opportunity Fund. Alpha Architect discusses only the explicit, 10-15% step up in basis for rolled capital gains. But that amount is also fixed in nominal terms, while the taxes are actually paid in less valuable future dollars. That means in real terms your taxes are reduced three times:

• Once by deferring them 5-7 years (you'd rather pay taxes later rather than sooner);
• Once by reducing them by 10-15% (you'd rather pay less than more);
• Once by paying them in 2027 instead of in 2018 (you'd rather pay in worthless 2027 dollars than in precious 2018 dollars).

For way more details on the tax implications of these investments, do check out the Alpha Architect post linked above.

Should economic policy be pro-business or pro-capital?

Consider, if you will, Census Tract 2.01, in Missoula County, Montana. This census tract describes, more or less, the part of Missoula locals call "the Northside," and it's eligible for Opportunity Zone tax incentives.The first thing to realize is that there are already businesses on the Northside. The KettleHouse Brewing Company has a big brewery and event space there. All the big box stores on the East side of Reserve Street are in the Opportunity Zone; all the big box stores on the West side of Reserve Street are out of the Opportunity Zone. The hottest new restaurant in town is in the Opportunity Zone. The beloved, run-down local bowling alley falls just outside it. Just for fun I checked, and poor Karl Tyler Chevrolet is just over the census tract line, while DeMarois Buick GMC Mercedes-Benz is safely within it.The most obvious problem this raises is the question of fairness, and it's a perfectly fair objection, if you're so inclined. If Mr. DeMarois sells his dealership to an Opportunity Fund, then not only is he going to get a better price than if Mr. Tyler sold, but the outside investors who purchase his dealership are going to be able to sell Buicks, GMC's, and Mercedes-Benzes at lower prices due to their lower after-tax cost of capital, compounding the injustice.But I'm not particularly concerned with the cost of capital. My concern is with business, which has nothing to do with the cost of capital, no matter how much financial capitalists try to convince you otherwise. Whether a brewery is profitable depends on whether it is making more money from selling beer than it costs to make beer. Whether a car dealership is profitable depends on whether it makes more money selling cars than it pays the manufacturer for cars. Whether a bowling alley is profitable depends on whether it makes more money selling games of bowling than it pays people to rummage around in the bowels of the building freeing stuck pins and whatnot.And the problem with Opportunity Zones is that it's an extravagant, expensive tax advantage handed out only to financial capital, not to businesses, including within the Opportunity Zone itself. If the Burns St. Bistro expands their hours, or adds more space, or hires more staff, they owe taxes on their expanded profits. If an Opportunity Fund buys the lot next door, hires their staff away, and sells the place in 10 years, their investors walk away without paying a cent in taxes.

Opportunity Zones point the way towards bold, ambitious policies

Like most people, I detest the 2017 tax reform bill because of its enormous transfer of the nation's wealth to the owners of existing capital. But while the structure of Opportunity Zones is just another example of that looting of the public, the enthusiasm among the financial elite does illustrate the potential of bold, ambitious policies.The key insight of the creators of Opportunity Zones was the magic of 0%. If you tell people they'll get a 10%, or 50%, or 90% discount you might be able to budge their behavior a bit one way or the other. This is, indeed, how municipal bonds work today. But when you tell people they'll pay nothing, ever, in taxes on an investment, they don't just get excited, they lose their minds.

What would a bold, ambitious, pro-business policy look like?

The fact that Republicans were willing to sign off on a policy with literally unlimited cost to the American taxpayer (remember, unlimited capital gains within the Opportunity Fund are completely tax-free after 10 years) should be an invitation to people who believe in the value of business, as opposed to capital, to be more ambitious in our demands.

• If we want to target specific areas for business development and growth, why not simply exempt payroll within Opportunity Zones from FICA taxes? That way existing businesses and new businesses would enjoy the same benefits as financial capital.
• If we want to encourage hiring, why not make hiring easy? Create a single federal portal to process payroll and withholding for employees, so there's no quantum leap between zero employees and one employee.
• If we want to level the playing field between small and independent businesses and those owned by financial capital, why not eliminate the employer's role in providing health insurance and retirement benefits?
• If we want to encourage worker-centered economic development, why not reduce business taxes to 0% on worker-owned cooperatives?

The key difference between these proposals and Opportunity Zones is that they are focused on businesses, not capital. The money spent, which would be considerable, goes to the businesses that are engaged in economic activity specifically to encourage that economic activity. For worker-owned businesses, that money goes to the workers. For privately owned businesses, it goes to the owner. And for corporate entities it goes to the corporation.Some people want to single out corporations for punishment; I don't feel any need to go that far. The corporation is a perfectly reasonably form of economic organization, where appropriate.But the one thing I know is that we shouldn't be singling out financial capital and specialized investment vehicles for special treatment while leaving actual operating businesses to suffer what they must at their hands.

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.

Wrapping my head around variable annuities

I've written before about indexed annuities, one of the most expensive, abusive, unnecessary financial products known to man, but I've recently had a couple occasions to learn more about variable annuities, the confusingly-similarly-named product offered at lower cost by more reputable firms, like Vanguard and Fidelity.

Variable annuities are expensive

There are two expenses that go into a variable annuity: the wrap fee and the fee for the underlying funds your money is invested in.For example, Vanguard charges 0.29% in annual administrative and "mortality and expense risk" fees, plus investment portfolio expense ratios ranging from 0.11% (Total International Stock Market Index Portfolio) to 0.42% (Growth Portfolio).Meanwhile, Fidelity charges 0.25% in fees plus portfolio expense ratios between 0.10% (Fidelity VIP Index 500) and 1.54% (PIMCO VIT CommodityRealReturn Strategy).Since you're a sophisticated investor, say you combine the best of both worlds and invest only in the cheapest fund with each provider. You'll pay 0.4% annually to invest in the total international stock market with Vanguard, and 0.35% annually to invest in the S&P 500 with Fidelity.Is that a lot? Well, it's over 3 times more expensive than buying Vanguard's Total International Stock Index Fund Admiral Shares and almost 9 times more expensive than buying Vanguard 500 Admiral shares, but it's not objectively very expensive, so if variable annuities offered tangible benefits, they wouldn't have to be very valuable to make back that difference.So, do they offer tangible benefits?

Variable annuities are not tax efficient

The first problem with variable annuities is they swap the extremely favorable tax treatment of capital gains and qualified dividends for the extremely unfavorable treatment of ordinary income. This happens in a fairly complicated way that I still don't fully understand, but essentially withdrawals from variable annuities are done against an after-tax contribution portion (which is untaxed on withdrawal) and an earnings portion which is taxed as ordinary income, a bit like how non-qualified withdrawals from 529 plans work (except more complicated).The advantage of this trade (capital gains for ordinary income) is theoretically that you can defer capital gains taxes during your high-earning years, when you might pay up to 23.8% on them, and then make withdrawals during your low-earning retirement years, when your marginal tax rate on ordinary income is lower.If capital gains were taxed as ordinary income (as I would prefer), this argument would be airtight, and variable annuities would be a commonsense way to smooth your tax burden over a lifetime. People would use variable annuities instead of taxable brokerage accounts for all their savings in excess of qualified retirement accounts, paying less in capital gains taxes during their working years and more in ordinary income taxes during retirement.The problem is that capital gains aren't taxed as ordinary income: they're taxed at preferential rates, and those preferential rates extend high up the income scale. The 23.8% rate I mentioned above is the highest rate paid on capital gains, while taxable income in excess of $82,500 is taxed at 24%, and rates only climb from there.Between Social Security old age benefits and required minimum distributions from IRA's and 401(k)'s, taking taxable withdrawals from a variable annuity can easily put someone's taxable income in the range where they're actually paying more on their gains than they would have if they'd simply held their investments in a taxable account and benefited from preferential capital gains tax treatment.

Variable annuities are terrible estate planning

When the owner of a taxable investment account dies, their heirs inherit their assets with a "stepped up" basis: the owner's unrealized, untaxed capital gains receive a new, higher cost basis and those capital gains will never be taxed.When a variable annuity is inherited, the account retains the distinction between contributions and earnings, and earnings will still be taxed on withdrawal at the heir's ordinary income tax rate.Heirs can either take a lump sum distribution of the account's balance (potentially paying up to 37% of the earnings in taxes), or spread the distribution out over 5 years. In either case, rather than the owner saving money on taxes in retirement, the account's gains are taxed at the likely higher tax rate of the inheritor.

The best case for variable annuities

I gather that I come across as a bit of a scold in this post, but I always try to find the good in everyone and in every financial product, so after a little bit of thinking, I came up with a perfectly reasonable use case for variable annuities.Consider a high earner who knows she wants to retire early. Because she's a high earner during her working years, she exclusively uses traditional IRA's and 401(k)'s to reduce her taxable income. Likewise because she's a high earner, she'll pay 23.8% in taxes on any dividends and capital gains distributions during her working years for assets held in taxable accounts.Instead, he contributes to variable annuities, perhaps splitting his contributions 50/50 between the lowest cost options at Vanguard and Fidelity (I don't know why Fidelity doesn't have a low-cost international stock portfolio. Or, rather, I do know why).If she contributes, say, $50,000 per year to her variable annuities, compounding at 5% annually over 20 years, she'll end up with $1.736 million, of which $1 million will be contributions and $736,000 will be earnings.At age 59 1/2 (when variable annuity withdrawals become penalty-free), he gives two weeks notice and start withdrawing 9.1% of the balance per year, or $158,000, of which $91,000 will be tax-free contributions and $67,000 will be earnings taxed as ordinary income (this is not exactly how it works, but close enough). Assuming no other taxable income, he'd owe a nominal amount of tax on that amount.Then, at age 70 she would file for her much higher Social Security old age benefit and at age 70 1/2 start collecting required minimum distributions from her traditional IRA and 401(k) accounts.In other words, since delaying filing for Social Security is so lucrative, even someone retiring early should find a way to delay claiming their Social Security old age benefit as long as possible. If they have no earned income in retirement, then the relatively unfavorable tax treatment of variable annuity withdrawals is irrelevant, as long as their total taxes paid on withdrawals is lower than the capital gains tax payments they would have owed during their working years had the assets been held in a taxable account.

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.

Follow-up: was I too harsh on "charitable clumping?"

On Tuesday I wrote that so-called "charitably clumping" was a fairly transparent marketing campaign by the philanthropy and money management industries to generate more contributions and assets under management.Commenters were not amused! After reading through the comments I'm happy to concede I overstated my case, while I think some readers might have passed over elements of my argument as well.

There's no secret to timing charitable contributions

As long as charitable contributions have been eligible itemized deductions, it's been possible to shift contributions forward or back in order to claim the maximum available tax benefit.Someone making $10,000 in charitable contributions per year has always been able to wait until the end of the year to estimate whether the deduction would be more valuable if made in December or January. That allows the taxpayer to maximize the value of their deduction while, as commenter DaveS put it, "For the charities the contributions all come 11-13 months apart – not a big feast or famine rhythm at all."This has nothing to do with the Republican tax bill, except that the higher standard deduction gives taxpayers one more thing to keep in mind when deciding which tax year to make a contribution in.If we're going to call shifting a contribution a few days or weeks in one direction or another "charitable clumping," then who could object to charitable clumping?

Proponents of charitable clumping make a much stronger claim

In the post I linked to in my original piece, and was attempting to be in dialogue with, Michael Kitces describes something completely different:

"The end result of this 'charitable clumping' strategy is that by doing 5 years’ worth of charitable contributions at once, the couple gets at least part of the value of the deduction for a charitable contribution, while also saving additional taxes by donating appreciated securities and “replacing” them (at a new, higher cost basis) with the money that would have been donated. Which means the net cash flows into the household and out to the charity are the same… but by engaging in the charitable clumping strategy, the couple obtains both a partial charitable deduction and avoids capital gains. (Or alternatively, the strategy could be executed by simply contributing cash to the donor-advised fund, which doesn’t produce any capital gains tax savings but still results in additional charitable deductions through clumping.)"

It's this stronger claim that I was objecting to, for the three reasons I explained in my original post:

• non-profits perhaps should, but definitely don't, treat a single large donation as the sum of multiple small donations spread out over many years;
• donor-advised funds promote charitable clumping in order to gather assets they can charge account maintenance fees on, reducing the total value of your contributions to the recipient;
• and charitable contributions are made periodically, instead of all at once, because of the individual taxpayer's fluctuating economic circumstances, and contributions to donor-advised funds can't be returned in cases of economic hardship.

None of these considerations matter if you're talking about shifting a donation a few days or weeks forward or back. I was addressing my argument at Kitces's "strong" form of charitable clumping, not the commonsense business of figuring out whether you should make a donation in December or January.

Conclusion

If you're a wealthy, high-income person planning to give away a million spare dollars in the next 10 years, you should certainly feel free to assign the contributions to tax years in which you would otherwise pay the highest marginal tax rate on that income.But if you're an ordinary worker, you don't need me to tell you that you probably shouldn't be making your 2023 charitable contributions in 2018, no matter how sweet the tax benefits are, because 2023 is a long time from now.

"Charitable clumping" is a clever marketing campaign, not a tax planning strategy

The 2017 Republican smash-and-grab tax reform bill made two related changes to individual tax deductions:

• The standard deduction was raised to 12,000 for individuals and 24,000 for joint filers;
• and the state-and-local-tax (SALT) itemized deduction was limited to $10,000.

Meanwhile, the charitable contribution deduction was unchanged, and the mortgage interest deduction was unchanged for existing mortgages (interest deductibility was limited to $750,000 for new mortgages).Altogether, that means in order to make their state and local taxes deductible at all, taxpayers need to have additional itemized deductions such that their total itemized deductions exceed the standard deduction. To receive the benefits of the maximum $10,000 SALT deduction, they'd ideally have additional deductions equal to or greater than their standard deduction: $12,000 or $24,000 in combined mortgage interest and charitable contributions.

What is "charitable clumping?"

As the always-effervescent Michael Kitces helpfully explains, charitable clumping refers to the idea of making the equivalent of several years of charitable contributions in a single year, raising the taxpayer's itemized deductions above the standard deduction and allowing them to claim all or part of the SALT deduction they'd otherwise be unable to claim.In theory, there is no obstacle to doing this. Indeed, an organization should theoretically be grateful to receive several years of contributions up front, especially taking into account the time value of money.

In practice this makes no sense

There are two obvious problems with "charitable clumping" in practice.First, non-profits spend essentially all of their revenue each year. If you've ever contributed so much as a dollar to a non-profit organization, you are well aware of the barrage of fundraising pitches you begin to receive immediately and which will never, ever stop. Non-profits have short memories. I have a family member who's a prodigious philanthropist but if she stopped giving to the Five Valleys Land Trust for 4 years she'd simply stop being invited to their events. What would they want a deadbeat there for? They already have her money, after all!If non-profits have short memories, I bet your church has an even shorter one. Are you going to give $25,000 to your church this year and then skip on tithing for the next decade? Are you going to explain to your rabbi that you were really making ten $2,500 annual gifts all at once? Good luck.But the second problem should be taken just as seriously: people make charitable contributions annually based on their present economic circumstances. The problem with making a large upfront contribution based on your estimated future giving is that your future giving is only estimated.Kitces's suggestion of making your upfront contribution to a donor-advised fund, which gives you the ability to "recommend" grants of the account's balance in future years, potentially solves the first problem, but not the second. Your contribution to a donor-advised fund is completely irrevocable — there are no hardship withdrawals, no loans against the balance, no way to pay a tax penalty to get the money back.That means charitable clumping can only make sense for a strange subset of taxpayers: those who have so much money that they can afford to make tomorrow's contributions today, but whose annual charitable giving is so low that, combined with mortgage interest, it doesn't exceed the standard deduction. If that describes you, I guess go ahead.

Conclusion

Upon even a moment's reflection, it should be obvious that "charitable clumping" is not a tax planning strategy at all: it's a marketing campaign by non-profits and donor-advised-fund administrators.The former want you to "clump" your contributions this year, while having every intention of returning next quarter or next year to ask for another "clump."The latter want to charge 0.6% of the assets under management each year, plus the management fees for your underlying investments.For the right taxpayer, in the right tax bracket, who's able to reach the right understanding with their preferred philanthropies, that may be a small price to pay. But the overwhelming majority of taxpayers should spend exactly no time thinking about how they're going to game the new higher standard deductions. Claim it and move on with your life.

Congress wants you to sell stocks to pay your taxes

The tax bill Republicans are planning to pass in the next day or two is not a good bill, and hopefully it will not pass. The fact that people have correctly identified it as a bad bill, however, has given rise to quite a bit of sloppy thinking about why, exactly the bill is so bad.

The effect of replacing the personal exemption with a larger child tax credit is genuinely ambiguous

Under current law, there are two different ways income is automatically shielded from the federal income tax: the standard deduction and the personal exemption. The standard deduction depends on your filing status, and the personal exemption depends on the number of people in your tax unit.As a single filer with no dependents, I'm going to see a slight increase in the amount of income automatically shielded, since my standard deduction will rise from $6,300 to $12,000, a bigger increase than the loss of the $4,050 personal exemption. However, I won't see a tax cut, since I don't pay federal income taxes; as a sole proprietor it's trivially easy to shield an arbitrary amount of income from taxes, and that will actually become modestly easier under the Republican tax bill due to the 20% passthrough deduction.Now take my married brother, who has three kids. His standard deduction will also almost double, from $12,600 to $24,000, but that increase is less than the loss of his $20,250 in personal exemptions. That means he'll have less income automatically shielded from the federal income tax. To illustrate this, assume he makes exactly $32,850 per year.

• Under current law, he owes no taxes since his income is entirely offset by the standard deduction and personal exemption.
• Under the Republican tax plan, he owes $885 in income tax.

So does he see an increase in his taxes? Not at all! That because three of his dependents are children, which allows him to claim the child tax credit. With no federal income tax owed, he's currently entitled to a refund of $1,000 per child, or $3,000. Under the Republican tax plan, $1,400 of the new $2,000 credit is refundable, which leaves him with a $4,200 refund.The interesting thing is what happens as his income increases. The Republican plan replaces the 15% marginal income tax bracket with a 12% bracket on up to $77,400 in taxable income. So while in 2017 my brother would owe $7,459 on $108,750 in earned income ($10,459 less the $3,000 child tax credit), in 2018 he'll owe $3,000 on the same amount ($9,000 less the expanded $6,000 child tax credit). In other words, the lower 12% marginal tax rate on the majority of his income, and the expanded child tax credit, more than offset the fact that a larger share of his income is taxable.Hopefully this stylized example shows why Republicans are able to say "most people" will see a tax cut in next few years compared to current law. The bill does nothing for low-income single adults, but modestly lowers taxes on middle- and high-income workers with multiple kids. These are also the provisions that are set to expire in a few years.

The effect of the state and local tax deduction cap is not ambiguous

So far we've only looked at stylized taxpayers with the only inputs being filing status, income, and number of dependents. Of course, what people are really talking about when they say their taxes will go up is the loss of the unlimited state and local tax deduction they enjoy today.Under the current tax code, to the extent your state and local taxes exceeds the standard deduction, you can deduct the difference from your taxable income (technically you deduct the entire amount instead of claiming the standard deduction, but the result is the same).Under the Republican plan, you can still deduct up to $10,000 in combined state and local taxes, but only to the extent your total itemized deductions (including the mortgage interest and charitable contribution deductions) exceed the new, higher standard deduction. That means even a joint filer that owes more than $10,000 in state and local taxes may end up actually deducting substantially less than that, if they don't have enough mortgage interest or charitable deductions to "fill up" their standardized deduction, while under the status quo state and local taxes can be deducted in their entirety, even by taxpayers without any mortgage interest or charitable contributionsNow, it should be obvious this isn't going to affect very many people. Property taxes are only paid by people who own real estate (renters don't get to deduct the portion of their rent used to pay their landlord's taxes). State and local income taxes, while less progressive on the whole than the federal income tax, are not so high that many people end up paying more than $10,000 without also having deductible mortgage interest and charitable contributions.So we are left with the conclusion that the state and local tax deduction cap will fall almost entirely on a fairly specific group of people: high-income people who also own real estate, and fall on them it will. Your level of sympathy for high-income owners of real estate depends on your taste; I'm not here to argue with you about how sympathetic you should find such people.However, there's one more moving piece in the Republican tax puzzle that becomes suddenly relevant when discussing this population.

Anticipation of corporate tax cuts has inflated asset prices

Remember the point of this entire tax cut exercise: to enact an enormous permanent cut in the corporate tax rate. The ostensible reason for doing so is to spur investment in the United States. The consensus of reputable economists is that this will not, in fact, occur, which is of course one of the many reasons the bill is bad and should not be passed.But there's no question that it will, in fact, cut the amount of taxes owed by corporations, and given general macroeconomic stability, the anticipation of that surge in post-tax profits has inflated asset prices, with the S&P 500 rising 18.6% in the last year.Of course, relatively few people own the overwhelming majority of financial assets in the United States. However, those exact same people also earn the highest incomes and own the most valuable real estate.

Economists pretend to believe marginal effects matter the most

When you read "heartbreaking" stories about wealthy suburbs of New York City, you see people complaining that their inability to fully deduct their property taxes will cause them to up stakes and head to a lower-tax jurisdiction, or perhaps lead to a tax revolt against high property taxes they now have to pay with after-tax income.That's because they've been convinced that it is marginal effects (tax rates in this case) that govern people's behavior. Each decision in every aspect of a person's life is supposed to be made by optimizing its marginal cost and benefit, resulting in an equilibrium that maximizes their total well-being. If property taxes become more expensive, the model has to be re-run and a new, lower-tax equilibrium has to emerge.There is no reason to believe anything like this is true. Economists pretend to believe it because it makes it easier to develop models of "rational" human behavior. But you can just ignore them.

Your corporate tax cut is just as real as your property tax increase

Look: I get it. You're a responsible investor. You max out your 401(k) contributions, your HSA, your 529, and your IRA. You invest in a sensible target retirement date fund. You save every raise so you don't suffer from lifestyle inflation. You don't speculate in bitcoin. And as your reward, you've seen your net worth reliably increase over the last 8 years. Those are your investments.And now you find yourself shocked to discover that due to the cap on the state and local tax deduction, your federal income taxes are going to go up by tens of thousands of dollars. You're being punished for working hard, for homeownership, for living in a good school district, for loving your family too much and wanting to keep them too safe.But your federal income taxes are going up to pay for a cut to the tax rate on your investments! I understand perfectly well the psychological disconnect. One of them shows up as a quarterly bill you have to pay out of pocket, and the other doesn't seem to show up at all. You're responsibly reinvesting your dividends, after all, so you won't even notice when Apple pays out an enormous special dividend with its repatriated profits; it'll be plowed right back into your target date fund.But the tax cut, the special dividend, and the rise in asset prices are still there. So if you're having trouble finding the cash to pay your higher federal income taxes, it's sitting right in front of you.

The effect of estate tax repeal on the 529 scam

One of the first posts I wrote here was about the 529 scam. I explained that 529 plans are a way for wealthy individuals to permanently shield an almost unlimited amount of assets from taxation, and that the scam was made sustainable by the very large number of middle class people saving a very small amount of money who are absolutely convinced that 529 plans are a way to save money for college, rather than a way for the wealthy to shield their assets from taxation.Like the mortgage interest, the state and local tax, and charitable contribution deductions, the actual benefits of 529 plans accrue to a tiny population of wealthy heirs and heiresses, who are protected from blowback by a large population of earnest upper-middle-class professionals.

What are the benefits of 529 college savings plans?

There is so much nonsense out there about 529 college savings plans that it's important to understand what the actual benefits of the plans are. There are only three:

• Internal tax-free compounding. Dividends and capital gains from the underlying investments are untaxed as long as they remain in the account, while they would be taxed if held in a taxable brokerage account.
• Tax-free withdrawals. Under certain conditions, withdrawals from the accounts are tax-free, while they would be taxable if the securities were instead held in a taxable brokerage account.
• Transfer of ownership of a 529 account is not a taxable event at the death of the account's owner, while it might be if the owner of a taxable brokerage account dies (although in that case the heir would benefit from the stepped up basis rule).

What are the limits on 529 college savings plans?

It is commonly believed that there is a limit of $14,000 in annual contributions to 529 college savings plans, or $70,000 if contributions are made upfront and reported over a 5-year period. This is precisely false.$14,000 ($70,000) is the annual (quinquennial) amount you can contribute without filing a "Gift (and Generation-Skipping Transfer) Tax Return."The actual limit on the amount you can contribute to a 529 college savings plan is the plan's maximum contribution balance. For my preferred 529 plan, the Utah Educational Savings Plan, the maximum contribution is $430,000. You can't contribute any more to the plan as long as your balance is at least that amount, but in case of a decline in the value of the account, you can "top up" the account to $430,000 again. As UESP helpfully explains:

"UESP will accept contributions for a beneficiary until all UESP account balances for that beneficiary reach $430,000. It is possible that balances may exceed $430,000 because of market performance. Contributions or portions of contributions that exceed this maximum will be returned to the contributor."

How would repeal of the estate tax affect the 529 scam?

In the absence of the estate tax, there would be no reason for our beloved oligarchs not to contribute the maximum account value to every 529 plan in the country. Without an estate tax, there would be no estate tax exclusion that such contributions could count against, and there would be no return that would need to be filed to record such transactions.To use UESP as an example again, in the absence of the estate tax, at birth every wealthy child in the country could receive a $430,000 transfer, invested in the stock market, that would compound tax-free forever, and with tax-free withdrawals when spent on eligible expenses.

About those eligible expenses

Here readers think they have caught me in some kind of trap. "A-ha," you say, "what good is an enormous tax-free inheritance that can only be spent on certain eligible expenses?"Don't worry, Ted Cruz is on the case. Senator Cruz included in the Senate version of the Republican tax reform bill a provision allowing $130,000 to be withdrawn for K-12 private school expenses, in addition to the undergraduate and graduate school withdrawals that were already allowed tax-free.Even if you're a responsible middle class professional, think about the logic of this provision. A diligent middle class saver starts investing money at the birth of their child and starts withdrawing it a few years later for private kindergarten expenses, so it's had perhaps 2 or 3 years of tax-free internal compounding. A wealthy person inherits a multi-million dollar 529 plan and is able to withdraw $10,000 per year for 13 years that has never been and will never be taxed. Then they can withdraw an unlimited additional amount, also tax-free, up to the total cost of attendance at their kid's private college and graduate school.Finally, as I mentioned in my original post, it's important to understand that a huge portion of the intergenerational transfer of wealth is precisely the transfer of educational opportunities and credentials. Far from being a "restricted" or "limited" form of inheritance, "forcing" your heirs to use a portion of their inheritance on the best private schools is far from a drawback of the 529 plan scam. For many of our oligarchs, it's the whole point.

How Ron Johnson’s weird idea for corporate tax reform might work

Senator Ron Johnson of Wisconsin announced last week that he couldn’t support the Senate tax reform bill because it failed to align the treatment of corporate income (which is taxed once when it’s recorded as profit and again when distributed to shareholders) with “passthrough” income, which is taxed only when it is reported on an individual taxpayer’s return. Rather than trying to align the total tax paid on the two forms of income through crazy schemes of allocating certain income to capital and other income to labor, Johnson’s preferred approach is to tax all business income as passthrough income.This is a surprisingly good idea, and if you have the political will to radically reform the tax system it has a lot of advantages over the current Republican proposals. However, implementing it would require a lot of interlocking changes in order to more-or-less replicate the total taxes we levy on corporate profits today. Here’s how I would set up such a system.

Tax dividends and capital gains as ordinary income

Today taxes are paid on corporate profits once at a rate up to 35%, then again on qualified dividends and long term capital gains at a preferential rate of between 0% and 20%. That means the total tax collected on a corporation's profits theoretically ranges from 35% to 55% depending on the precise composition of the corporation’s shareholders: if a corporation happens to have a disproportionate number of shares owned by low-income taxpayers, tax-free or tax-deferred savings vehicles, and untaxed endowments, its profits will be taxed less than a corporation with a disproportionate number of shares owned in taxable accounts by high-income taxpayers.Since the point of Johnson’s proposal is not to privilege one business structure over another, you would want to strip out that difference by taxing all corporate distributions at ordinary income tax rates. Otherwise, profits distributed to low-income shareholders would never be taxed at all (because of the preferential 0% capital gains rate), while high-income taxpayers would see a 64% cut in the taxes they pay on corporate profits, since they would only pay taxes on profits once, at the 20% rate.If a business's profits ultimately belong to the business’s owners, applying the same progressive income tax rates to business income as we do to labor income makes perfect sense: low-income business owners will pay lower income tax rates on their combined labor and capital income, and high-income business owners will pay higher income tax rates on their total income, without the artificial floor created by the corporate income tax.This also has the advantage of obviating the need to distinguish “active” and “passive” ownership, since income, rather than ownership, would become the basis for taxation.

Impose an excise tax on corporate profits distributed to foreign shareholders and endowments

Similarly, if corporate profits were distributed to foreign shareholders without being taxed at the corporate level, they would never be taxed at all, so you’d need to impose an excise tax of 30-40% on corporate profits distributed to non-US persons in order to not create a massive distortion in the ownership of US assets. Presumably our hardworking diplomats could hammer out the details in tax treaties to include reciprocal treatment of such income so foreign shareholders aren’t punished for investing in US companies, and vice versa.A similar logic applies to untaxed foundations and endowments. Currently their income from corporate ownership is taxed when the corporation records it but not when it’s distributed to them; levying a roughly 35% excise tax on such distributions would keep such entities from shielding corporate profit from taxes indefinitely.

Lower the estate and gift tax exemption

The extremely high estate and gift tax exemptions we have today mean that assets in tax-deferred savings vehicles are only taxed once, at the corporate level, and then never taxed again as their distributions and appreciation accumulate before being transferred to heirs tax-free. If we eliminated the tax on corporate profits, then those profits would never be taxed at all. This may be reasonable for small inheritances in order to avoid the administrative hassle of filing estate tax returns, but lowering the exemption to $500,000 or $1,000,000 would ensure that as much untaxed corporate profit as possible is eventually recorded. This could be even paired with a lower rate for smaller estates which are less likely to engage in the elaborate tax planning extremely wealthy shareholders have access to, and therefore more likely to have paid taxes at some point on the corporate profits they contain.You can imagine achieving a similar result by eliminating the stepped-up basis rule but that approach would be much more administratively complex and we’re trying to simplify, not complicate the tax code!

Conclusion

This is one combination of policies that would achieve the dual objectives of treating business income equally regardless of the legal structure the business uses to organize and raising roughly the same amount of revenue from capital income as we do today. I suspect that if completely implemented this combination of policies would in fact raise an enormous amount of revenue which could be used to cut the marginal tax rates paid on all forms of income (if you were so inclined).So, hand it to Ron Johnson: he may not have any idea what he’s doing in the Senate, but the idea of equalizing corporate income taxation with passthrough income taxation makes a hell of a lot more sense than the attempts in the House and Senate to do the opposite.

Five questions about tax "reform"

Back during the Affordable Care Act repeal debate I wrote pretty extensively about the threat repeal posed to entrepreneurs and entrepreneurship by preventing self-employed people from being able to sign up for affordable, comprehensive health insurance.Instead of the doing the same thing for the House and Senate tax "reform" bills, I thought I'd take a different approach and throw out a few broad areas to keep an eye on as these bills are negotiated and debated.

How much will corporate tax reform add to the deficit?

There's no doubt that America's corporate tax system could be reformed by eliminating preferential treatment of certain expenses ("loopholes") and using the resulting revenue to reduce the maximum statutory rate, if we were inclined to do so.That is not, however, the Republican corporate tax reform plan. Instead, they plan to make modest changes to corporate tax law, radically reduce the top statutory rate, and exclude foreign earnings from taxation.This accounts for the overwhelming majority of the cost of the GOP plan, so any changes or delays in this part of the bill will make a big difference. A 25% rate instead of the proposed 20% rate, for example, would reduce the impact on the deficit substantially, as would a decision to continuing to tax foreign earnings at the maximum statutory rate instead of a special lower rate on overseas or global activity.

How will repatriated profits be handled?

It's often said that US corporations "can't" repatriate their foreign earnings because of the taxes they would have to pay on them. It would be more correct to say that US corporations have been instructed by the Republican Party not to repatriate their foreign earnings and instead wait until Republicans are able to permanently exempt them from taxation.If they're able to do so again (there was an earlier repatriation holiday under George W. Bush), it will reinforce the conviction in US boardrooms that they should accrue, on an accounting basis, as much of their earnings as possible in overseas tax havens, until the next opportunity comes around to repatriate them tax-free.

How will passthrough income be handled?

Currently, passthrough business income is taxed at the recipient's individual tax rate, and is fairly simple to handle on an IRS Form 1040 once you get the hang of it. Will a parallel tax system be created that taxes part of passthrough business income as earned income and part as capital income? If so, how hellishly complicated will that parallel system be, and what kinds of firms will be subject to it?From a revenue standpoint this discussion has focused on large passthrough enterprises like real estate investors and hedge funds, but the overwhelming majority of US businesses are organized as passthroughs, so introducing unnecessary complexity here would be a massive penalty on small business formation and a direct attack on entrepreneurs and entrepreneurship.

How are deductions changed?

There are three moving parts to keep an eye on when it comes to income tax deductions:

• the standard deduction and individual exemption;
• non-itemized deductions;
• itemized deductions.

Raising the standard deduction has two effects: it increases the amount of money low-income filers have completely exempted from federal income taxation (note as always that FICA taxation starts with your first dollar of earned income) and it reduces the value of itemized deductions since only itemized deductions in excess of the standard deduction reduce filer's owed taxes.Non-itemized deductions are available to everyone regardless of whether they itemize deductions, but that means they also complicate everyone's tax filing process. For example, Line 26 on Form 1040 is simply labeled "Moving expenses. Attach Form 3903." Since I move fairly frequently, almost every year I have to dig up Form 3903, then complete the "Distance Test Worksheet," then check if I meet the "Time Test," then find out I don't qualify (I've never qualified). Eliminating these deductions is unpopular because they all have appealing-sounding names (although Line 24 "Certain business expenses of reservists, performing artists, and fee-basis government officials. Attach Form 2106 or 2106-EZ" needs a press agent) and you can always find a journalist willing to express outrage over eliminating them. I would personally encourage you to resist that temptation.Itemized deductions, unlike non-itemized deductions, are only available if you don't take the standard deduction. This means they're only claimed by people with deductible expenses in excess of the standard deduction. Raising the standard deduction would mechanically reduce the number of people who find it worthwhile to file tax returns with itemized deductions, but focusing on the number of people who actually itemize deductions on their tax return misses the much larger number of people who are forced to calculate whether or not to itemize deductions. Eliminating itemized deductions entirely would be the best approach to tax simplification, but any deductions that are eliminated would constitute an improvement over the status quo by reducing the number of people who are forced to calculate their taxes twice.

How are credits changed?

Here are the Form 1040 tax credits I consider eligible for elimination (there are a few more that work as adjustments to payments made during the year that I'm not including here):

• Credit for child and dependent care expenses;
• Education credits from Form 8863;
• Retirement savings contributions credit;
• Child tax credit;
• Residential energy credits;
• Earned income credit (EIC);
• Nontaxable combat pay election;
• Additional child tax credit;
• American opportunity credit;
• Credit for federal tax on fuels.

If anything these credits have even more appealing names than the deductions I mentioned above, and they elicit even more passionate defenses from the journalists covering this debate.

Conclusion

You can come to your own conclusions about the proper way to go about reforming our tax code. The current proposals cut taxes on corporations by about $2.5 trillion and raises taxes on individuals by about $1 trillion over the next ten years. Another approach might be to make corporate tax reform deficit neutral and individual tax reform deficit-neutral, paying for corporate rate cuts with corporate loophole repeal, and paying for individual rate cuts or refundable credits with individual deduction and credit repeal. Yet another approach could raise taxes on corporations in order to reduce the taxes paid by individuals.But whichever outcome you personally favor, hopefully these five questions give a sense of where the bodies are buried in the current tax reform debate.

I am rabidly in favor of tax simplification, which is why I oppose "tax reform"

Having failed to strip health insurance from tens of millions of low-income Americans, the Republican Congress has moved on to their next project of radically reducing the taxes paid by a sliver of high-income Americans. If you follow this debate over the course of the next few months, you'll hear a lot about the distributional consequences of their plan. The top tax rate will be lowered, the bottom tax rate will be raised, and they'll briefly talk about eliminating some deductions until the lobbyists arrive and "convince" them otherwise.I think our tax code needs to be radically simplified, but I don't have any interest in lowering rates, reducing the number of tax brackets, "broadening the base," or any of the other talking points Republicans will use during this debate.I think our tax code needs to be radically simplified because its complexity imposes a psychic tax on every American, plus a financial levy on people who find themselves paying tax preparation firms because they're unable to navigate the tax code's complexity on their own.

Eliminate itemized deductions

Itemized deductions have one small problem and one big problem.The small problem is they've only claimed by high-income taxpayers, who pay enough in mortgage interest, state and local taxes, and charitable contributions in order to be eligible to claim them.The big problem is that the ability to deduct these and other items means even middle-income taxpayers are forced to think about them, gather receipts, store documents, and fret about being audited for each itemized expense.This is the psychic toll of itemized deductions people treat as so natural they forget they're paying it.

Equalize treatment of labor and capital income

The preferential treatment of qualified dividends and long-term capital gains have one small problem and one big problem.The small problem is that the ownership of capital is held disproportionately by the extremely wealthy, who do not need preferential tax treatment for their capital income.The big problem is that the preferential treatment of capital income induces the owners of capital to go to preposterous lengths to secure preferential treatment of their income.For example, the co-called "carried interest loophole" doesn't have anything to do with carried interest. It should properly be called the "capital gains loophole," since it's exclusively a function of the preferential treatment of capital gains. If capital income were treated the same as labor income, there would be no carried interest loophole.

Don't create an additional parallel income tax system for passthrough income

The single worst idea in the Republican "tax reform" plan is to create a third, parallel system of income taxation for passthrough income, the kind of income earned by sole proprietorships and S corporations. Today, your passthrough income is combined with your other earned income and taxed according to the tax tables found in the IRS Form 1040 instructions.That means under their proposal a person who has earned income, capital income, and passthrough income will have to calculate three different components of their income tax. Already today people have to calculate their earned income, short term capital gains (taxed at ordinary income tax rates), and long term capital gains (taxed at preferential rates).Under the Republican "tax reform" proposal, they'll also have to calculate an additional income tax based on their passthrough income.

I truly do not care what you do with the money

Eliminating itemized deductions and taxing capital income at the same rate as labor income would raise a phenomenal amount of money. My weak preference is for the federal government simply to keep the increased revenue and increase the budgetary headroom available to deal with the coming economic calamities.Alternately, you could cut marginal income tax rates. How and where to cut marginal income tax rates would surely be a lively source of debate on Capitol Hill.Or you could chop up the increased revenue and turn it into a guaranteed basic income for all Americans.The point is that it doesn't matter what you do with the money, because simplifying the tax code is an unalloyed good.The small problem with the Republican tax plan is that it's designed to funnel enormous amounts of money towards the wealthiest Americans.The big problem with the Republican tax plan is that it doesn't do a thing to simplify the tax code.

Why I do my own taxes (and why you might not)

Every year around February 1, I fire up the IRS's Free File Fillable Forms and begin the arduous process of manually inputting all my income and expenses for the year. I have what you could think of as either a very complex individual tax return or a very simple business tax return.It's a very complex individual tax return since I have to fill out Schedules C and SE in order to report the income from my sole proprietorship, while most employees just have to copy the information from the W-2 their employer provides. Alternately, it's a very simple business tax return since I don't have any depreciation, cost of goods sold, inventory, etc. I have my income and my expenses, and essentially all I have to do is deduct the latter from the former.Due to my low income I'm eligible for free commercial tax filing software from the IRS, but I have used the public FFFF for the past 4 years of tax preparation.

"Interview-based" tax preparation software drives me nuts

Every commercial tax preparation software I've used has the same model for tax return preparation: you're asked a series of sequential questions covering every imaginable situation the tax code covers. For example, you'll be asked a seemingly harmless question like, "did you move during the tax year?" If you answer "yes," you'll then be subjected to another hundred questions about your moving expenses, how far you moved, how soon after moving you started your new job, how the weather was during your move, etc.My problem with this system is that it treats the answers to the questions as constants, when in fact they're variables. "How much money did you contribute to an IRA this year?" is not a constant — you can contribute money to an IRA up until your tax filing deadline, well into the next calendar year. That means the system's outputs, like adjusted gross income, are also variables. Whether you qualify for a retirement savings contribution credit, and how much it works out to, depends on your AGI. But your AGI depends on how much you contribute to qualified retirement plans! By treating these variables as constants, tax software in my experience is actively harmful for folks trying to minimize their tax bill. It offers a faux static precision for a process that is better understood as dynamic.

Free File Fillable Forms is not perfect

I personally like the IRS's Free File Fillable Forms since it lets you fiddle with individual variables and then recalculate the resulting values (they call this function "do the math" because they think they're cute). You're given the option of adding virtually any of the common IRS forms to your return, inputting the values you have control over, then allowing FFFF to do all the worksheet calculations in the background, and populate your 1040 with the final values.One problem I have run into occasionally is that while forms populate their values to the 1040, it doesn't always work in reverse. For example, Form 8880 (Credit for Qualified Retirement Savings Contributions) will properly populate line 51 of Form 1040, but it takes as one input your AGI from line 38 of Form 1040, and that has to be manually inputted.That sounds like a quibble, but if you don't know about it and you do something elsewhere on Form 1040 to change your AGI (e.g. increase contributions to an IRA or other pre-tax retirement account), you have to remember to go back into Form 8880 to manually adjust it, for example if you're trying to get your AGI below the highest-credit threshold of $18,500.

For most people in most years free commercial tax software is probably fine

Most employed folks who receive exclusively W-2 income, participate in a retirement savings plan at work, have an IRA, and might be making student loan payments are probably well-served by free commercial tax software. The earned income and retirement savings contribution credits phase out fairly quickly, so moderate-income people are unlikely to be able to claim them (unless they have a lot of kids, in the case of the earned income credit), and the standard deduction is high enough that moderate-income people are also unlikely to benefit from itemizing deductions for things like state and local taxes and charitable contributions.

Tax complexity is a payoff to the tax preparation industry

Of course, that begs the question: since most people's tax returns are so simple they require nothing more than your W-2, your IRA contribution, and the number of people in your household, what's the point of the rest of the lines? The point is to create a tax system so complex that people feel compelled to resort to commercial tax preparers in order to avoid the risk of audits and penalties, and to create a generalized animosity towards the payment of taxes in general. Don't believe me? Here's Grover Norquist of Americans for Tax Reform on tax simplification:

"This system will gradually be expanded to more and more taxpayers, and will eventually become mandatory. Income tax filing will be like getting a real property tax statement in the mail—it will become little more than paying a bill."

To be clear, he means this as criticism, not the praise it's rightly understood as.

Conclusion

It's possible to hold two ideas in your head at once:

• Tax preparation is something that needs to be taken seriously and done well, especially for the self-employed and those seeking to retire early. Knowing about and maximizing the value of retirement contributions, identifying potential deductions, harvesting capital losses and gains, and rolling over pre-tax and post-tax accounts as appropriate are all appropriate strategies for saving money given the tax code as it currently exists.
• The tax code as it currently exists is deeply broken not because it incentivizes the wrong sorts of activity, but because the fact that it contains incentives for this kind of behavior at all makes tax planning occupy a disproportionate and unnecessary share of the cognitive real estate of people who could otherwise spend their time doing literally anything else.

In other words, the problem with the mortgage interest deduction is not that it drives up real estate prices and costs the US Treasury $70 billion a year. The problem is that it makes people think about the mortgage interest deduction. Eliminating the deduction and giving all the money back to taxpayers through lower rates wouldn't just be a good idea for eliminating a distortion in the housing market; it would be a good idea so no one ever had to think about the mortgage interest deduction again.Likewise the earned income credit has received a lot of praise, both deserved and totally undeserved, for reducing poverty among low-income workers. But it also requires a 38-page booklet of instructions for properly claiming it, primarily because of its elaborate phase-in and phase-out rules, definition of "earned" income, limits on investment income, etc. Even if you think a refundable tax credit for low-income workers is a good idea, why phase it out or place any limits on it at all? Why not simply reclaim the value of the credit through higher rates on higher-income workers, creating a kind of negative income tax for low-income workers at no net cost to the Treasury?At the end of the day, you shouldn't support tax simplification because your personal finances will suffer or be improved by it. You should support tax simplification because you deserve better than to build your life around optimizing your tax situation every year.

A modest proposal for individual tax reform

I talk a lot about simplifying the tax code, for two big reasons. First, the complexity of the tax code leads to absurd economic outcomes, like arbitrary cutoffs between eligibility and ineligibility for benefits like the Retirement Savings Contribution Credit. Lest you think my concern is exclusively for the poor, I’m equally infuriated by things like the personal exemption phase-out for high-income tax filers and income-testing for retirement accounts like Roth IRA’s.Whether you think a progressive income tax or a flat tax is the best way to finance the government, there’s no reason to believe that a tax code with marginal tax rates that simply bounce up and down all over the place is the best way to finance the government.The second reason tax simplification is one of the defining issues of our era is that the complexity of the tax code is harmful in its own right. You could imagine a tax code as complex as ours that nevertheless resulted in smoothly rising marginal tax rates. That tax code would still be a crisis, because it would demand the time and attention of taxpayers that could instead be used doing something, anything, besides filling out IRS worksheets.With that in mind, here is my three-part plan to simplify the tax code. Feel free to share it with your friends, neighbors, and legislators.

1. Tax all income in the year it’s earned.
2. Tax capital gains as ordinary income.
3. Lift the cap on income subject to Social Security taxes.

I call this a three-part plan, but that’s mostly a function of how our income tax code is currently constructed, and where the complexities are hiding to be rooted out. It’s really a one-part plan: count up all the income you receive each year, look it up in the tax table, and write a check. Let’s take a look at each part in turn.

Tax all income in the year it’s earned

This part of the plan ends all tax-deferred and tax-free savings vehicles. I have written before that I don’t have any objection to a Roth-like savings vehicle that would allow people to save a fixed amount of money that could compound and be withdrawn tax-free. Such accounts don’t create any kind of complexity, since they don't require any adjustments to income in the year it's earned. My objection is to any and all programs that allow people to defer present year income, because such programs create harmful complexity.This would mean the end of 401(k)’s, HSA’s, FSA’s, traditional IRA’s, dependent care savings accounts and any other vehicle that allows people to avoid paying taxes on the income they receive each year.The reason to do this is not to punish people who save for retirement, or save to pay medical bills, or save to pay for dependent care. The reason to do this is to simplify the tax code.

Tax capital gains as ordinary income

I’ve written on this before so I can be brief: the reason to tax capital gains and dividends as ordinary income is not to punish the owners of capital, or to discourage capital formation, or to combat income inequality. The reason to tax capital gains and dividends as ordinary income is to simplify the tax code.No more tracking the purchase date for each lot of shares you buy, no more 60/40 splitting of profit from futures contracts, no more deducting long-term losses against short-term gains. Your capital gain is the amount you received in excess of what you paid — that's the amount you pay taxes on.

Lift the cap on income subject to Social Security taxes

Each year the "wage cap” on Social Security earnings is adjusted to reflect wage inflation. In 2017, it’s $127,200. That means if you have multiple jobs, or a job and a small business, or multiple small businesses, you have to calculate how much of your income from each source on which to pay the full 15.3% FICA tax and how much to pay the lower 2.9% Medicare tax on. Higher-income earners then also have to decide how much income to pay the so-called “Additional Medicare Tax” on.Lift the cap and levy a flat tax on all the income people earn each year. Again, the reason to do this is not to punish high-income individuals. The reason to do this is to simplify the tax code.Here you might be tempted to stop me and say, “but Indy, if we already have a progressive income tax levied on all income in the year it’s earned, why do we even need a separate Social Security tax?” That is an excellent question. The answer is that things should be made as simple as possible, but no simpler. I don’t believe Social Security needs a “separate funding stream” in order to be protected from political meddling. However, I do believe Social Security benefits should be earned and paid out based on income from work and not from capital. It would be curious indeed to calculate the government pension of a capitalist based on the amount of dividends they’d received over the years! A separate Social Security tax levied exclusively on earned income is a simple, rather than complex, way to track people's earned income throughout their working life.

The advantages of this plan

After implementing these three policies, tax preparation would consist of adding up all your income from all sources during the calendar year, subtracting the standard deduction and any personal exemptions, and looking up the resulting number in a tax table. A simple online calculator would do 90% of the work.

The disadvantages of this plan

The biggest disadvantage of this plan is that it would raise a phenomenal amount of money, and close 76% of the Social Security "funding gap" (click on Revenues, then "Subject All Wages to Payroll Tax"). Since the Republican Party has used the federal deficit as a policy bludgeon for 40 years, reducing the deficit through tax simplification would create an enormous amount of pressure to cut tax rates in order to increase the deficit back to "crisis" territory in order to justify cuts to the welfare state. You saw this strategy at work back in 2001 when Federal Reserve Chairman and Ayn Rand apostle Alan Greenspan testified that federal budget surpluses created the risk of the federal government having to accumulate private assets, potentially destabilizing the capital markets. His solution? Tax cuts, and the federal deficits of the 2000's.But besides the purely partisan challenges this plan would create, it's important to keep in mind what this plan would not do:

• it would not remediate lead contamination in residential areas, playgrounds, or parks;
• it would not repair or replace any roads or bridges;
• it would not modernize the electrical grid to address the challenges of intermittent energy sources like wind and solar;
• it would not make higher education more affordable;
• it would not subject banks to sufficient regulatory scrutiny to prevent another global financial catastrophe;
• it would not increase the density of expensive coastal cities where high-paying jobs are increasingly concentrated.

These are all serious problems in American life that need to be addressed, and my tax simplification plan doesn't address any of them.That's because we need to stop asking the tax code to solve all our problems. The tax code should raise the money we need to finance the state as painlessly as possible.Once the tax code is simplified, we should welcome fights over what tax rates are appropriate and what activities the federal government should spend our tax dollars on. We should have vigorous disagreements about the appropriate size and scope of government activity. But every year we make tax simplification a hostage in those fights is another year we go without tax simplification.

S corporations: logic and illogic

I've been doing a deep dive lately into one-participant 401(k) plans, which has caused me to observe that people are often extremely unclear about what they are talking about when they talk about one-participant 401(k) contribution limits. The reason is that multiple types of legal entities can sponsor one-participant 401(k) plans, including unincorporated sole proprietors (like your humble blogger).This led me to the further observation that many self-employed people seem to prefer S corporations to sole proprietorships. There is a very specific logic to this preference, but if you don't understand the logic, you're unlikely to correctly decide which is right for you.

Self-employment income versus S corporation distributions

As an unincorporated sole proprietor, I report all my net profit on schedule C, pay 15.3% in self-employment tax, and then deduct half my self-employment tax to calculate my earned income for IRS form 1040.As an S corporation employee-owner, you pay reasonable W-2 income to yourself, with the corporation paying (and deducting from profit) 7.65% and you, the recipient of the income, seeing another 7.65% deducted from your paycheck. The remainder of the S corporation's profit is issued as "distributions," which are subject to ordinary income tax but not the 15.3% FICA tax.For this reason, many people believe they are "saving" 15.3% of the amount they receive as distributions, since neither the S corporation nor they themselves pay FICA tax on it.This is an error. Consider someone who, for 35 years, earns $100,000 in 2016 dollars. They have the option of receiving $100,000 of it in self-employment income reported on schedule C, or $50,000 in W-2 income and $50,000 in S corporation distributions, taxed at their ordinary income tax rate but without paying any FICA taxes.At full retirement age, the person receiving $100,000 in self-employment income will receive a monthly Social Security benefit of $2,670.Reducing their FICA contributions 15.3% of $100,000 to 15.3% of $50,000 will receive that monthly benefit to $1,845.At full retirement age, our sole proprietor will receive $825 fewer 2016 dollars per month.The next question is, how much will she have saved in the 35 years of shielding her income from FICA taxes? The answer is 15.3% of $50,000, or $7,650 per year, for a total of $267,750.The "breakeven" point in this case is roughly 27 years: if you live that long, you'll collect more in wage-inflation-adjusted Social Security benefits than you "saved" in FICA taxes.

Eligibility for tax-advantaged retirement savings accounts

Of course, as a self-employed person, hopefully you're also saving for retirement, and you'd think those unpaid FICA taxes could help.Both sole proprietors and S corporation owner-employees are eligible for retirement savings accounts, but in slightly different ways.To calculate their earned income for purposes of contributions to retirement savings plans like 401(k)'s, an unincorporated sole proprietor uses 92.35% of their net self-employment income. Of that total, the first $18,000 can be contributed to either a traditional or Roth 401(k) account, and up to $54,000 total can be contributed on self-employment income of a little over $190,000.Owner-employees of S corporations can only make employee elective and employer non-elective retirement savings contributions based on their W-2 income, not their S corporation distributions. Of course, you're free to save rather than spend your S corporation distributions, but those savings won't compound tax-free and will be subject to capital gains taxes upon sale.While non-elective S corporation retirement plan contributions aren't subject to FICA taxes, the employee-owner's W-2 earnings are. This creates a tension: the point of the S corporation is to minimize your W-2 income subject to FICA taxes, but minimizing your W-2 income reduces your capacity to defer taxes on retirement savings. You can raise your W-2 income in order to contribute more to a one-participant 401(k) plan, but your increased W-2 income will then be subject to FICA!

Squaring the circle

All of this is to say that while many self-employed people and finance hackers treat an S corporation election as a no-brainer or default option, your decision on how to organize your business depends on several factors. Here are a few:

• for businesses with net income below about $22,077, there's zero justification for incorporation, since you can contribute your entire net business income to a 401(k) and pay no federal income tax on it at all (an $18,000 elective deferral and $4,077 non-elective deferral).
• for businesses with net income substantially above $180,000, and for business owners with more than $127,200 in W-2 income from another employer, an S corporation election is, ignoring setup and maintenance costs, tax-advantaged compared to sole proprietorship, since you can maximize your Social Security wage base ($127,200) and defer the maximum $54,000 into a one-participant 401(k) by paying $144,000 in W-2 income and making an $18,000 elective contribution and $36,000 non-elective contribution. Distributing profit in excess of $180,000 will avoid the 2.9% Medicare tax. Note: that is just $2,900 for each $100,000 in additional S corporation profit, so if your setup and ongoing maintenance costs are high they could take years to recoup, if ever.
• For businesses in the middle of that range, the question comes down to what you actually intend to do with the FICA taxes you avoid with a S corporation distribution. If you're simply going to invest the money in a taxable brokerage account, you're trading one investment, an inflation-indexed annuity (Social Security), for another less tax-advantaged one. On the other hand, there are investments that are difficult or impossible to make in a retirement savings account: real estate, futures, private equity, or even more creative options. A high level of confidence in your ability to deftly manage the money you save on taxes could alone justify taking the money as a taxable distribution instead of squirelling it away in a tax-advantaged account.

The sole proprietor's marginal federal tax rates

[edit 6/13/17: I've been convinced that employee "elective" and employer "non-elective" solo 401(k) contributions can be made with the same money, so have slightly updated the values below to reflect that employer contributions don't have to be made with what's "left" after deducting up to $18,000 in elective employee contributions. I'll have a post soon exploring this issue in more detail.]Everybody gets a song stuck in their brain sometimes, the only proven cure for which is putting on the song at maximum volume and belting it out in your underwear.Along with songs, I also get personal finance calculations stuck in my mind that I can only stop thinking about once I work out the math and blog about it.Recently I've been thinking about what should be, but isn't, a trivially simple question: what is the marginal federal tax rate on a sole proprietor's income?For each calculation I'll be assuming the sole proprietor is filing as a single taxpayer and has no other taxable income. Additionally, all retirement contributions will be made pre-tax. In other words, this is a taxpayer whose only objective is to pay as little as possible in current-year federal taxes. Adjusting these rates for your own situation is an exercise left for the reader.Finally, these rates are calculated on the net business income reported on line 48 of Schedule C. Don't confuse that with "earned income" or "adjusted gross income." These are just the marginal tax rates paid on your actual profits from your actual business, if it's your only source of income.

Marginal federal tax rates on a sole proprietor's income

• 15.3% for income up to $54,142 $60,638. At $60,638 in self-employment income, you'll owe $9,277 in self-employment tax. Reducing your self-employment income by half that amount, $4,615, will leave you with $56,000 in earned income. A $5,500 traditional IRA contribution, $18,000 pre-tax "employee" solo 401(k) contribution, and $14,000 "employer" solo 401(k) contribution will reduce your adjusted gross income to $18,500. After deducting your $4,050 exemption and $6,300 standard deduction, you'll be left with taxable income of $8,150 and income tax due of $818 which will be fully offset by your retirement savings contribution credit of $818.
• 41,800% on the next dollar or two of income. It's actually a bit tough to calculate the precise point when your adjusted gross income will tip over to $18,501 due to the multiple decimal places involved, but at that point, you'll owe the same $818 in taxes but your retirement savings contribution credit will drop to $400. You'll pay $418 in taxes on a dollar or two of income, leaving you with a marginal tax rate of 41,800% (or 20,900% if you want to spread it over two dollars of income).
• 23.4% for income up to $62,336. It's important here to note that, having maxed out your $18,000 in straight employee 401(k) contributions, you can only contribute one out of every four dollars as an "employer" contribution to your solo 401(k). That means the $1,500 in adjusted gross income up to the next retirement savings contribution credit threshold is actually $2,000, which has to be adjusted for the usual and obnoxious 92.35% adjustment, for a total of $2,165 in net self-employment income you can earn before the next threshold. In this band, every $72 in net self-employment income results in an additional $5 in federal income tax and $11 in self-employment tax ($72 reduced by 7.65%, then by 25%, results in $50 in adjusted gross income).
• 25.7% up to $62,804. In this band, every $72 in net self-employment income results in roughly an additional $7.50 in federal income tax and $11 in self-employment tax.
• 20,000% on the next dollar or two of income. As above, moving from the 20% retirement savings contribution credit band to the 10% band reduces your credit by $200.
• 25.7% up to $78,686. Here you're still in the 15% income tax bracket and receiving a $200 retirement savings contribution credit.
• 20,000% on the next dollar or two of income. This is the final phaseout of the retirement savings contribution credit. Earn a buck, pay $200.
• 25.7% up to $103,230. At $103,230, your adjusted gross income will total $48,000, leaving you with $37,650, the top of the 15% income tax rate.
• 32.7% up to $127,200. In 2017, $127,200 in net self-employment income will max out the Social Security component of your self-employment tax (finally!), and leave you with $54,252 in taxable income, squarely in the middle of the 25% income tax bracket.

Let's take a break here to talk about the next two things that are going to happen. First, the amount by which your net self-employment income will be adjusted is going to change. Before we'd been using a variable 7.65% adjustment to account for half the self-employment tax, which is figured as 15.3% of your net self-employment income up to $127,200. Now we're going to use a fixed $9,730 adjustment, which is half of the 15.3% levied on the first $127,200, plus a variable adjustment of 1.45% on the amount over $127,200, which is half the self-employment tax levied on amounts in excess of $127,200. So $128,000 in self-employment income will be reduced first by $9,730, then a second time by $11.60 (1.45% of $800). That's going to bring down your marginal tax rate, a lot. We can still contribute 25% of what's left as an employer contribution to our solo 401(k). In this case, that employer contribution is $29,564.That brings us to the second thing that's going to happen: the ability to make employer contributions to your solo 401(k) will end when total employer contributions total $35,000. We'll have $35,000 in employer contributions when our total self-employment income is $150,061. Reduce that amount by $9,730 and 1.45% of the amount in excess of $127,200 ($331) and we'll have $140,000. The quarter of the remaining amount is your maximum employer non-elective 401(k) contribution: $35,000. Just as lower self-employment taxes lower your marginal tax rate, losing the ability to contribute a quarter of what's left will have the effect of raising your marginal tax rate.One final note here: Matt and I have disagreed about whether you can contribute the same dollar twice: once as an employee and once as an employer. I think you can only contribute the same dollar once, which is why I have assumed all employer contributions are made from what's left after the maximum employee contribution is made. If anyone has a definitive answer to this question, I'm all ears. I've been convinced that Matt is right about this.Ok, back to business.

• 21.4% up to $150,061. Between $127,200 and $150,061, you'll pay 2.9% in self-employment tax on each dollar of net self-employment income, then 25% of 75% of 98.55% of what's left.
• 27.5% up to $171,117. In this band you're paying the lower self-employment tax rate of 2.9% on each marginal dollar of self-employment income, but now have to pay 25% of the entire 98.55%: you're no longer able to make additional employer contributions to your solo 401(k).
• 30.5% up to $272,334. Here you'll pay 2.9% in self-employment tax on each dollar, then 28% of the remaining 98.55%. 
• 32.5% up to $330,173. At $330,173 in net self-employment income, you'll have an adjusted gross income of $259,000.

At this point, the personal exemption starts to phase out, until it's eliminated completely at an AGI of $381,900 (net self-employment income of $454,881).

• 33.6% up to $454,881. For each $2,500 you earn, you'll pay 33% on 98.55% of your net self-employment income plus 33% on 2% of $4,050 (no, I'm not kidding).
• 32.5% up to $496,586. Now that the personal exemption has been completely phased out your marginal tax rate drops back down to 33% of 98.55% of your net self-employment income.
• 34.5% up to $498,331.
• 39% on all additional marginal dollars of net self-employment income.

Conclusion

Now that my brainworm has been well and truly exterminated, there's only one thing to do to reward folks who have made it all the way to the end, and that's show exactly the same data in chart form:One hell of a way to run a railroad.

Five ways to capitalize asset price movements

I am on the record as skeptical of the value of paying a roboadvisor to execute capital-loss harvesting, but capital-gain and capital-loss harvesting is a subject that excites financial independence bloggers (e.g. here, here, and here), so I don't want to brush off the subject completely.For those unfamiliar, capital-loss harvesting allows you to offset capital gains you realized during a calendar year or, if none, apply up to $3,000 of losses against ordinary income (and roll unused losses forward to the next tax year) while capital-gain harvesting allows you to sell appreciated assets and pay the long-term capital gains tax rate on your profits. The key difference is that while capital losses are subject to the wash sale rule, capital gains are not, so you can repurchase substantially identical securities immediately with the proceeds of the original sale.

Two notes on the logic and illogic of these practices

There are two things it's important to keep in mind about the practices of capital-loss and capital-gain harvesting.The first is that these antics are entirely products of two decisions made by the authors of the current tax code: the ability to apply capital losses against ordinary income (thereby getting up to a 39.6% rebate on your bad investment choices) and the decision to tax long-term capital gains at lower rates than short-term capital gains. These are very bad decisions, but they are currently enshrined in law, so I don't pretend to criticize anyone taking advantage of them.The second is that under the most popular current interpretation of the tax code, the rules around wash sales are interpreted so loosely as to be practically meaningless. For example, selling an S&P 500 ETF and using the proceeds to buy a total stock market ETF is not treated as a wash sale, nor is the reverse transaction, despite their near-perfect correlation. Likewise the IRS doesn't seem to object to selling a developed-market ETF at a loss and using the proceeds to buy one European and one Pacific developed-market ETF. This is a bad interpretation of a bad rule, but it is the current prevailing understanding of the rules.This second point is important because it means your capital-loss and capital-gain harvesting doesn't need to affect your overall asset allocation, since you can use the proceeds of your transactions to replicate your original holdings through differently-though-similarly-indexed ETF's (I'm not a tax lawyer, and I'm definitely not your tax lawyer, so please consult with him or her before actually attempting this).With that out of the way, I want to take a closer look at five ways you might, if you were so inclined, harvest capital gains and losses.

Harvest all losses

This strategy would work by identifying a certain number of correlated but not "identical" ETF's, and swapping between them each time you see a loss, while keeping the 30-day wash sale rule in mind. For example, you could use the Vanguard 500 ETF and Vanguard Total Stock Market ETF, and sell on every day with a loss that brings your share price below your purchase price and move the money to the other, as long as the transaction wouldn't put you in violation of the wash-sale rule (i.e. put you back in the original ETF within 30 days of sale).It would be relatively easy to configure such a rule with stop-limit orders, although you'd have to actively execute the subsequent purchase order and actively monitor your wash sale compliance.

Harvest all gains

Another approach would be to look at your holdings just once a year and sell all your securities that have long-term capital gains, paying the lower long-term capital gains tax rate and using the proceeds to repurchase the same securities at a higher basis.A sub-strategy here would be to only sell appreciated securities up to the total income limit of the 0% long-term capital gains tax rate ($37,650 AGI for single filers).This strategy is far simpler than the above because it only requires you to know the date you purchased your securities, without needing to reallocate between similar-but-not-identical securities, capital gains not being subject to the wash-sale rule.

Harvest everything

Every year-and-a-day, you could sell all your year-old securities and either deduct your losses or pay long-term capital gains taxes on your gains. The advantage of doing so would be to, over time, step up your cost basis more-or-less in line with inflation and price appreciation, while paying only the long-term capital gains tax rate and also accruing tax losses in down years to offset future capital asset appreciation.This would require more extensive book-keeping and compliance with the wash-sale rule, but would only need to be done once per year, making it potentially less burdensome than the "harvest all losses" option above.

Offset all losses

One of the advantages of a diversified portfolio (I do not have a diversified portfolio) is that your assets aren't supposed to be perfectly correlated. That means a portfolio with a total US stock market ETF, a total developing market ETF, a European developed market ETF and a Pacific developed market ETF will experience different returns at different times: some gains and some losses.One way you could respond to this is to sell your loss-making securities (which can be either short-term or long-term) and offset those losses with gains-making securities, preferably those with short-term capital gains. You can use the proceeds of those sales to buy similar-but-not-identical securities to the loss-making ones, and identical securities to the gains-making ones.If properly executed and reported, this should result in no net tax bill.

Offset all gains

The converse of the above strategy is to sell capital-gains-making securities and offset those with loss-making sales. The advantage of this strategy would be avoiding paying capital gains taxes (while securing a stepped up basis for your securities by re-buying your gains-making securities immediately) while also avoiding the necessity of tracking and rolling forward capital losses year to year.

Conclusion

The decision whether to pursue any or none of these strategies ultimately depends on a number of factors:

• do you believe touching your investments more often will make your investments perform better or worse than leaving them alone?
• what is your level of confidence in your ability to choose and successfully execute one or more of these strategies?
• what is your level of confidence that you understand the rules surrounding wash sales, capital gains, and capital losses?
• what is your marginal income tax rate, marginal short-term capital gains tax rate, and long-term capital gains tax rate?

My personal answers to those questions are "worse," "low," "low," and "0%," which explains why my interest in these strategies is purely academic. If your answers are "better," "high," "high," and "40%," then these strategies will understandably seem more appealing!

What's the advantage of tax-advantaged accounts?

On Sunday I wrote about what I consider a fairly important oversight in the world of financial independence enthusiasts: a glaring disregard for just how minimal the taxes they spend so much time avoiding really are. Capital gains harvesting, for example, is the practice of realizing long term capital gains as often as possible in order to pay minimal taxes on the proceeds. That's all well and good, and perfectly legal and whatnot, but for the overwhelming majority of investors it's also completely unnecessary.However!I don't want that to shade into saying that tax-advantaged investment accounts don't have advantages. They do, but they're somewhat orthogonal to the ones people generally emphasize. So today I want to spell out the advantages tax-advantaged accounts really do have.

Internal tax-free compounding

Once funds are invested in a tax-advantaged account, whether it's an IRA, 401(k), 403(b), 529, HSA, or any other vehicle that suits you, they have the great advantage of offering internal tax-free compounding: instead of owing taxes, however minimal, on dividend and capital gains distributions each year, those distributions can be reinvested (or not) within the account without incurring any income tax liability.It is treated as an article of faith that this feature of tax-advantaged accounts is an unalloyed good and a key to increasing your net worth, achieving financial independence, and all the other things to be mined from the Big Rock Candy Mountain. Since I take money literally, I have to break it to you that it's just not so.Consider an account holding $10,000 in a mutual fund paying a 2% annual dividend. Actually, let's be rich people, and hold $1,000,000 in a mutual fund paying a 2% annual dividend. In a taxable account, we'll earn $20,000 per year in dividends and owe the maximum marginal capital gains tax rate of 23.8%: the maximum 20% long term capital gains tax rate plus the 3.8% net investment income tax.This, all things considered, sucks. $4,760 of our annual dividend goes straight to Uncle Sam and his bizarre effort to provide health insurance to the working poor.Now consider the case of the millionaire who, thanks to frequenting financial independence blogs and forums, has managed to squirrel away the whole million into a Roth IRA. Each year the investment spins off $20,000 that he's able to reinvest tax-free, thus realizing the dream of internal tax-free compounding.The question is: what does he do with the $4,760? I have never met anyone who looks at their tax-advantaged investment accounts each year, calculates the amount they saved by avoiding the federal capital gains tax, and then invests that amount. In the past I've called that "compounding discipline," and no one has it. You don't have it, I don't have it, no one has it.

Make decisions without tax consequences

Friend of the blog Alexi over at Miles Dividend M.D. has explained his adoption of Gary Antonacci's "dual momentum" investment strategy, whereby you invest in domestic stocks, foreign stocks, or cash, depending on which has performed best over the last 12 months (I'm not doing the strategy justice, for obvious reasons).While such strategies may not trade "frequently," they certainly trade more frequently than "buy and hold forever," which is my preferred strategy. If you've been convinced that such a strategy will best serve your financial interests, you'll be much better off pursuing it in a tax-advantaged account than in a taxable account where moving in and out of funds will incur annual short-term capital gains, taxable at your marginal federal income tax rate.While such strategies are an extreme case, there are other reasons you might want to make investment decisions without tax consequences. When I took control of my IRA, it was invested in a number of funds which I simplified into a Vanguard target retirement date fund. Several years later, as I learned more about investing, I simplified it further into the Vanguard 500 fund. I have yet to hear a compelling argument for doing so, but someday I may simplify it even further into the Vanguard Total Stock Market fund. These aren't market timing decisions, but simply the natural course of my investing education, and I'm certainly grateful not to have incurred any taxes or even significant paperwork along the way!

Manage adjusted gross income

While it isn't applicable to everyone, the ability to use pre-tax retirement savings vehicles to manage your reported adjusted gross income can sometimes provide an outsized return on investment. It's why I earn $18,500 every year, for example. Other than the reasons explained above, I do not generally think that it's worthwhile aggressively managing your adjusted gross income, unless you are able to bring it below a threshold that triggers special tax benefits (these benefits shouldn't exist, but as long as they do I understand and share the impulse to game them).

Lock in today's tax rates

Finally, I'm not trying to ignore the elephant in the room: assets that can be shielded in Roth IRA's and Roth 401(k)'s, and withdrawn in retirement, will never be taxed again. The same is true of 529 college savings plans when the funds are spent on qualified higher education expenses. Such accounts give you access to internal tax-free compounding, reallocations and reinvestments without tax consequences, and tax-free withdrawals.It's no secret that I believe capital gains should be taxed as ordinary income (perhaps with an inflation deflator if held for a long enough period), but if that dream ever becomes a reality, then people with the foresight to seize every possible opportunity to shift their investment balances into after-tax Roth accounts and tax-free inheritance vehicles will surely be laughing at all the suckers who figured that long-term capital gains taxes were too low to bother shielding their investments from it.

Conclusion

There are reasons to contribute to tax-advantaged investment vehicles, particularly after-tax and never-taxed vehicles like Roth retirement accounts and 529 college savings plans. But if you don't know why you're doing something, you're vanishingly unlikely to be doing it for the right reasons. So before harvesting your losses, harvesting your gains, or harvesting your artichokes, be sure it actually makes sense for your situation.