This should be a golden age of entrepreneurship; why isn't it?

It's no secret that I'm a cheerleader for self-employment and entrepreneurship. I now run two blogs, this one here on the Saverocity network and another at freequentflyerbook.com. I've never asked anyone permission to start a business, I don't have a "business license," I just run a business like a goddamn American. That's the spirit I'm trying to promote here: if you aren't willing to start a business until you're convinced you'll be able to replace your salary as an employee, you'll never start a business and you'll never be an entrepreneur. The only way to start a business is to start a business.Moreover, there are a number of factors that should make our times a golden age of entrepreneurship:

• comprehensive health insurance is now affordable to entrepreneurs through the expansion of Medicaid and subsidized insurance on the Affordable Care Act exchanges. So-called "job lock," which kept people slaving away as employees instead of implementing their small business ideas in order to retain access to affordable health insurance should be a thing of the past: today you should be able to start a business with no income whatsoever, and graduate from Medicaid, to subsidized exchange health insurance, to unsubsidized exchange health insurance. While pre-ACA only those confident or stupid enough to go without health insurance, or young and male enough for insurance to be affordable, could ever dream of venturing out on their own, today anyone should be able to quit their job and immediately enroll in comprehensive health insurance with premiums, deductibles, and co-pays corresponding to their income level;
• on the flip side, employee benefits have gotten stingier and stingier as conservative ideologues do everything they can to strip employees of the protections unions and defined benefit pension plans used to provide. While waiting for a pension to vest and seeing your benefits in retirement grow and grow used to be a compelling reason to stick with a unionized workplace for as long as possible, the gutting of both unions and retirement plans in the private sector has made self-employment relatively more attractive than becoming a "company man;"
• meanwhile, current public market asset prices are so elevated that it's reasonable to expect relatively low returns on investments in publicly traded securities. If you don't have enough money or contacts to subscribe to one of the few high-quality venture capital funds, you can do the next best thing: start your own private business, and keep every dollar you earn.

What happened?

Given the confluence of factors above, why is it that I still need to be out here in the wilderness shouting at people to start their own businesses? I don't have a definitive answer, but I do have some suggestions.

• the refusal to expand Medicaid in many Republican-governed states has created an enormous obstacle to affordable health insurance. Instead of being able to seamlessly transition up through Medicaid eligibility to subsidized and then unsubsidized exchange coverage, these states are left with an enormous coverage chasm. If an entrepreneur knows that she'll be left without affordable, comprehensive insurance coverage if she becomes pregnant, let alone suffers a serious disease or injury, under what possible circumstances would she risk that?
• Businesses are privileged in the provision of certain benefits. Everyone knows about the exclusion of health care benefits from taxable pay, but there are other considerations as well: when employers match contributions to 401(k) plans or HSA's, the benefit to participants is subsidized by the contributions of non-participants. In other words, an employer that matches 3% of payroll contributions to a 401(k) isn't spending 3% of payroll on 401(k) matches. They're only matching the contributions of participants in the plan, reducing the overall impact on wages of the employer match. While the self-employed are free to open 401(k) accounts, they're solely responsible for both the employee and employer contributions to the plan. An obvious solution would be to create a generic retirement plan open to everyone, whether employee or self-employed, which would reduce or, preferably, eliminate the role of the employer in our retirement savings regime.
• In connection with the above, businesses which provide paid family or maternity leave have an advantage over the self-employed, since entrepreneurs have to pay for their benefits out of retained earnings (or debt), instead of spreading the cost over an entire workforce. An obvious solution would be to support a universal paid leave policy funded by a modest increase in payroll taxes on all workers, whether they work for themselves or for someone else.
• Bureaucratic malfeasance. There is an important difference between regulation (good) and implementation (typically terrible). It's the difference between getting a facility inspected and approved before using it to prepare and sell food and requiring 30+ days to get an inspector on site to inspect and approve your facility. It's the difference between requiring a license to drive and requiring people to wait in line for 2 hours to get their picture taken for their driving license. It's the difference between requiring entrepreneurs to register for an account to pay estimated taxes quarterly and requiring entrepreneurs to get their bank to notarize a form before getting their estimated tax payment account approved.
• Finally, the self-employed are treated with suspicion and disdain by most civic institutions. If you follow me on Twitter you've probably seen me talk about this anecdote before, but it is absolutely representative of the general experience of being an entrepreneur. The Brookings Institution and the American Enterprise Institute recently released one of their "consensus" proposals on a program for paid family leave. On page 25 of the report, you'll find the following paragraph: "Requiring that employers protect the job of a worker who takes leave is desirable (see Chapter III), but sensible restrictions on eligibility and work history will ease the burden on employers, especially smallbusinesses, and reduce workers’ ability to abuse the system. Expanding the coverage to the self-employed is potentially vulnerable to fraud and misuse." I was fortunate enough to attend the presentation of the report (if you listen or skip to the end you can hear me ask the panel about this apparently deliberate insult to the self-employed). Why would anyone, let alone an organization ostensibly dedicated to free enterprise, accuse entrepreneurs, the very people whose risk-taking is the backbone of a competitive capitalist economic system, of fraudulently misusing state programs of support? What would it even mean to fraudulently misuse paid family leave? Faking a pregnancy? This is the United States of America, not a long-running Broadway musical.

We can fix this, but we have to decide to fix it first

If we want to promote entrepreneurship and self-employment, there's nothing standing in our way. Start with asking actual entrepreneurs a few questions: what obstacles did you face while starting your business? What could be done to help others pursue self-employment? I've provided some answers, but I don't have all of them. Maybe tax attorneys face different issues than restauranteurs, who face different issues than artists, who face different issues than musicians, who face different issues than garment retailers, who face different issues than mail scanning and forwarding services. There may not be a single solution to the problems faced by entrepreneurs in different industries. It may take time and ingenuity. But the first thing required is discovering the issues that entrepreneurs face and tailoring solutions to make entrepreneurship a real possibility for more people who are discouraged by the misuse and abuse of small businesses by the American political system.

In defense of lifestyle inflation

An important conceit of a variety of forms of financial advice, including the financial independence space but also genuine financial planners, is the avoidance at all costs of "lifestyle inflation." Lifestyle inflation, the theory goes, is the curse of spending additional money on living expenses just because your income increases, whether it's due to raises, promotions, bonuses, or job changes.My insight into this phenomenon may be unfamiliar to you, because unlike your favorite financial independence blogger or investment banker, I'm poor.

Living below, above, and within your means

You can imagine at any income level someone choosing to spend more than they earn, less than they earn, or as much as they earn. In this context it's irrelevant whether the person is saving aggressively for retirement or not: they can save aggressively whether they are spending more or less than they earn each month. For example, like many people I both have student loans and make sure to max out my Roth IRA each year. Additional years of IRA contributions are worth more to me than accelerating the pace of my student loan repayments, so I privilege IRA contributions above student loan payments. Your calculus, naturally, may be different.

Living below, above, and within your needs

The important thing to me is not whether you are living within your means. The important thing to me is whether you're living within your needs.As a poor person, I know that your means and your needs have different values. I live within my means, but below my needs. For example, this is my office:[embed]https://twitter.com/FreequentFlyr/status/876907518609551362[/embed]To the right of my desk is a wall. To the left of my desk is a dining room table. If I made more money, the most natural thing in the world would be to rent an apartment with an additional bedroom so I could set up a proper office instead of working at a small desk tucked away in the corner. This is an illustration of what it means to live within one's means but below one's needs.

Why don't financial independence types understand this?

It appears to me that the reason financial independence bloggers are so obsessed with cutting expenses out of their budgets is that, never having been poor, they leapfrogged the "living within your means" step all the way to "living above your needs." While the ordinary working poor have never had to "decide" to cut "unnecessary" expenses of their budget, the suddenly wealthy — whether doctor, accountant, or real estate magnate — immediately start spending their entire disposable income, including on things they later discover are entirely unnecessary.But to be clear, this stylized case is extremely unusual among the public at large, however common it is among financial independence bloggers; whether or not your expenses are within your means is an entirely different question from whether they're within your needs.

In defense of lifestyle inflation

For an ordinary person, i.e. not a highly-paid software engineer or owner of a vast real estate empire, the essential principle of financial management is not to "cut out all unnecessary expenses." The important thing is the addition of all those expenses that are needed, but only those expenses that are needed.I need an additional room to work in, but I can't afford it. If I could afford it, I would happily pay for it.Sound budgeting, in other words, isn't about cutting out the unnecessary, it's about adding the necessary. It's irrelevant to me whether your necessary expenses are Vegas conferences with colleagues, chophouse dinners with clients, or something as minor as a little extra room to work in.This is something that only someone building a lifestyle from poverty can understand; if you went straight from college to leasing new German automobiles, you're naturally bound to find unnecessary expenses in your budget. If you never make that mistake, you have the great advantage of being able to spend more on things that matter, rather than spend less on things that don't.

My stubborn preference for mutual funds over ETF's

I understand that I sometimes come across as a bit crotchety when it comes to the early retirement blogging community. Nothing could be farther from the truth! I retired at 29 and haven't regretted it for a day since (if Mitch McConnell manages to scrounge up 50 votes to take away my health insurance we can revisit this discussion). Anybody who advocates quitting your job and doing what you love for the rest of your life is alright in my book.Of course, there are things that I disagree with. The idea that "graduate with the most lucrative degree you can," "get the highest-paying job you can," and "save as much money as possible" constitute some kind of secret insight, instead of being perfect distillations of middle-class American values (for good and ill) is a somewhat bizarre affectation.On the other hand, there are other prejudices of the early retirement folks that I endorse whole-heartedly. One of those is the preference for mutual funds over exchange-traded funds.

It has become very fashionable to prefer ETF's over mutual funds

You can't open the business section of a newspaper these days without reading about exchange-traded funds. You'll virtually always hear their virtues described using the same formula:

• they're traded throughout the day so you can buy and sell ETF's any time you want while markets are open, while mutual fund transactions are only settled once per day;
• unlike mutual funds, ETF's aren't required to distribute capital gains and losses to shareholders at the end of each year, making them more "tax-efficient" investing vehicles.

The important thing to keep in mind is that both of these statements are true. I'm not here to tell you that you can't buy and sell ETF's throughout the day, or that ETF's do, in fact, make taxable capital gains distributions each year.I just don't care.

Why I stubbornly prefer mutual funds to ETF's

I can boil down my preference for mutual funds over ETF's into three main ideas.First, low-cost passive indexed mutual funds do not, in general, distribute taxable capital gains. Here are some examples of funds you might include in a broadly diversified portfolio, if you were so inclined:

• Vanguard 500 Index Fund (VFIAX): no capital gains distributions in previous 10 years;
• Vanguard Emerging Markets Stock Index (VEMAX): no capital gains distributions in previous 10 years;
• Vanguard European Stock Index Fund (VEUSX): no capital gains distributions in previous 10 years;
• Vanguard Pacific Stock Index Fund (VPADX): no capital gains distributions in previous 10 years;
• Vanguard REIT Index Fund (VGRLX): capital gains distributions in 2007, 2008, and 2016 (so-called "return of capital" distributions may reduce your taxable basis, which is largely irrelevant in this context);
• Vanguard Global ex-U.S. Real Estate Index Fund (VGRLX): no capital gains distributions in previous 10 years.

It doesn't make any sense to privilege one fund structure over another for a reason that doesn't actually exist.Second, mutual fund transactions are settled at the daily net asset value, while ETF purchases and sales have to cross the bid-ask spread existing at the precise moment of sale. This is the flip side of being "able" to buy and sell shares throughout the day. In order to buy at 11 am you have to be willing to pay what sellers are asking, and in order to sell at 3 pm you have to be willing to take what buyers are offering. In extremely liquid ETF's during periods of market tranquility that friction will be trivial. In illiquid ETF's and during periods of market volatility you can pay handsomely for the privilege of trading in and out of ETF's at will.Finally, the argument for ETF's begs the question: what are you doing trading in and out of investments on a daily, let alone hourly, let alone minute-by-minute basis? If you had a great batting average, if you had finely-tuned instincts for when an index would tick higher and when it would tick lower, if you really could "read the tape," you would still be crossing the bid-ask spread over and over again, and for what? I'm no fan of so-called "behavioral" economics or "evolutionary" psychology, but you don't need to conjure up some fantasy of cheating death on the savannah to understand that the more opportunities you give yourself to fail, the more likely you are to fail. Systematically adding funds to a portfolio of low-cost passively-indexed funds (as few as possible, but no fewer), with a maximum(!) transaction frequency of once per day, is a way of methodically reducing the opportunities you have to screw up. The high liquidity and low trading cost of ETF's isn't a feature — it's a recipe for disaster.

The use and abuse of "the 4% rule"

I had a good time recently appearing on the Saverocity Observation Deck podcast with Noah from Money Metagame and host Joe Cheung.One thing that I think got a little muddled in our conversation was my feelings about "the 4% rule," which is much beloved by financial independence and early retirement enthusiasts. Rather than try to tell you I'm right and they're wrong about financing early retirement, I think it might be more useful to isolate a few different factors that go into planning a stream of retirement income.

I don't have anything against "the 4% rule" — as it actually exists

Back in the 90's some erudite finance scholars got to work on a historical asset price dataset and determined that in the overwhelmingly majority of cases a retiree could withdraw 4% of their starting portfolio value as of their retirement date, adjust the withdrawal for consumer price inflation annually, and still have a positive portfolio value at the end of a retirement period ending 30 years later.There are two key elements of this analysis to keep in mind: it's based on historical data, and it describes a retirement period that ends 30 years after it begins.To adopt such a rule to finance your retirement, you would therefore have to make two assumptions: the future will be like the past, and your retirement period will end 30 years after it begins.I don't have any clue how members of the early retirement community arrive at the conclusion that those two conditions are true. The first is a violation of the obligatory maxim that "past performance is not a guarantee of future results," and the second is absurd in light of the very premise of early retirement: having more, in some cases many more, years of retirement than the 30 that traditional retirees have had (if they get lucky).

An important aside about Social Security retirement income

Most people are aware of the importance of adjusting prices and income for inflation: the general tendency under conditions of growth for prices to rise over time. A $1 avocado today doesn't cost the same as a $1 avocado in 1970: it costs much, much less, since a dollar is worth much less in 2017 than it was worth in 1970 (no, I don't have any idea how much an avocado cost in 1970).That means to maintain the same absolute standard of living, retirement income needs to be adjusted for consumer price inflation, so that in retirement you'll be able to afford the same standard of living you had upon retiring.The Social Security Administration made the important observation that indexing retirement benefits to consumer price inflation was inadequate: a 95-year-old retiree with benefits indexed to consumer price inflation would today be able to afford the same standard of living as she had in 1987, at age 65. In other words, she wouldn't be able to afford any of the conveniences of modern life, none of which existed in 1987!Instead, Social Security retirement benefits are indexed to wage inflation, so that retirees don't fall behind as productivity and output rises. Their benefits keep up with the rise in technology and productivity that the US economy provides.

An early retirement rule that successfully provides consumer price inflation-adjusted income will immiserate you in old age

The reason the above aside was necessary is that over a retirement stretching not 30 years, but 60 or more years, a rule that provides consumer price inflation-adjusted income will not maintain your relative standard of living. A simple way to illustrate this is using the Social Security Administration's wage deflator. Earnings in 1990, just before a decade-long rise in productivity and earnings, are indexed at a rate of 2.29: each dollar earned in 1990 is worth $2.29 towards Social Security retirement benefit calculations in 2016.Meanwhile, a dollar in 1990 was worth just $1.84 in 2016 according to the consumer price index. The difference? Wage growth tracks productivity growth, which usually exceeds consumer price inflation in a growing economy. Between 1990 and 2016, wage growth exceeded consumer price inflation by 24.5%. That means across the economy at large, wage-earners became 24.5% wealthier than those who successfully tracked consumer price inflation with their investment decisions.At age 35, or 40, or 45, are you willing to lock in your absolute standard of living today? Are you willing to forego flying cars, neural implants, and vacations to Mars? The mass market innovations of tomorrow will remain affordable to people who participate in productivity growth; people whose income merely tracks consumer price inflation will fall further and further behind.

Equity investing gives you a chance to participate in productivity growth

Of course, the easiest way to participate in wage-inflation-adjusted standards of living is to earn a wage. But earning a wage, for obvious reasons, doesn't feel like retirement, let alone early retirement.The other way to participate in national, and even global, increases in productivity is to invest in the companies involved. Today, it's fortunately possible to do so through low-cost indexed investment vehicles. While workers might participate in productivity growth both through increased wage income and the increased value of their investments, one out of two ain't bad: owning a broadly diversified portfolio of stocks will at least allow you participate in one side of the global growth in output.Across a broadly diversified portfolio, the dividends that companies pay out to shareholders will rise along with profits, which reflect the companies' participation in overall economic growth. Think of this as the flip side of Henry Ford's desire for his factory workers to be able to afford Model T's: the more Model T's the workers can afford, the fewer his shareholders can afford. While individual firms strike that balance in different ways ("This is frustrating. Labor is being paid first again. Shareholders get leftovers.”), across the entire economy all profits will be split between labor and capital.

A viable plan for early retirement requires goals, not rules

Of course, as Noah, Joe and I get into during the podcast (which I really do recommend if you want to hear us discuss these and other issues in more detail), many early retirement types also belong to a kind of loosely-organized ascetic community that treats as extravagant luxuries purchases which most Americans treat as staples. It's more than possible that such people experience price inflation lower than the consumer price inflation which the federal government records.But that's a question that actually has to be answered before developing a plan for retiring radically early. A plan to simply save up 25 times your 2016 expenses and withdraw 4% per year, adjusted for consumer price inflation, will leave you relatively destitute in 30 years even if your early retirement goes exactly according to plan.

Yes, we have to talk about the Senate healthcare bill

This is a blog about self-employment and entrepreneurship, and access to affordable comprehensive health insurance has always been one of the biggest obstacles to entrepreneurship. That makes the newly-released draft of the Senate's healthcare reform bill squarely in this blog's wheelhouse, just as the House's version was back in March.First, we need to briefly review the Affordable Care Act and how it made comprehensive health insurance affordable.The majority of Americans under the age of 65 receive health insurance through their employers. The Affordable Care Act made that insurance somewhat more comprehensive by specifying the "essential health benefits" such plans had to provide, and somewhat more affordable by eliminating annual and lifetime spending limits. If, like most Americans, you work for an employer who provides your family with health insurance, those are the only changes that affected you (the original ACA also included a so-called "Cadillac tax" on especially generous employer-provided health benefits, but it has never been implemented due to repeated delays by Congress). Employer-provided health insurance was already prohibited from discriminating against employees based on their pre-existing conditions and from underwriting their premiums, and the ACA didn't change that.Then the Affordable Care Act did something unprecedented in American history: it attempted to make comprehensive health insurance affordable to people who didn't receive health insurance through their employer. It did this in 4 ways:

• Income up to 133% of the federal poverty level: expanded Medicaid eligibility. Medicaid is an extremely generous single-payer health insurance scheme with low negotiated reimbursement rates for doctors and hospitals, no premiums, and low co-pays on prescription drugs. (For reasons that are unclear to me, the District of Columbia has unusually generous Medicaid eligibility, stretching up to 210% of the poverty level);
• Income up to 250% of the federal poverty level: private marketplace health insurance plans with subsidies and cost-sharing reductions. Since only "Silver" plans are eligible for cost-sharing reductions, in this income range you're expected to choose such a plan: advance tax credits will cover most or all of your insurance premium, since they're anchored to the second-lowest-cost Silver plan on the exchange (more on that in a moment), and cost-sharing reductions dramatically lower your out-of-pocket maximum. As a personal example, while living in Wisconsin (a non-Medicaid-expansion state) I chose a Silver plan with a $200.84 monthly premium and received an advance tax credit of $200 per month. Due to the cost-sharing reduction my deductible and out-of-pocket maximum were each lowered to $500 from the plan's original $5,150 deductible and out-of-pocket maximum.
• Income up to 400% of the federal poverty level: private marketplace health insurance plans with subsidies but without cost-sharing reductions. Here you will receive federal tax credits that cap your premium at a certain percentage of your income, anchored to the second-lowest-cost Silver plan on the exchange, but you're responsible for the plan's deductible and co-payments. You can choose a Bronze plan instead and the second-lowest-cost Silver plan subsidy will go further towards paying the plan's premium, or a Gold plan and the SLCSP subsidy will cover a smaller portion of the premium.
• Income above 400% of the federal poverty level: you're responsible for paying the entire premium for the marketplace plan of your choice.

Once you understand this simple four-part structure, you can see that there are several dials you can turn up or down to affect the overall shape of the system:

• You can turn the Medicaid dial down and the subsidy dial up, reducing the number of people eligible for the Medicaid expansion and increasing the number eligible for marketplace subsidies and cost-sharing reductions. This would reduce the amount of federal expenditures on Medicaid and increase the amount spent on advance premium tax credits. Since private insurance is more expensive to provide than Medicaid (Medicaid only pays out on actual treatment, while private insurance collects payments whether or not you receive treatment), this would be somewhat more expensive to the federal government but would improve the health profile of private insurance pools, which would help steady premiums in the medium and long term, including for non-subsidized high-income enrollees. The Affordable Care Act struck one balance between those two forces, but perhaps a different balance would be better overall.
• You can turn the cost-sharing reduction dial up or down, increasing or decreasing the number of people with access to lower out-of-pocket costs. An important complaint of people who are eligible for subsidies but not eligible for Medicaid is that people with lower incomes have better health insurance, due to their lower out-of-pocket expenses. This is true: Medicaid is great health insurance, and people with Medicaid are very happy with it. You may not have heard this because doctors (who receive lower reimbursement from Medicaid) have louder voices than the poor, who actually benefit from Medicaid. One solution would be to raise the income limit on cost-sharing reductions, so more people benefit from the lower out-of-pocket costs that lower-income people pay.
• You can turn the subsidy dial up or down, increasing or decreasing the number of people with access to advance premium tax credits to pay for marketplace health insurance plans. Personally, my view is that once you've gone to the trouble of calculating the second-lowest-cost Silver plan and basing a subsidy on it, you should simply provide that subsidy to everyone, and pay for it with a progressive income tax, since means-testing is an expensive, flawed bureaucratic nightmare.

The Senate bill smashes all the dials and tips over the mixing board

With this framework we can see what the Senate healthcare bill does on each of these fronts:

• turns the Medicaid dial all the way back to zero, then breaks it off and turns it even further. Starting in 2020, states would receive no additional federal money to cover the Medicaid expansion population. Since expansion states would be responsible for covering that shortfall, most or all would end the Medicaid expansion and dump those low-income adults onto the exchanges. Then the amount provided for the existing pre-expansion Medicaid population will be linked to inflation instead of to the actual health expenses Medicaid enrollees incur.
• turns the cost-sharing reduction dial down to zero. Moving people from Medicaid to the exchanges would be a defensible policy choice if new enrollees received premium subsidies and cost-sharing reductions that kept their premiums and out-of-pocket expenses minimal. However, as explained above, that would increase the cost of covering such people, since Medicaid costs so much less than private insurance. Instead, the Senate bill ends cost-sharing reductions entirely after 2019. That means the new exchange enrollees would be responsible for the entire deductible and co-payments associated with their new private insurance plans.
• turns the subsidy dial way down. In addition to increasing the out-of-pocket costs of the lowest-income population, premium subsidies are also reduced in two key ways. First, eligibility for premium subsidies is reduced to 350% of the federal poverty level, so folks earning between 350% and 400% of the poverty level are cut off completely from premium subsidies. Second, those who continue to be eligible for subsidies will receive subsidies anchored not to the second-lowest-cost Silver plan, as they do today, but rather to the median Bronze plan. What's the difference? Across the enrolled population, a Silver plan is required to have an actuarial value of 70% (it will cover 70% of the expenses of the enrolled population), while a Bronze plan's actuarial value is just 58%.

Each of these dials produces cost savings: ending the Medicaid expansion and capping pre-expansion Medicaid reduces the cost of that program by kicking people off Medicaid; ending cost-sharing subsidies reduces the cost of enrolling low-income people on the exchanges; drastically cutting subsidies reduces the amount of aid going to low-income people by forcing them into stingier health insurance plans.Why do this? Why turn all the dials down, instead of adjusting them so they cover more Americans with more comprehensive, more affordable health insurance? Why make entrepreneurs decide between health care and investing in their business? Why stand by and watch the number of uninsured, the number of medical bankruptcies, and the amount of unreimbursed health care return to its pre-ACA levels?In order to reduce the marginal tax rate on passive investment income for the very wealthy by 3.8 percentage points.

Free Business Idea: Made in America Great Again

Yes, it's that time again! Time for me to share a free business idea you can use to become your own boss.After the first entry in this series I gathered there was some confusion over my goal in sharing these ideas. The point is not to give you ideas that will make you rich. The point is to give you ideas that will make you self-employed. I want more people to explore the possibility of self-employment, and you can either use these ideas as-is or as a launching pad for your own business.Some readers seemed to get the impression that I was offering a way to get rich quick, or attract venture capital, or go public with a billion dollar valuation. But getting rich quick is the wrong goal, on the wrong time frame. Most people never get rich, and you want to do it quick?The point of being self-employed is to be self-employed, and my free business ideas are here to help.

Made in America Great Again

If you've ever met me at a Saverocity DO or at one of my subscribers-only meetups, you may remember my hilarious, or at least chuckle-worthy, graphic t-shirts. What you may not know is that they're printed on American Apparel t-shirts, which are made by union labor in a factory in downtown Los Angeles (for now).Clothes made in the United States? Aren't those preposterously expensive, due to our onerous labor regulations and crushing minimum wages? Couldn't you save thousands of dollars buying t-shirts from Southeast Asian sweatshops?Nope. You can buy 12 graphic t-shirts printed on American Apparel for $143.88, plus $10.99 in shipping, from RoadKill T-Shirts (not a referral link, you should just shop there):Now, is $12.91 per t-shirt more than you can pay for the cheapest sweatshop t-shirt on the market? Of course. Does the cheapest sweatshop t-shirt on the market have a hilarious graphic design? Of course not.Moving on from t-shirts, I recently decided I needed a better khaki than the Dockers I've been buying for the past few years. After an hour or two of googling about, I discovered the All American Clothing Co.Think back to the last pair of casual trousers you purchased. Go ahead and pull it up on Amazon if you have to. How much did you pay? My go-to pair of Dockers is currently listed at $49.30 on Amazon, with free shipping as you'd expect.Using a 20%-off coupon code for "new" customers, and purchasing 3 pairs of these khakis to get my order over $100 in order to qualify for free shipping, my all-in cost on each pair of trousers made in the United States was $43.96:They recently arrived and after wearing them for the last couple days I can tell you they are twice as comfortable as my old Dockers. Paying less for high-quality, American-made clothing is a no-brainer.By now you may have gathered where this is going, and what my free business idea is: if American-made goods are much less expensive than you think they are, then they're also much less expensive than other people think they are. And that means you can buy them for the real price and sell them for the inflated price people think they're worth.

Nuts and bolts

The great thing about Made in America Great Again is that it lets you start as small as you'd like and scale up as you go. The prices I showed above are retail prices. To get started, you could order 20 pairs of khakis in a range of sizes, and pick your favorite 3 or 4 graphic designs and order 24 shirts in a variety of sizes and colors (you need to order multiples of 12 to trigger the biggest discount). Then hang out a shingle at your local flea market, people's market, or farmer's market. Selling the trousers at a modest profit margin of $20-30 each, and t-shirts for $10-15 more than you paid will secure you a decent profit you can roll into the next order, and give residents of your neighborhood or city access to affordably-priced US-made clothing.Once you've discovered the designs and sizes that have the most demand, you can reach out to the merchants to secure wholesale pricing and start selling more often, and at larger profit margins. This free business idea offers essentially unlimited potential for growth since most people in the United States don't have convenient access to US-made apparel.Finally, keep in mind that these trousers and shirts are just a starting point. As you expand you should add other great American-made goods, like can openers. It's your business now: what American-made goods do you think people in your community should have access to? Make it happen!

The Robinhood free stock catch (and an easy workaround)

I don't think you should invest in individual stocks, but gambling is, famously, fun, and when I want to gamble on individual stocks I use the Robinhood iPhone app, which offers commission-free trades for stocks and ETF's listed on US exchanges. If you were so inclined, you could even use it as your primary taxable brokerage account, although I don't believe you can link it to services like Mint or to roboadvisors that would help you periodically rebalance your portfolio.A little while ago they launched a referral program which gives new users and the existing user who referred them a free share of one of a few stocks. The exact stock you receive is determined randomly among the stocks they offer, which seem to currently include Facebook, Apple, or Microsoft (expensive) and Ford, Sprint, or Freeport-McMoRan (cheap). Apparently the stocks available change periodically based on share price and market capitalization.If you aren't a user, feel free to use my referral link: http://share.robinhood.com/stephes23.

Free stocks "lock up" your account's withdrawable cash

According to the terms and conditions of the free stock referral offer, "[t]he cash value of the stock bonus may not be withdrawn for 30 days after the bonus is claimed."That seems reasonable enough, since the point of the referral bonus is to get you onto the platform and trading. They want you to leave the value of your free stock on the platform for 30 days, whether you hold onto the stock or sell it and buy something else.However, they've implemented this restriction in a particularly sneaky way. As the terms and conditions go on to say:"You have to keep the cash value of the stock in your account for at least 30 days before withdrawing it. After the 30-day window, there are no restrictions on the money.

• "If we add 1 share worth $10 to your account, you cannot withdraw the $10 you receive by selling the stock for 30 days.
• "If we add 1 share worth $10 to your account and you deposit $100 dollars into your account, you can only withdraw $90 until you sell the stock bonus. After you sell the share, you will be able to withdraw an additional $10" [emphasis mine].

Read that second bullet carefully: it says that as long as you hold your free stock, up to 30 days, you can't withdraw money added to the platform from your own bank account.I've referred a couple of people to Robinhood, and just ran into this exact situation. I received one share each of SPLS (Staples) and VER, a real estate investment trust. I had previously made a few profitable bets on China, which I was ready to sell. To my surprise, when the trade settled, my withdrawable cash was $8.96 lower than the proceeds from the sale. I couldn't for the life of me figure out what had happened, until I started scrolling back through the "history" tab and spotted precisely that figure: it was the value of a share of Staples on the day I claimed my free share (I had received my VER share more than 30 days ago).The amounts involved in my case are very small, but you can imagine if you lucked into a share of Apple or Facebook that having a few hundred dollars of your own money tied up could be a real nuisance if you were counting on withdrawing it as soon as a trade settled and the cash became available.

I don't like this restriction but it's easy to work around

I had been holding on to my two free shares as a kind of laugh, since they didn't cost me anything, so I was disappointed to see that I had been punished for doing so. To withdraw the $8.96 of my own money, I would have to sell my share of Staples (now worth $8.84). Then I could reinvest the $8.84 or wait a few more weeks to withdraw it. That's a weird hassle for a platform that I've praised in the past for its simplicity and ease of use.The workaround is simple: if you plan on using Robinhood to actually gamble or invest, simply sell your free shares as soon as possible, two days after receiving them. That will tie up your own cash deposits for the shortest possible time.

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!

Everyone needs, and no one has, compounding discipline

I have written elsewhere about the importance of what I call "compounding discipline:" the deliberate choice to take the return you earn on alternative, irregular, and weird activities and reinvest them, instead of spending them. Exercising compounding discipline is essential to realizing the full benefits of those activities over medium and longer terms, but is next to impossible for humans.

Gaming the tax code can't make you rich without compounding discipline

While financial independence types have raised it to an art form, people in all walks of life engage in what I consider fairly outlandish antics in order to minimize the income taxes they pay. And these antics, more or less, work. On the extreme side, you can harvest capital gains, harvest capital losses, recharacterize contributions, or roll 401(k)'s over, under and through IRA's. Even setting those aside, ordinary people cheerfully deduct mortgage and student loan interest and claim this means they're "saving money" on their home or education.Consider the case of a single homeowner with $50,000 in income who paid $10,000 in mortgage interest in 2016. Since $10,000 is higher than the standard deduction of $6,300, the homeowner decides to itemize her deductions, and reduces her adjusted gross income from $39,650 by $3,700, to a total of $35,950. By deducting mortgage interest, the taxpayer reduces her tax liability from $5,690 to $4,933, a savings of $757.My question for you is, what does she do with the $757?The answer, of course, is that she does nothing with the $757. She never, in fact, sees the $757 unless she overpaid her taxes during 2016 (note that making interest-free loans is an odd way to get rich).

Compounding discipline turns savings into assets

I wrote back in February about bringing my adjusted gross income below $18,500 each year in order to trigger the maximum Retirement Savings Contribution Credit, and wrote:

"In 2016 my income was about $22,500, or $4,000 above the cutoff for the maximum credit, but leaving me eligible for a $200 credit. Contributing $2,500 raised that to $400, and contributing $4,000 raised it to $1,000 (I had an excess premium credit repayment in 2016 so I was able to claim my whole credit).An $800 return on a $4,000 contribution was a no-brainer for me."

Making a $4,000 contribution to my solo 401(k) saved me $800 in federal income taxes, but it didn't do anything to make me wealthier because I didn't invest the $800. I never even saw the $800! I have $800 more in my bank account than I would have without the contribution, but I didn't make a "special" $800 contribution to any of my investment accounts.But that's exactly what I would have to do if I wanted to use my tax savings to become wealthier. Likewise, a homeowner deducting mortgage interest really could become debt-free faster by applying his tax savings to his mortgage, a student borrower could use her tax savings to accelerate the repayment of her loans. That's compounding discipline, and no one does it.

It's fine not to have compounding discipline (no one does), just be realistic

Financial independence types love to talk about how important frugality is because every dollar you save will become a zillion dollars in 100 years compounding at 50% APY (or something like that). I don't dispute the math, although it will certainly be interesting to see how FIRE bloggers react when their investments start negatively compounding in the next bear market. What I dispute is that financial independence types actually exercise compounding discipline and invest the savings they achieve with their tax minimization antics.That doesn't mean the savings aren't real! But saving $1,000 on your taxes makes you $1,000 richer. It only makes you a zillion dollars richer if you invest it, which you won't. In fact, you'll never even see it.

Fish for scholarships in the deepest pools of money

One of Charlie Munger's beloved aphorisms is to "fish where the fish are." It doesn't mean you're guaranteed to succeed, but you're much more likely to succeed than trying to fish anywhere else.When it comes to college scholarships, there's a cliche so old it's practically an antique: apply for as many scholarships as possible, no matter the amount, because every little bit helps to make college affordable.I don't know the origin of this conventional wisdom, but it's so banal I'm not even going to bother to disagree with it (though I think high school students have better things to be doing than applying for $50 scholarships from their local credit union). Instead, I'm going to suggest an alternate approach.

Think like a grant applicant

When the federal government wants to research the causes of diabetes, it sends out a request for proposals for research into the causes of diabetes. All the nation's diabetes researchers submit their proposals, and the federal government selects the most promising proposals to fund.There's nothing you can do about the amount of money appropriated for diabetes research, which determines the number of proposals accepted. What you can focus on is the one thing you can control: being a diabetes researcher with a compelling research proposal. That's because no matter how much money is appropriated, only diabetes researchers are going to be approved to receive it.The same logic applies to receiving student aid: become the kind of person who receives student aid, and you're much more likely to receive it.

Research government funded educational programs: that's where the money is

Let's start with an easy one. Everyone knows that low-income college students are eligible for federal Pell grants. But did you know there's a second low-income college scholarship program, the Supplemental Education Opportunity Grant? The catch is, not every institution participates in SEOG — to receive a grant, you need to attend a participating institution. Unfortunately, 20 minutes of searching didn't yield an official list of participating programs, which means you'll need to check each institution you're interested in individually. Searching for the institution's name and "FSEOG" or "SEOG" typically works, although you can also call the financial aid office and ask directly.Now let's take it one step further. The Department of Education also runs a competition to award Foreign Language and Area Studies, or FLAS, grants to undergraduates studying "modern foreign languages and related area or international studies." To receive a FLAS grant, you need to be studying a foreign language at a school that receives FLAS funding. It's no good to study foreign language anywhere else, and it's no good to study anything else at a FLAS school. Fortunately, a list of 2014-2018 FLAS schools is available online.Finally, there are entire educational programs funded by the federal government. To continue the example of foreign language training, the federal government, at great expense, has created undergraduate language fluency programs in Arabic, Chinese, Hindi Urdu, Korean, Persian, Portugese, Russian, Swahili and Turkish. Note that while the programs are generously federally funded, they don't include scholarships for undergraduate students. That brings me back to the first point above: think like a grant recipient. The programs themselves don't have to include undergraduate scholarships, but if you can enter a language flagship program suddenly you become the work product of the grant applicants, which means they have an incentive to see you succeed, whether that means writing letters of recommendation, finding scholarship funding, or providing work-study opportunities.I've been using examples from foreign language studies since that's my own background, but opportunities exist in other fields as well: do you know about the Ronald E. McNair Postbaccalaureate Achievement Program? You have to attend one of the 151 participating institutions to participate.

Conclusion

My readers already know that you don't need "scholarships" to go to college for free: you just need to have a low enough income and attend a school that promises to meet your full financial need with grant aid. If you've decided to have a high income, or decide to attend a school that expects you to contribute to the cost of your tuition, then it may make sense to pursue scholarships. But if you're going to do so, you're going to have much more luck going from big to small than vice versa. And when it comes to "big," there are no deeper pockets than Uncle Sam's. Start there.

How can you be paid to take risks you don't understand?

Let me state right off the bat: I love alternative investments. Today there are a huge range of opportunities to invest outside of the public markets, and I've written about some of them in the past:

• Wunder Capital. You can buy unsecured notes from Wunder Capital that are paid back from repayments on solar panel installation loans.
• Rich Uncles. Rich Uncles is a non-traded REIT that invests in commercial real estate and passes the rent through to investors each month.
• Lending Club and Prosper. The original crowd-funded loan marketplaces let you contribute to personal loans made to individual borrowers.
• Kickfurther. You can contribute to inventory purchased on behalf of small merchants, and are paid back as the inventory is sold.
• Kiva. It's kind of hard to describe what Kiva does, but basically you can claim the principal repayments of loans made to individual and groups of borrowers around the world (you don't earn any interest, but can fund transactions with rewards-earning credit cards).

Why, you ask, would anyone invest in one of these vehicles? Good question!The primary reason these vehicles are attractive is that they offer the possibility of higher returns than investments on the public markets. I say they offer that "possibility," but in fact they seem to practically guarantee it in their public advertising. Wunder Capital's "Wunder Term Fund" has an "Annual Target Return" of 8.5%. What does that mean? Well, once you open an account you can read the offering memorandum, where you'll find out your notes are a "risky and speculative investments," that you "should not purchase Notes unless [you] can afford to lose their entire investment," and that the notes "are not secured by any assets of Issuer or any other party, including the Underlying Loans."A second reason you might invest in one or more of these alternatives is out of a belief that the investment is uncorrelated with your other investments. For example, you might think that homeowners will continue to repay their solar panel installation loans even if the stock market experiences a sustained drawdown.And of course many of these investments have some kind of emotional hook, like investing in environmental sustainability, women in the developing world, or small businesses.

Return is supposed to correspond to risk

When financiers and academics get together they meticulously calculate what they call "risk," which is generally used to refer to the amount an asset's price fluctuates (either up or down). Since "riskier" assets offer the possibility of loss if the owner is forced to liquidate them (since the asset might be fluctuating down at the time of sale), the owner demands a higher return on their investment.You'll sometimes hear about the "equity risk premium," which refers to the added return investors demand to hold stocks instead of less-volatile bonds, but you can call anything a "risk premium:" long-dated bonds have a "duration premium," lower-rated bonds have a "credit premium."Alternative investments pay a lot of premia! Wunder Capital's Wunder Term Fund 8.5% "Annual Target Return" logically is the combination of an issuer risk premium (Wunder Capital could go bankrupt), a borrower risk premium (homeowners could stop repaying their loans), a liquidity premium (investments can't be liquidated until the 84-month term is up), a duration premium (if interest rates on safe bonds go up in the next 84 months then the value to investors of the risky Wunder Term Fund will fall due to higher risk-free returns elsewhere), and probably a couple more I'm forgetting.

You will never know if you're being paid enough for the risks you're taking

The problem with these investment vehicles is not that they're risky. Risk is lucrative! The problem is that they are so illiquid that there is no meaningful way to determine if you're being paid appropriately for the risks you're taking.If you invest in a fund with an 8.5% "target return" that actually does return 8.5%, were you overpaid for what was, in fact, a risk-free investment? If the investment instead becomes worthless were you underpaid for what was, in fact, an extremely risky investment?It's impossible to say because there's no way to measure the fluctuation of the liquidation value of the asset, so there's no way to determine what kind of return it merits. Even the secondary market for Lending Club notes doesn't give insight into the market-clearing price of notes over time since notes themselves aren't fungible and a given note isn't always for sale (many, if not most, notes are held to maturity).

I love alternative investments, but not these

When I say "alternative" investments I mean everything outside the publicly traded markets, and it turns out there are a lot of things outside the publicly traded markets. On a recent podcast episode I heard a financial independence blogger say that he had earned $40,000 in the previous year from his blog (selling credit cards, I assume). Well, to earn $40,000 from Treasury bonds you'd need about $1.34 million worth at 2.99% APY. Writing a financial independence blog is a highly risky, illiquid asset, so you can slice and dice the return however you like: maybe he has a $670,000 asset yielding 6%, or a $335,000 asset yielding 12%. Obviously I'm not talking about return on invested capital — the website probably costs a few hundred dollars a year to run. Rather, I'm talking about the risk-adjusted, capitalized value of the income stream.The fact is, there are countless opportunities to deploy capital outside the public markets in order to earn a higher return without introducing the risks involved with the prepackaged alternatives I listed above. If you want to invest in real estate, invest in real estate (I recommend Vanguard mutual funds, but obviously you can just buy houses and stuff too). If you want to get paid by homeowners who install solar panels, become a solar panel installation technician. If you want to invest in retailing knick-knacks, become a knick-knack merchant. These aren't risk-free investments — that's not the point. Rather, these are investments where the risks are apparent and, most importantly, you receive the entire risk premium without having to divvy it up between middlemen.If you're not happy that the Federal Reserve has depressed the return on publicly traded assets, you have two options: you can invest more in the public markets to make up for lower forward-looking returns, or you can take the hint and seek return elsewhere.

Is your car a cost center or a profit center?

I've been catching up on some episodes of a podcast targeted towards financial independence enthusiasts called ChooseFI. The hosts make up for a fairly rudimentary understanding of money with a ton of enthusiasm, which makes it fairly enjoyable depending on the episode. In a recent episode they started talking about car ownership, and something clicked with me about how people both inside and outside the FIRE community understand, or misunderstand, car ownership.

Why do people own houses?

I've written before about the appeal of real estate investing to early "retirees," but that's a small part of a bigger question: why do people own houses at all? The most straightforward answer is that since people need somewhere to sleep at night and keep their stuff, they have a need for a finished product we normally call "housing."Of course there are multiple ways to purchase that finished product, the two most common being renting and owning a home. There's an important difference between the two, however: when a renter pays rent to the provider of their housing, the provider has to treat the payment as taxable income. When a homeowner provides herself with the finished product, the exchange is tax-free. Homeownership is, in this way, an extremely lucrative tax shelter: by requisitioning needed housing from assets held by the household, the conversion of the asset into income is completely shielded from taxes. In the economics literature this is referred to as "imputed rent:" the rent a homeowner doesn't charge herself, doesn't receive from herself, and doesn't pay taxes on, to live in her own home.

Why do people own yachts?

Yachting, I'm given to understand, is a wonderful hobby. Wealthy people who enjoy spending time on the water with friends and family purchase or rent yachts in order to fish, swim, or play basketball.What yachts are not, however, is a way to generate the finished product of shelter (admittedly, if I personally owned a yacht I'd probably live on it). Yachts are a depreciating asset that is used for recreation, like tennis rackets or golf clubs.

A car is an asset that converts energy into transportation

Financial independence enthusiasts typically frame the question of car ownership something like this: "is it better to pay more in rent to live within walking or biking distance of work, or pay less in rent but be forced to own a car in order to get to work?"In other words, you can tally up your total expenses for housing and car ownership under both circumstances, and the one with a lower total cost is your best bet for achieving financial independence, leaving as it does more residual income to invest.The problem with this framing is that it treats your costs as variables but your income as fixed. And indeed, this is how most people go through life: given a job, what is the most cost-effective way to build your life around that job?A different way of looking at car ownership is that on-demand, independent, self-contained automotive transportation is an extremely valuable intermediate good in its own right. Transportation to your workplace is an important input into your ability to work and receive income. Transportation can be converted directly into cash using apps like Uber or Lyft by offering rides to strangers. And transportation is an intermediate good in many other kinds of money-making schemes, like sourcing products cheaply to resell at a profit.Being someone else's employee lends itself to the first, cramped view of car ownership: "I need a car to get to work, so a car is an expense I have to incur to get paid." Being self-employed, the true value of car ownership is much more obvious.For example, when I lived in Wisconsin, I had a credit card that allowed me to earn thousands of dollar a month on certain purchases. The merchants involved were spread so far apart that I needed to use a car to efficiently travel between them each day. The gas and depreciation of the car weren't a cost center for me, they were a profit center: the car was an asset that allowed me to convert gasoline into transportation, which I used to visit merchants and earn money.Note that I wasn't forced to own a car. I chose to have and use a car because the car gave me access to income in excess of the expenses of driving and maintaining the car.

Is your car more like a house or a yacht?

Homeownership is a tax-advantaged way of securing housing.Yacht ownership is an expensive way to relax.For most people, car ownership plays both roles. Commuting to work in a car you own is tax-advantaged in the same way homeownership is: if you took a cab the fare would be taxable income to the driver, if you took a public bus the driver, mechanics, civil engineers, and others would all pay taxes on the income your fare contributes to, while you don't have to pay any income tax on the imputed fare you provide yourself with.Car ownership can also be an expensive way to relax: the closer a substitute a bus or train would be for car ownership, for example a car owner who lives directly above a subway station, the more car ownership will seem like an expensive extravagance, like yacht ownership.The question, then, is not whether you can arrange your life such that car ownership becomes unnecessary. Of course you can. The question is whether the acquisition of an asset that gives you access to on-demand, independent automative transportation is worthwhile given the opportunities you have available to convert transportation into income.

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.

Sources of taxable income in retirement

Finance hacking enthusiasts spend a vast amount of time minimizing the taxes they pay and shielding income and assets from taxation in the future. These techniques range from the commonsensical (max out IRA contributions each year) to the unhinged (name your favorite front-door/back-door/side-door/trap-door IRA strategy).How deep you decide to go into the weeds of managing your tax liability is up to you. But you're exceedingly unlikely to make the right decision if you don't have a grasp of what your tax liability is, in fact, likely to be, and it appears to me that many tax minimization antics are predicated on a grossly exaggerated idea of the tax code's actual burden.With that in mind, I want to break down three sources of taxable income in retirement and indicate what tax rate each source is likely to incur.

Earned income

There's no rule that says you have to stop working once you retire, and in fact it appears to me that most retirees of the finance hacking genus continue to earn income, whether it's through real estate management, blogging, or some other activity. This earned income is taxed at the normal income tax rates, which is to say the first $10,350 in earned income ($20,700 for married folks) is untaxed. After that, you'll pay a modest 10% or 15% marginal income tax rate on additional income until your earned income reaches mid-to-high 5 figures.

Capital gains and dividends

Long-term capital gains and dividends are taxed at preferential tax rates and it's absolutely essential to keep in mind that these are marginal tax rates, just like the ones I discussed last week. As this post clearly explains, you don't need to worry about triggering a higher tax rate on your long term capital gains by "accidentally" having too much earned income or too many realized capital gains: the high tax rates are only applied to additional dollars on the margin, so the lowest preferential rates will still apply to every dollar of capital gains that's eligible for them.The categories of earned income and capital gains interact in an important way. Look at the two categories in conjunction: a single person can earn $10,350 in earned income to "fill up" their standard deduction and personal exemption, then an additional $37,650 in realized long-term capital gains and qualified dividends at the preferential 0% tax rate. And if they earn more income or realize more long term capital gains than that, only the marginal dollar is taxed at higher rates — the first $48,000 is still tax-free.The terror of triggering higher tax rates appears to me to be based on the misconception that the higher rate applies to one's entire income. That's just not so.

Social Security

If your only source of income in retirement is Social Security (and Roth retirement savings accounts) then you'll never owe income taxes in retirement. However, under certain circumstances part of your Social Security benefits is added to your taxable income before calculating the income tax you owe:

• if your AGI plus nontaxable interest (e.g. from municipal bonds) plus 50% of your Social Security benefit is between $25,000 and $34,000, you may have to add 50% of your Social Security benefit to your taxable income;
• if it's above $34,000, you may have to add 85% of your Social Security benefit to your taxable income.

Avoiding the tax on Social Security benefits is one reason folks are so eager to put as many of their retirement assets as possible into Roth accounts, withdrawals from which don't trigger the tax on Social Security benefits. And indeed, if you have earned income and taxable capital gains and Social Security income, you're more likely to owe some tax on your Social Security benefits.However, it's worth taking a look at the case of someone with just Social Security benefits and taxable capital gains. In this case, if your taxable long term capital gains plus half your Social Security benefit requires you to report half your Social Security benefit as taxable income on Form 1040, line 20b, the federal income tax will apply first to that amount, meaning you'll owe no federal income tax on up to $20,700 in Social Security benefits, and then no long term capital gains taxes on the same $37,650 in long-term capital gains we calculated above.In other words, even if your Social Security benefit is taxable, you still might not owe any taxes on it.

Conclusion

There are a lot of common sense strategies, and some esoteric strategies, for maximizing the assets available to you to fund retirement, whether you decide to retire early, late, or right on time, and my intention isn't to say "tax planning doesn't matter." Tax planning can matter.However, if you don't have at least a preliminary grasp on what you're likely to actually owe in taxes, then you are vanishingly unlikely to make smart decisions about how to invest, where to invest, and most importantly, how much time to spend researching your options!

Why "narrowly focused" middle-class tax cuts overwhelmingly benefit the wealthy

Since the White House finally got around to announcing the outlines of their tax reform plan today, I want to briefly address an issue that's generally ignored in discussions of income tax rates and brackets.

Marginal tax rates mean you pay taxes at lots of different rates

You often hear as shorthand that "the wealthy pay a 40% income tax." That's exactly wrong: the wealthiest Americans pay a 39.6% marginal income tax rate. If a single person reports a taxable income of $418,401 in earned income, they pay a 39.6% income tax...on exactly one dollar.On the first $470,700 in taxable income, the person pays 10% on $9,325, 15% on $28,625, 25% on $53,950, 28% on $99,750, 33% on $225,050, and 35% on $1,700. Only after paying all those tax rates does our single taxpayer begin to pay 39.6% on additional dollars of income.

Tax cuts disproportionately benefit people who fill up each tax bracket

Let's say that we decide the middle class is working longer hours for less pay and that the solution is a tax cut for hardworking middle class families (insert gagging sound effect here). $50,000 in taxable income seems like a good place to target our middle class tax cut, since that would imply about $60,400 in earned income, a solidly middle-class income. $50,000 in taxable income falls in the 25% tax bracket, so what happens when we cut the 25% marginal tax rate all the way down to 15%?Our solidly middle-class taxpayer saves $1,205 in federal income taxes: 10% of the amount of taxable income in excess of $37,950.Meanwhile, how much would someone making $100 million in earned income save? They'd pay $5,395 less in federal income taxes, 10% of the entire $53,950 bucket of earned income.And remember, this is the outcome of a federal income tax cut narrowly focused on middle-class taxpayers.But in this day and age, who can survive on $50,000 in taxable income? Let's raise the threshold for our narrowly focused middle-class tax cut all the way to $100,000, which puts our single middle-class taxpayer in the 28% tax bracket, and we'll cut the 28% tax bracket down to 15% as well.Now our solidly middle-class taxpayer gets to save the entire $5,395 in federal taxes our titan of industry saves, plus an extra $1,053: 13% of her taxable income in excess of $91,900.But sure enough, our hedge fund manager wins again, saving $12,967 (13% of $99,750) plus the $5,395 saved in the lower bracket.So much for narrow focus.

The only way to narrowly focus a middle-class tax cut is to raise marginal tax rates on higher incomes

This is a mechanical outcome of the nature of a system of progressive marginal income tax rates, and there's nothing that can be "done" about the savings the wealthy get from cuts to marginal tax rates in the lower income tax brackets.On the other hand, there's no secret to "narrowly focusing" a tax cut on the working or middle classes: you recoup the money saved by high earners through higher marginal income tax rates on the upper brackets.To recoup the $5,395 saved by high-income taxpayers by cutting the 25% rate to 15%, you can raise the 33% bracket by 2.4%. To recoup the $12,967 saved by lowering the 28% bracket to 15%, you could raise the 33% bracket by 5.8%.Note that this would still constitute a net federal income tax cut on everyone with taxable income up to $416,700, since only at that point will the entire tax savings in the lower brackets be recouped.

The idiocy of an "across the board" tax cut

To be clear, I'm not in favor of any of the above proposals because I don't think our middle class is suffering under the cruel yoke of an expropriating tax code. But even if you think taxes should be lower, even if it's out of pure greed, you have to understand that the wealthy receive a federal income tax cut when tax rates on lower incomes are lowered, even if the marginal tax rate on higher incomes is unchanged.You do not need an "across the board" in order to cut everyone's taxes. Cuts exclusively to the marginal tax rates of lower tax brackets not only benefit high-income taxpayers, they disproportionately benefit high-income taxpayers.

Financial independence, early retirement, and real estate

If you have your eyes open, one of the first curious things you notice about the "FIRE" community (Financial Independence, Retire Early) is their fixation on real estate. For example, Mr. Money Moustache "retired" from his job as an engineer in order to become a residential property manager, writing that "many of us consider property ownership to be a key part of our early retirement strategy." One of the very first real life conversations I had with a FIRE enthusiast very quickly turned to his plans to buy up residential real estate in Memphis. And of course the Saverocity Forum has extensive threads on the promise and peril of real estate management.Residential real estate is a fairly curious asset class. It's a depreciating asset (the structure) resting on top of a commodity (the land). Meanwhile, converting the asset into a revenue stream requires active management. It doesn't have to be actively managed by the owner, of course: there are residential real estate management firms that will handle tenant screening, maintenance, and so on for a fee. But whether it's managed by an amateur or a professional, the size and steadiness of the revenue stream ultimately depends on the competence of the management in addition to the quality of the structure and desirability of the land.Based on everything I've seen and heard, here are four things that I think make residential real estate appealing as an investment to people in the finance hacking and FIRE community.

Ease of leverage

If you simply want to invest in real estate as an asset class, Vanguard offers mutual funds that give you exposure to domestic (VGSLX) and ex-US (VGRLX) real estate investment trusts. The Admiral shares have expense ratios of 0.12% and 0.15% and have non-SEC yields of 3.92% and 4.73%, respectively (I had to manually calculate the yield on the ex-US fund so it's as non-SEC as it gets).I recently listened to a podcast episode with someone who decided to coin the term "house hacking" to describe buying multi-unit properties, living in one unit and renting out the rest of the units to cover his mortgage payments. One of his key concepts is "the 1% rule," whereby you should aim to buy properties where the monthly rent is 1% of the property's purchase price. If you bought a property outright according to this rule, you'd earn 12% annually, minus taxes, maintenance and vacancies.But if you buy the property with a 20% down payment, your return on equity is suddenly five times that (minus the interest on the 80% of the purchase price you borrow).The key advantage of doing so is not the leverage itself: you can buy stocks and bonds on margin if you're so inclined. The key advantage is that the underlying asset is never marked to market! Even if you found a broker willing to let you buy VNQ or VNQI (the ETF equivalents of the mutual funds mentioned above) with 20% equity, even a modest decline in real estate prices or change in interest rates would wipe out your equity and trigger a margin call. In the residential real estate market, you can take advantage of rising real estate prices through cash-out refinancing, but even if housing prices decline you'll never lose your shirt as long as you keep making your mortgage payments (which are currently being offered on very generous terms).

Value of specialized knowledge

The stock market is a brutal place to try to apply specialized knowledge. You can know everything there is to know about solar panels, electric storage technology, and self-driving cars, and it still shouldn't give you the slightest hope of guessing whether Tesla's stock will go up or go down, or whether it will do so tomorrow, next month, or in a decade.The residential real estate market, on the other hand, is the kind of place where a person feels they should be able to fairly easily apply their knowledge, experience, and intuition. Everyone knows the neighborhoods in town which are becoming more popular and those which are becoming less popular. Everyone knows where students and young families like to live, and where drug dealers and vagrants gather. You can flip open the local newspaper and see where hip new bakeries are opening and where storied local institutions are closing because of lack of foot traffic.All this means that a person feels like they should be able to pick the "right" properties to invest in even if they're fully aware they're incapable of picking the "right" stocks to invest in and sensibly choose a low-cost indexed portfolio instead.

Tax advantages

No matter how pure your intentions, nobody stays a residential real estate investor for long before they also become an amateur CPA. If you'll allow me to quote at length from the Saverocity Forum:

"Now seeing that we have a positive cash flow on the year most people might think that we're due to owe uncle same based on this cash flow. What most people don't realize is that when you own rental real estate, you are required to depreciate the cost of the property and apply that towards your income/expenses on your Schedule E(real estate profit/loss tax form). Without getting too complicated this means that a portion of the property value(not including the land it sits on) gets to count as an expense over the next 27.5 years of your ownership. So while you get the benefit of claiming an additional expense(albeit an invisible one) on your profit/loss sheet, this does effect the basis value of the property for when its time to sell. For now, based on the property value I get to claim $3000 of depreciation for the year. If I count this against the 1080/year in cash flow, I have a $1920 tax loss on the year. The nice thing about losses from your Schedule E is that they can be counted against your primary income(as long as your income is below 150K, between 100K-150K the amount of losses you can claim against income is phased out and above 150K you can only carryover those losses to use against future capital gains from sale of property). In this case, assuming I am able to claim the loss against my income, that $1920 loss could equate to about a $500 in tax savings(assuming a 25-30%ish tax bracket)"

Obviously I don't have anything against CPA's, amateur or professional, but it's hard to argue that becoming an amateur CPA looks anything like "retirement." To me, it looks like spending a lot of time poring over the tax code making sure all your T's are dotted and all your I's are crossed.Nonetheless, being able to deduct depreciation against earned income gives middle- and upper-class taxpayers a big incentive to actively invest in real estate, essentially supplementing their rental income with subsidies in the tax code.

The triumph of the material?

Together, I think the three features above explain 85% of the appeal of investing in residential real estate for finance hackers and FIRE enthusiasts, and if you asked 85% of them they would say that those features explain 100% of the appeal.But I think it's worth mentioning, at least, that there's something potentially uncomfortable about "just" owning a slice of the S&P 500, or the total US stock market, or the total world stock market. In fact, it might not feel like you own anything at all when the only thing you can see are digits bouncing up and down on your quarterly brokerage statements.Owning real estate isn't like that. If you manage your own properties, you can drive by and see them every day. You have deeds that are recorded in government offices that meticulously spell out the boundaries of your property. You can mow the lawn, lay down new pavement, replace the appliances. The properties, in other words, exist in your own material world, and I think some people find comfort in that above and beyond their tax-advantaged, highly-leveraged, compounding-revenue-stream-generating residential real estate business model.

Solo 401(k) accounts from Vanguard, with beneficial illustrations and calculations

One of the great advantages of being self-employed is the ability to open and manage your own small business retirement account. Employed people have to either take or leave their employer's 401(k) or 403(b) plan offerings, regardless of the quality or cost of the funds it offers, while the self-employed get to choose their own plan provider and pick exactly the assets they want to invest in. Naturally, many choose Vanguard, and since I recently opened a solo 401(k) with them, I thought it would be useful to share my experience.

Opening an account (1): selecting funds

To open a solo 401(k) with Vanguard you have to download and print the "Individual 401(k) kit for employers" from their small business website. The kit is pretty straightforward, although there are a few sections I want to highlight.In section 3 of the New Account Form you have the option of opening either a traditional, pre-tax account, a Roth, post-tax account, or both.If you open a pre-tax account, you have to select at least one fund to receive your contributions:Likewise if you open a Roth account, you have to select at least one fund:There's a $20 annual fee charged per fund held in each account, so if you open both accounts you'll have to pay $20 per fund each year, even if you hold the same fund in both accounts. The $20 fee is waived if you have $50,000 in assets across all your Vanguard accounts (so-called "Voyager services").Note that Solo 401(k)'s do not have access to Vanguard's lower-cost Admiral shares. That matters for two reasons: first, you'll pay slightly more for funds that you currently own as Admiral shares. That's bad. But it also matters because when people compare the fees on Vanguard's all-in-one funds to a "do it yourself" portfolio of Vanguard funds, they are usually comparing the all-in-one fund costs to the cost of Admiral shares. But if you don't have access to Admiral shares, that's not the right comparison.For example, Vanguard 500 Admiral shares have a hyper-low expense ratio of 0.05% — a third the cost of a Target Retirement or LifeStrategy fund. But Vanguard 500 Investor shares, the ones you have access to in a Solo 401(k), have an expense ratio of 0.16%! Suddenly the comparison doesn't seem so compelling, particularly if it comes with the added $20 per-fund fee and the additional hassle of periodic rebalancing. That's one reason I chose the LifeStrategy Growth fund for my 401(k), as you'll see below.

Opening an account (2): designating beneficiaries

Vanguard has what appears to be an extremely straightforward system for designating beneficiaries. First, you select your primary beneficiary:Then, you select your secondary beneficiary:This is not, in fact, an extremely straightforward system. As my primary beneficiary, I selected "To the person I'm married to at the time of my death," and as my secondary beneficiary I selected my partner. About a week later I got a call from Vanguard to clear up their confusion. It turns out that in spite of all logic and reason, you're only supposed to select "To the person I'm married to at the time of my death" if you're already married, which seems to me to defeat the purpose of such a checkbox, but what do I know?

Making contributions

Once Vanguard has accepted your plan documents, you'll receive a barrage of mail from them, including information on configuring your online account administrator access. Unlike the fairly powerful personal investor interface, the small business interface is extremely primitive:When you select "Make a contribution online" you're first asked which tax year the contribution is for, and then taken to this screen:The "Individual 401(k)" contribution fields are for pre-tax contributions, which can be made as employer or employee contributions (more on that in a moment). The "Individual Roth 401(k)" contribution fields are for post-tax contributions, which can only be made as employee, not employer, contributions.

Contribution limits

Solo 401(k) contributions limits aren't hard, they're just complicated. I think the best way to think about them is in three parts:

• 100% of net self-employment income, minus half the self-employment tax, up to $18,000. If your net self-employment income from Schedule C is less than $19,491, then you can contribute 92.35% of your net self-employment income in the left-hand "employee" contribution columns. You can split that amount between the pre-tax Individual and after-tax Roth fields however your own tax needs dictate.
• 25% of your remaining net self-employment income, minus half the self-employment tax. If your net self-employment income is $30,000, then after deducting half the self-employment tax ($2,295), you're left with $27,705. You can contribute 100% of the first $18,000 in the left-hand "employee" column and 25% of the remaining $9,705 ($2,426) in the pre-tax right-hand "employer" column.
• $54,000. The most you can contribute in total to a solo 401(k) plan per calendar year is $54,000 in 2017. To make $54,000 in solo 401(k) contributions you'd need to make $175,419 in net self-employment income. Deducting half the self-employment tax would leave you with $162,000, and after contributing the maximum $18,000 in employee contributions you'd be left with $144,000, 25% of which is the $36,000 in employer contributions you need to reach the maximum.

Note that you do not need to actually make contributions in this order!This is simply the order that will maximize your contributions for a given level of self-employment income. You can reach the $54,000 contribution cap exclusively from employer contributions. However, the required net self-employment income is much higher: $54,000 is 25% of $216,000, which is almost $234,000 in net self-employment income after the self-employment tax is added back in.And of course if you want to take advantage of Individual Roth 401(k) contributions those can only be made as employee, not employer contributions.

Adding and exchanging funds

An important benefit of Vanguard retirement accounts is that it's possible to contribute to funds without meeting the minimum initial investment requirement. In other words, you don't need to contribute $3,000 in order to purchase shares of a fund that otherwise has a $3,000 minimum investment.However, this benefit is only extended to contributions processed through the small business investing portal. When you log into your personal investor account, you'll see your 401(k) account(s) there but won't be able to transact the funds in those accounts until you meet the minimum investment requirements.If you want to add a new fund to your 401(k) but don't want to exchange shares in an existing fund, Vanguard can do this over the phone if you call 1-800-205-6189. The reasons for doing so might be to trigger the minimum investment waiver for future contributions to the account, or simply to diversify your existing funds.

Conclusion

Solo 401(k) plans are a way to defer taxes on a substantial amount of self-employment income and, in Roth accounts, potentially avoid taxes entirely by making Roth contributions in years when you are able to pay little or no federal income tax.Vanguard's Solo 401(k) kit makes it just about as easy as possible to get started, given the legal requirements involved. And even if you make a mistake when designating your beneficiaries or selecting funds, their phone personnel have been extremely capable every time I've had to speak with them (including researching this post).And of course, best of all a Vanguard Solo 401(k) gives you access to Vanguard's suite of low-cost mutual funds!