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

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

Asset allocation, asset location, and asset selection

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

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

Most federal interest payments are exempt from state income taxes

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

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

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

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

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

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

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

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

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

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

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

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

Split IRA's between spouses and heirs

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

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

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

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

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

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

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

I knew everything about the ACA, lost my insurance, and got sick

Become a Patron!Since I've been self-employed almost as long as the Affordable Care Act has been law, I've had lots of opportunities to learn the finer points of the law. At its best, the ACA works as the gentlest possible nudge for folks who rely on employer-provided health insurance to start their own businesses, knowing they'll have access to affordable, comprehensive health insurance, without exclusions for pre-existing conditions.In the past I've written about triggering "special enrollment periods" by moving to a different zip code. In Wisconsin, which under Scott Walker refused to expand Medicaid, I paid $0.12 per month in premiums for a Silver plan with no co-pays or deductibles.The District of Columbia has what I call "Super Medicaid," which covers adults earning up to 233% of the federal poverty line, far higher even than in other Medicaid expansion states. Enrolling was a bit of a hassle, but after harassing them on Twitter about their terrible IT, I was eventually enrolled and received my insurance card in the mail a few days later.Besides a couple of teeth cleanings, I never used my insurance, but knowing I was insured meant I knew an accident, injury or illness wouldn't bankrupt me. Since it's Medicaid, it wouldn't even cost me anything.

I lost my insurance — 6 months ago

At the beginning of the year we all receive a slew of tax documents. At a minimum we expect W-2's for wage income, 1099's for interest, dividend, and miscellaneous payments, and health insurance verification documents to prove we were insured the entire preceding year.Imagine my surprise when, a few weeks ago, I received my health insurance verification document from DC and the little black X's abruptly stopped in July. I'd been uninsured for the last 6 months and no one had told me.After some research, I eventually started to piece together what had happened. Like most states, the ACA is administered in DC through two separate programs, the "ACA (or Obamacare) exchanges," which we call "DC Health Link," and Medicaid, which we call "DC Healthy Families." I was enrolled in Medicaid — DC Health Families. But since I had started my enrollment — all the way back in 2016 — through DC Health Link, my renewal material was being sent to that website, instead of to the Medicaid website. Since I wasn't enrolled in an exchange health plan, I never logged into that site, and never got the renewal notification. Since I never completed the renewal application, my insurance was cancelled, and the notification of that was also sent to the DC Health Link website — again, a site I have not used since August, 2016.

Enrolling again was easy

Fortunately, since I know how the law works, it wasn't a big deal to complete another application. Since I'm earning a bit more these days, and in order to avoid this mayhem in the future, I decided to enroll in an exchange plan this time, estimated my income at the level to maximize the possible subsidy, and selected a plan for coverage to begin March 1. I'd still rather be on Medicaid, but private coverage won't be the end of the world, and it might get me into a better hospital if something serious happens to me.

Then I got sick. Then I got sicker.

About three weeks ago I started to develop a pretty unpleasant cough. It wasn't horrible, but it was certainly annoying. I started warning people on the phone that I might have to go on mute if I had a particular nasty fit. It would come and go, I tried to stay hydrated, drank a little Robitussin here and there to see if I could bring up whatever was irritating my lungs.Then it started keeping my partner up at night. I thought as long as I felt fine, and it was just a cough, it would have to clear up eventually. I promised I'd go to the doctor as soon as my insurance kicked in on March 1.Then it started keeping me up at night. I couldn't sleep for more than a few hours without waking up trying to cough up something I couldn't cough up. I couldn't sleep at night and I was useless during the day.And on Wednesday, something finally clicked. I didn't "have a cough," I was sick. I knew I needed medical care. But where on Earth was I going to get it? I don't have insurance, I don't have money, and I didn't know what the hell I'd contracted. I (half-) jokingly started praying it was coronavirus so the National Guard would quarantine me and treat me for free.So, like any right-thinking millennial, I started Googling free health clinics.

There are no free health clinics in DC

My mom volunteers at a couple of free health clinics, and my brother runs a network of community health centers, so I had vaguely assumed in a large, diverse, working-class city like DC there would be 20-30 walk-in clinics around town and I just needed to find which ones were open on Wednesday mornings. I knew I'd be waiting around for a few hours, but since my body was rapidly shutting down, I figured I didn't have anything better to do.It turns out, there are no free walk-in clinics in DC (or if there are, they keep a pretty low profile). This is partly a consequence of how successful Medicaid expansion has been: since all low-income people are covered by Medicaid, and all high-income people are covered by exchange plans or their employers, there are relatively few uninsured people in the District.I just happened to be one of them.

So I went and stole some healthcare

My mom has always told fond stories about living in DC and working at the Columbia Road Health Services clinic, which was a Christian mission attached to the nearby Potter's House and Christ House. The clinic now belongs to a big health insurance chain, but since it's just down the street, I thought I'd try my luck. I walked in, said I was sick, and asked if they could help me.As it turned out, they took really good care of me. It's not "fun" seeing a doctor, but they took my vitals, listened to my chest, listened to me describe my symptoms, gave me something called "breathing therapy" (not highly recommended) and diagnosed me with "community-acquired pneumonia." The doctor called in a prescription for antibiotics and gave me a "GoodRx" discount card (I ended up paying $17 for a five-day supply at the CVS down the street).Then I walked out of the clinic. They didn't ask for money and I didn't offer.

Interlude: "Walking Pneumonia"

In September, 2016, there was a brief round of news coverage when Hillary Clinton had to be helped into her vehicle after attending a memorial service at Ground Zero. She was later diagnosed with pneumonia; she had simply continued to campaign until she was finally sidelined by it for a few days.This almost exactly mirrors my own experience. I kept working for the last few weeks through a "nasty cough" until the moment when it clicked for me that I needed help. And at that moment, it was inescapable.I realized the real issue was giving myself "permission to be sick." It's a funny way to describe the feeling, since obviously most people don't want to be sick — why would they give themselves permission to feel bad? But the second I acknowledged I was really sick, I realized I wasn't "just coughing." My body hurt, my head hurt, I was sweating and freezing, and I was exhausted. Basically, once I gave myself permission to be sick, I finally started putting myself in a position to recover (the drugs helped).

What's next?

I'm a bit curious about this myself. I assume eventually the clinic is going to send me a bill, but since healthcare prices are completely imaginary, I simply have no way of guessing how much it's going to be: $200 or $10,000?Besides the obvious (money is expensive), one reason it's relevant is that Medicaid allows retroactive coverage for medical expenses up to 3 months before enrollment. That means if I can manipulate my income sufficiently, I could apply for Medicaid once I get the bill and have them cover the expense "as if" I were insured when I received treatment. That would be exceptionally annoying since I just completed my ACA exchange enrollment, but it's one option.Another option is simply declaring bankruptcy in order to discharge the medical bill. Financially speaking this wouldn't be a big problem since virtually all my assets are in retirement accounts that are protected in bankruptcy, but it would obviously be a big inconvenience, if for no other reason than that I earn a lot of rewards with my credit cards, which would presumably be closed after a bankruptcy filing.

Conclusion: Medicaid for All

The Affordable Care Act was a remarkable achievement in a country that has given up on remarkable achievements: it virtually eliminated uninsurance among low-income people in Medicaid-expansion states (and would have eliminated it entirely if not for the Supreme Court's intervention); it gave entrepreneurs and sole proprietors access, for the first time, to affordable comprehensive health insurance; and it provided important guarantees of care to workers covered by employer-provided insurance (guarantees that would be even more valuable if the Supreme Court hadn't proceeded to undermine them).But the fact is, despite knowing every nook and cranny of the law, the ACA left cracks big enough for even me to fall through. The law has provisions for people who earn more money to transition from Medicaid to the exchanges. It has provisions for people who earn less money to transition from the exchanges to Medicaid. But it has no provisions for someone unknowingly disenrolled from Medicaid, who enrolls in an exchange plan, and needs medical care in the intervening 20 days. How could it?The answer, the next step, has always been as simple and obvious as it sounds: Medicaid for All. No premiums, no deductibles, no co-pays. No retroactive enrollment, no prospective enrollment, no income verification, no residence verification, just Medicaid. For. All.Become a Patron!

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

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

There are serious arguments for a wage replacement model

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

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

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

Wage replacement is a complicated, intrusive policy design

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

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

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

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

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

Conclusion

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

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

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

The (weird) optionality of Series EE savings bonds

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

Some unique features of Series EE savings bonds

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

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

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

A binary interest rate

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

Annual interest rate resets

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

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

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

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

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

Just a few more complications

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

Conclusion

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

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

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

What is the QBI deduction reduction?

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

What's the problem

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

Conclusion

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

Smart people overestimate the difficulty of maximizing the interest earned on savings

Become a Patron!I've been using high-interest rewards checking accounts and other "gimmick" accounts for so long, I had somehow convinced myself that everybody else was using them, too. So imagine my shock listening to a recent episode of the Milenomics Squared podcast, hosted by two of the savviest guys I know, when they both essentially said, "it seems like too much work."If Sam and Robert can't be bothered to set up high-yield accounts, what hope do the rest of you have? So for their sake and yours, here is my extremely simple, straightforward guide to earning double or triple your current interest rate on totally liquid, federally-insured cash savings.

Find a high-interest rewards checking account

Many big cities have credit unions or banks offering their own branded version of rewards checking accounts, but the place I usually start is depositaccounts.com.Select the highest-interest account you're eligible for (hint: you're probably eligible for all of them), and verify the interest rate is still correct.I use Consumers Credit Union's Free Rewards Checking since they've historically offered the highest rates (5.09% APY on up to $10,000), but that's subject to change, so while I'll use it as my example below, don't interpret that as a permanent recommendation or endorsement.

Find the requirements to trigger the highest interest rate

I know Consumers Credit Union's requirements best, but they're all pretty similar:

• set up electronic statement delivery
• direct deposit $500 per month
• make 12 signature debit transactions totaling $100 per month
• spend $1,000 on one of the bank's credit cards

Open the account

Each bank and credit union will have its own eligibility requirements; in the case of Consumers Credit Union, I had to join the "Consumers Cooperative Organization," which has a one-time fee of $5 and is integrated into the credit union account-opening process.Many credit unions and some banks will perform a "hard" credit pull during account opening, so ideally you'll also want to open a linked credit card at this point in order to hopefully combine the two applications on your credit report.This may also be an opportunity to fund your new accounts with an existing credit card in order to earn free credit card rewards, typically capped at a few thousand dollars. If you take this route, be sure to set the cash advance limit on the card you use to $0, in order to prevent any fees or interest charges from sneaking in.

Automate meeting the requirements

Once your new accounts are opened and you've received your debit and credit card, it takes about 10-15 minutes to automate meeting the account requirements.

• Set up electronic statement delivery.
• Change your payroll direct deposit to send the required minimum deposit to your new checking account (e.g. $500 if monthly, $250 if biweekly). Most modern payroll processors are happy to chop up your paycheck into as many accounts as you request.
• Configure 11 repeating monthly payments of $1 each to an eligible payee through a service like Plastiq. If you are new to Plastiq and enroll using a referral code (mine is 532426) you can receive "Fee-Free Dollars" that make your first $500 in payments free. If you don't have Fee-Free Dollars, you'll pay $0.01 per payment, so this would cost up to $0.11 per month in that case.
• Configure one repeating monthly payment of $89. This will bring your total monthly debit card purchases to the necessary $100.
• Finally, spend $1,000 per month on your new credit card. If you decide to use Consumers Credit Union, their Visa Signature Rewards card is the best option because it offers bonus points on up to $6,000 in annual grocery store spend.

Profit!

The total, maximum cost of this technique annually is perhaps 10-15 minutes of your time and $12 in Plastiq fees (if you don't have and can't earn any Fee-Free Dollars), plus any purchase and liquidation fees if you meet the $1,000 monthly credit card spend requirement with manufactured spend, minus the value of any rewards earned on that spend.The total interest earned on the maximum high-interest balance of $10,000, at 5.09% APY, is $509. This sum is taxable, but so is the interest earned on low-interest accounts and bank account signup bonuses, so this is truly an apple-to-apples comparison.Note that if you want to earn a higher interest rate on more than $10,000, this procedure is quite scalable as you move down the list of high-interest accounts and discover additional options. And, of course, spouses and partners offer additional account-opening opportunities.

Conclusion

Hopefully this post has convinced you how easy it is to maximize the interest you earn on your savings.Sadly, I have no confidence that it has convinced you to actually do so. And that, dear readers, is the blogger's burden to bear alone.Become a Patron!

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

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

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

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

A tax on current income can't fix past errors

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

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

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

A VAT is clumsy, ineffective, and un-American

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

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

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

Biden is wrong about Social Security, but so is everybody else

Become a Patron!In a bit of a surprising turn in the lead-up to the Iowa caucuses, former Vice President and Delaware Senator Joe Biden has finally come under sustained criticism for his career-long advocacy for cuts to Social Security.I'm not sure why his rivals didn't elevate this criticism earlier, but it's obviously correct: he has advocated and voted for cuts to Social Security. During his second term in the US Senate, he voted for the Social Security Amendments of 1983, which increased the full retirement age gradually from 65 to 67, a cut in benefits for the majority of workers who claim their old age benefit at age 62 (by increasing the reduction in their old age benefit), and also cutting benefits for those who delay their retirement until age 70 (by reducing the number of delayed claiming credits they earn).I know my readers are more sophisticated than average, but I want to review this because it's important to understand the mechanism at work here. Workers with 40 Social Security credits (roughly 10 years of reported work history) are:

• eligible to claim a reduced old age benefit at age 62;
• eligible to claim the "primary insurance amount" of their old age benefit between age 65 and 67, depending on their year of birth;
• and eligible to claim an increased insurance amount between their full retirement age and age 70.

Those with a full retirement age of 65 filing at age 62 received a maximum reduction of 3 years (if they filed at age 62) and a maximum increase of 5 years (if they filed at age 70). By raising the full retirement age to 67 for my generation, the Social Security Amendments of 1983 increased the maximum reduction to 5 years, while reducing the maximum increase to 3 years.But this has no connection whatsoever with the age at which people stop working, or increased life expectancy, or improved health, or anything of the kind. It was purely a cut to Social Security old age benefits: those who claim their old age benefit at age 62 receive less money, and those who claim their old age benefit at age 70 receive less money. Everybody receives less money, because it's a benefit cut, which Biden advocated for and voted for.

Social Security is already "means-tested" at the top

One of the strange defenses that has been floated for Biden's career-long support for cuts to Social Security is that wealthy, high-income people don't depend on Social Security in retirement, so "means-testing" Social Security old age benefits is a common-sense way to shore up the program's finances. Here, we run into a problem, since Social Security old age benefits are already means-tested for high earners.Old age benefits are subject to a flat and arbitrary cap. This is the purely mechanical result of the limit on earnings subject to the Social Security portion of the payroll tax. The Social Security Administration makes it deliberately difficult to calculate this, but if you fiddle around with the "Quick Calculator" long enough you can get it to spit out the facts: someone reaching age 62 in 2020 with a 35-year history of maxing out their Social Security earnings is eligible for the following old-age benefits.That's because the annual amount of earned income subject to the Social Security portion of FICA, and included in the old age benefit calculation, is capped at the amounts shown here (35 years):So the maximum old age benefit to the highest-earning American, in 2027, will be roughly $47,364 per year. That's more than I make, but it's hardly a princely sum.

Social Security is also "means-and-compliance-tested" at the bottom

In the Year of our Lord 2020, we all know what means-testing really means: cutting off benefits for those who can't or won't comply with increasingly onerous reporting requirements. Fortunately, if you're a sadist, Social Security old age benefits are also means-tested at the bottom. To earn the maximum of 4 annual Social Security credits in 2020, you need to earn about $5,640.Or, more precisely, you or your employer needs to report about $5,640 in earnings. If your employer fails to report your earnings? No credits. If your employer misclassifies you and you fail to report your earnings? No credits. Whatever you think about the quality of wage-and-hour compliance in the United States, no one thinks that it comes close to 100%.Even worse, the compliance rate is lowest for the lowest-income earners, which is especially problematic for a system like Social Security in which old age benefits can only increase until 35 years of earning history are accumulated (at which point the lowest-earning years start to roll off). As I've described in the past, since reported earnings are wage-inflation-adjusted, the earlier you earn them the more they contribute to your earnings history as they have more time to appreciate along with wage growth.

Social Security is also "means-tested" in the middle

So high-earners already have their old age benefit capped by the earnings limit, and low-earners have their old age benefit restricted by their employers' compliance with wage reporting. What about those in the middle?They get to enjoy the phased-in taxation of Social Security! It turns out, 0%, 50%, or 85% of your old age benefit may be taxable, depending on your adjusted gross income. As I've explained before, just because your old age benefit is taxable doesn't mean you owe any tax on it — it may be taxable but the tax owed is $0.For those with some earned income, some taxable income, and some required minimum distributions from IRA's and 401(k)'s, their old age benefit is already "means-tested:" the more they earn from those sources, the more they owe in taxes on their old age benefit.

This is, obviously, madness

There's no secret if anybody came along and felt like "fixing" Social Security:

• Remove the earnings cap on the Social Security portion of FICA;
• Make capital gains and other business income subject to FICA;
• Improve enforcement of and compliance with wage and hour laws;
• and make all Social Security benefits subject to ordinary income taxes.

But nobody wants to "fix" Social Security. The entire project of Social Security "reform," from Joe Biden's vote in 1983 to the present day, is driven by the desire to cut benefits, because the people pushing reform don't believe in Social Security.But if you do believe in Social Security, all you have to do is keep fighting for it, now and forever.Become a Patron!

Direct indexing and shareholder democracy

Become a Patron!The late Paul Volcker is famously said to have quipped that he hadn’t seen a worthwhile financial innovation since the ATM, which makes him slightly more cynical than even I am. In fact, I think we're on the brink of a real revolution in shareholder democracy.

Mutual funds and direct ownership are competitors

Vanguard has offered low-cost, commission-free, passively-managed mutual funds my entire adult lifetime, which makes it easy for people of my generation and younger to dismiss the seriousness of the problem Jack Bogle solved. After all, stockbrokers and mutual funds long predated Vanguard, so a savvy investor always had the option of either opening a brokerage account with a local provider and buying an appropriately diversified basket of stocks and bonds, or selecting an appropriately diversified mutual fund from one of the many available firms.The obstacle was cost: with commissions as high as $75 per trade, buying and selling a single stock, let alone a basket of stocks, was enormously expensive: you could spend almost $2,000 in commissions when buying just 25 stocks. Once you owned shares, of course, the ongoing cost to hold them was negligible.Mutual funds offered a different tradeoff. By paying a single up-front commission, you could buy into a basket of "expertly-managed" stocks that would be rebalanced at the manager's discretion. Of course, expert management isn't cheap, so you'd also pay an ongoing fee to keep the lights on at headquarters and return profits to the fund company's shareholders.We don't normally talk about it this way, but these models are in competition: stockbrokers offer wealthy investors and institutions the ability to save on their ongoing holding costs by charging large up-front commissions, while mutuals funds appeal to middle-class investors willing to pay higher ongoing costs in exchange for a smaller up-front investment.In the context of this competition, Bogle's solution was elegant: fire the company's shareholders (by making Vanguard's mutual funds the owners of the company itself), fire the experts (by offering passively-managed, market-capitalization-weighted funds), and pass the savings on to the shareholders in his mutual funds.Bogle won the first round, and Vanguard's investors have benefited enormously. But today, we're seeing the early stages of the stockbrokers' revenge.

Fee-free trading was a breakthrough; direct indexing of fractional shares will be a revolution

I've written plenty of times about Robinhood, the fee-free trading app. It's had some growing pains, both regulatory and technical but it has always fulfilled its essential promise: commission-free buying and selling of stocks and ETF's.As a company, Robinhood is as hopeless as Uber, incinerating millions of dollars in Saudi oil profits with signup bonuses and operating expenses that their revenue can't even begin to cover, praying to be acquired by a real company before the next crash.But as an idea, Robinhood was a brilliant strike back against Bogle's triumph: if trading is commission-free, and holding shares is free, then what advantage does a mutual fund have over ownership of the fund's underlying shares? Ownership of shares gives investors the right to vote at shareholder meetings, and it allows precision tax-loss harvesting, while even Vanguard ETF ownership only allows you to vote your shares of the mutual fund, not the underlying companies, and by blending together the performance of its constituents limits the availability of tax-loss harvesting.Robinhood offered one solution to one problem, but it's not enough, for the simple reason that it does not, and in my opinion cannot, offer fractional shares. That makes direct ownership of even a tiny, unrepresentative index like the Dow Jones Industrial Average absurdly expensive: the purchase of a single share of each DJI constituent would cost $4257.52. A market-cap weighted purchase of the average would be many times more expensive, if you can dredge up from grade school how to calculate lowest-common-denominators.

Fee-free trading of fractional shares will make mutual funds obsolete

I'm making this claim in the strongest way possible not because I think it is anywhere close to happening, but because I think it is inevitable.The earliest, easiest adoption will come in market-cap-weighted funds: when a Google or Excel spreadsheet can sit on top of your brokerage account and sell losers while replacing them with the shares of similar companies at no cost, why would anyone own a mutual fund or even an ETF that blends together the tax liability of capital appreciation with the tax benefit of price declines?Active managers and funds will feel the pressure a bit later, but they'll feel it eventually. Why pay an ongoing management fee when you can subscribe to a newsletter or website that sends a .csv file individualized for your brokerage and your tax lots?

Shareholder democracy matters and mutual funds aren't helping

It's a cliche that three companies (Blackrock, Vanguard, and Charles Schwab/TD Ameritrade) control a vast swathe of publicly traded shares through their mutual funds, and it's fashionable to point out they cast their votes as shareholders in ways their investors may resent, or even despise. Vanguard has gone so far as to hold its shareholder meetings not in populous, accessible Philadelphia, but in a satellite office in Arizona, to make sure as few people as possible show up and complain about how it deploys its influence over global capitalism.I don't think that mutual fund companies vote their shares with any kind of corrupt intent; on the contrary, I believe they vote them based on their belief about what is going to produce the greatest financial return for the shareholders of their mutual funds.But that's not how people vote, and if in 20, 30, or 50 years direct indexing has allowed investors to reassert humane control over the companies they own, it will ultimately come to be viewed as an enormous economic and ethical revolution.Become a Patron!

Prosperity, precarity, anxiety, and solidarity

Become a Patron!As we plunge into a second decade of economic and employment growth since the global financial crisis, I've noticed an interesting divide open between different methods of experiencing the present moment. It's interesting because while the divide has political content, it isn't intrinsically partisan, and the divide goes far beyond party politics.

Prosperity

You cannot describe the present moment without describing the US recovery from the depths of the global financial crisis: almost a decade of continuous monthly employment growth, record-low unemployment, and GDP growth.Contrary to mainstream economists' expectations, employers have been willing to dig deeper into the reserve army of labor and hire previously marginal applicants: those without a high school degree, with criminal convictions, or with a spotty work history.This is what prosperity is supposed to look like: good-paying jobs for all who want them, rising wages, and rising living standards.This has led the prophets of prosperity to ask a simple, obvious question: "What are you complaining about?" The system is working. Incomes are increasing. Don't rock the boat — you may not like the water.

Precarity

Precarity is a term usually used in reference to the "gig economy," the bizarre 19th-century piecework labor popularly embodied by Uber, Lyft, GrubHub, and their many competitors. I don't find this framework particularly useful, simply because virtually no one is employed in the gig economy. That may sound shocking, if you regularly order rides, food, liquor, or cannabis through an app, but it's true: research suggests about 1% of workers participate in the gig economy. That's not nothing, but it's also not driving any important changes in American life (not least because none of the "gig economy" companies have ever managed to turn a profit, and will inevitably be washed out with the next tide).To me, precarity describes a different phenomenon: the fact that even the beneficiaries of prosperity understand that their well-being is delicate, fragile, contingent, or in a word, precarious.This manifests itself in a thousand different ways: how willing is a newly-employed diabetic to reject her boss's sexual advances, knowing that losing her job means losing her access to insulin? How willing is a new father to take time off to bond with his child? How willing is a barista to refuse to clock out before she finishes cleaning the Starbucks?This does not mean these people aren't beneficiaries of prosperity, low unemployment, and rising wages. It means they are conflicted. They know a new job, more hours, or a raise will increase their gross income. But does a raise that increases a worker's income out of Medicaid eligibility increase or decrease their well-being? Will a new job make a worker ineligible for SNAP, the earned income credit, or housing assistance?Just like prosperity, precarity is a real, material way people experience the world. Most importantly, it isn't "subjective." It isn't just some worker's "opinion" that they'll lose their health insurance if they lose their job. That's actually how the system works: they will lose their health insurance if they lose their job. Maybe they'll qualify for Medicaid, maybe they'll qualify for subsidies on the Affordable Care Act exchanges, but the one thing they definitely won't qualify for is employer-based health insurance; they will lose their insurance, full stop.

Anxiety

Obviously precarity causes stress, anxiousness, pain, and suffering. But I want to precisely identify a different phenomenon. Anxiety is the experience of knowing you are not yet the target of state harassment, while knowing you could be at any time.This has obviously been the principle experience of immigrant and immigrant-adjacent communities during the Trump administration. Iranian-Americans had not been targeted for border harassment until the current conflict began, but as soon as it did, they began being held for hours without cause at a Canadian border crossing.Now, what is more true: that Iranian-Americans had no reason to worry about being targeted for harassment by the state, since they hadn't yet been harassed by the state, or that a nationwide regime of racist harassment is a threat to all minority communities, whether or not they have yet been targeted?The prophets of prosperity say, "what are you complaining about? You've got a job, and you haven't personally been targeted for racist harassment." The anxious, regardless of their prosperity, say "what makes me different from the people you're already arresting and throwing into cages?"

Solidarity

Solidarity poses a fourth and final question: how should people who know (or think they know) they won't be affected by economic changes, health insurance reforms, or a racist police state relate to these issues? I want to isolate this group because it is the obvious target of the "why should you care?" appeals. After all, the unemployed care about employment because they're unemployed. The precariat cares about the welfare state because their livelihood is precarious. The oppressed care about justice because they're the victims of injustice. They all, in short, have a reason to care.But why should anyone else care? I think there are a few obvious, and a few not-so-obvious, reasons.

• To dispense with the obvious, if you have the influence or power to create a more just society, you should exercise that power whether or not it benefits you personally, and the less it benefits you personally, the more pressing your moral imperative is: the less vulnerable you are to the tides of political fortune, the more committed you should be to protecting those who live below sea level (not to stretch the metaphor too far).
• You aren't as financially secure as you think you are. The primary mechanism for long-term care insurance in the United States is dual eligibility for Medicare and Medicaid; to trigger eligibility, you have to deplete the overwhelming majority of your assets. Most people, who have no savings, are dual-eligible almost immediately. A tiny minority have sufficient assets that they'll never be dual-eligible. But there's also a broad group of people who think their net worth makes them "financially independent," but who will in fact have to spend down virtually their entire net worth before they become dual-eligible.
• You may not be as American as you think you are. We know that native-born Americans are having their citizenship questioned because their birth certificate was signed by a midwife. Do you know who signed your birth certificate?
• Your identity may not be as safe as you think it is. We know Iranian-Americans are being targeted for persecution by immigration authorities because of current events. But until a few weeks ago, Iranian-Americans seemed like some of our most loyal citizens. How sure are you that your ethnicity, your party affiliation, your sexual orientation, or your country of origin isn't going to be the next reason we start harassing people at the border?

Conclusion

There will always be people saying, "you have citizenship," "you have a job," "you have health insurance," "you have legal permanent residency," so what do you have to worry about?Those people are telling you to sit down and shut up. But I'm telling you to stand up and speak up. You don't have to do it "for the vulnerable." You are the vulnerable. Do it for yourself.Become a Patron!

How to think about the Spousal IRA deduction gap

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

How spousal IRA's (are supposed to) work

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

Why does the spousal IRA deduction gap occur?

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

Maximizing the value of the spousal IRA deduction gap

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

Planning around the spousal IRA deduction gap

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

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

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

Existing retirement plan startup cost credit

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

Expanded retirement plan startup cost credit

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

Credit for auto-enrollment

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

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

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

Why are charitable contributions deductible?

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

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

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

The alternatives are obvious

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

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

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

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

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

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

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

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

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

Conclusion: it doesn't have to be this way

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

Strategies to pay for an early retirement

Become a Patron!Last month I got to spend some time with a relation who recently left a high-powered tech job, and who asked for some advice about financing a more or less indefinite period of unemployment. I am strongly opposed to mixing money and family, but I eventually relented and offered some ideas in general terms about how I would advise someone who came to me in his situation. I thought it might be useful to write up those ideas in case they're useful to anyone else in his situation.

Get your finances in order

Over the course of a 15 or 20 year career, workers accumulate an enormous quantity of financial junk. Multiple 401(k) and 403(b) plans, stock options and grants, individual stocks, term and whole life insurance policies, etc. Even if you tend each garden carefully, it can be hard to figure out what you really own: is a Fidelity target retirement date fund really equivalent to a Vanguard fund with the same target date? Is a Betterment "aggressive" portfolio the same as a FutureAdvisor "growth" portfolio?An underrated advantage of an early retirement or break in your working life is that it's an opportunity to get all that junk sorted out at minimal or no cost, for the simple reason that long-term capital gains are untaxed if your taxable income (after deductions) is below $39,375 for single filers and $78,750 for married joint filers. In low-income years you should be "harvesting" as many gains as possible in taxable accounts, and unlike with capital losses, there's no wash sale rule with respect to gains. In low-income years, you can realize taxable gains, pay a 0% long-term capital gains rate on them, and then buy identical securities with a new, higher cost basis.In addition to resetting your taxable basis, you should also consolidate your old retirement accounts in traditional and Roth IRA accounts with your preferred custodian. This is a good idea in general, but a break from the workforce is as good a time as any to finally get around to doing it.

How likely are you to return to work, and when?

This is the single most important question when contemplating early retirement, but unfortunately one of the most difficult to answer accurately. The two easiest answers are "I'm certain I will return to work in 1 year," and "I'm certain I'll never return to work," but few people are able to give either. On the one hand, in one year unemployment could be 15% and no one will be hiring 40-year-olds with unexplainable gaps in their resume. On the other hand, 3 months into a supposedly "permanent" retirement you might have already landscaped the lawn, oiled all the hinges, replaced your floor, repainted your living room and be pulling your hair out from boredom.Nonetheless, while it may only be an educated guess, guess you must, since whether or not you return to work is the main input into the most important question: how much risk can you expose your savings to? Unlike some people in the FIRE community, my attitude towards risk is simple: if you do not plan to return to work, you cannot risk any money you need for retirement, while if you are certain to return to work, then you can expose a relatively large amount of your assets to risky investments.You may have noticed a semantic trick I played: I'm not interested in your total assets, I'm interested in the assets you need for retirement.Take the case of a 40-year-old with $1 million in liquid, taxable assets, in a brokerage account for example, who never intends to return to work. They can spend $2,778 per month for the next 30 years, before claiming their maximum Social Security old age benefit at age 70, the very day they exhaust their brokerage account balance. But what if, upon studious reflection, they determine that they only need $1,500 per month to live? In that case, while keeping $540,000 in safe assets, they're free to invest $460,000 in risky assets, knowing that even complete disaster will leave them enough money to meet their needs.It doesn't matter what they call that $460,000, whether it's their "legacy" or "play" money or "gambling" money, what's important is that you can't risk money you need to survive.Hopefully this makes clear the importance of the return-to-work question: if you're certain to return to work in a year, then your "sabbatical" shouldn't have a substantial impact your asset allocation at all: set aside 12 or 18 months worth of cash, CD's, or Treasury bills, and leave the rest invested in an age- and risk-appropriate long-term portfolio. 5 years out of the workforce requires a higher allocation to safe assets, both for the longer timeframe and to take into account the likelihood of lower earning as your experience and skills age. To account for 10 years of early retirement you should count on a significantly lower income, if you do ultimately return to work.

Health insurance

While healthcare costs can pose a serious financial hardship for workers, in retirement the situation is much simpler: if you live in a Medicaid expansion state, you can enroll in Medicaid, which has no premiums or deductibles, and nominal co-payments for prescription drugs. There's no open enrollment period, so you can enroll as soon as your employer-sponsored insurance coverage ends.If you live in a non-expansion state, you'll need to claim the maximum advance premium tax credit and cost-sharing reductions by entering an income into your state's health insurance marketplace that's right around 140% of the federal poverty line, and selecting an eligible Silver plan. You may end up paying a few dollars a month in premiums — in non-expansion Wisconsin my monthly premium was $0.83, so I just paid the $12 once a year in advance to make sure my policy wasn't canceled in case I forgot. When you file your taxes you'll be asked to calculate how much of your advance premium credit you have to repay, which will be $0 or close to it, as long as you're sure to keep your income low enough.And once you turn 65, of course, you're eligible to enroll in Medicare. While Medicare is worse insurance than Medicaid (coming as it does with premiums, co-payments, and deductibles), it does give you access to a somewhat wider range of providers, which is increasingly valuable as you age, depending on your health status.One quick note here: many people have heard of the "Medicaid asset test," which requires people enrolled in Medicare to spend down certain assets before they become "dual eligible" and begin to receive much more generous Medicaid coverage. This asset test does not apply to non-Medicare enrollees living in Medicaid expansion states. Thanks, Obama.

The incredible advantage of working at least a little bit in pretirement

Finally, I want to point out an important advantage to bringing in at least a little bit of income in retirement, or "pretirement" as my relation calls it. Consider the same 40-year-old above, with $1 million in liquid assets and $1,500 in monthly expenses, who therefore needs $540,000 in safe assets and can invest $460,000 in risky assets — an overall asset allocation of 46/54.Earning $500 per month (33 hours at $15 per hour, or roughly 8 hours per week), reduces the cash need over the next 30 years to just $360,000, leaving $640,000 to invest in risky assets — a much risker overall asset allocation of 64/36, with a consequently higher expected final value.A few hours of work per week, whether it's as a high-powered consultant, or a low-powered Walmart greeter, relieves an enormous amount of pressure on your assets.

A few notes on timing

I mentioned above the advantages of harvesting tax-free capital gains in low-income years, but I want to point out a few other opportunities that arise once you've stopped working.Once you've rolled over your workplace-sponsored retirement balances to IRA's, you're able to convert your traditional IRA balances into Roth IRA balances. This is a taxable, but penalty-free, event, so you can convert up to the amount of your standard deduction every year (or your remaining standard deduction after accounting for earned income) tax-free (and substantially more than that at today's favorable income tax rates). Those Roth balances can then be withdrawn tax-free any time after age 59 1/2, and aren't subject to required minimum distributions.Finally, it's worth considering how and whether to make withdrawals from retirement accounts in general. An example of a "simple" strategy would be to draw down taxable assets before age 59 1/2, take distributions from qualified retirement accounts until age 70, then rely on your Social Security old age benefit and any remaining required minimum distributions from then on. More sophisticated strategies do exist, however: your assets may last longer, or accommodate higher spending (two ways of saying the same thing) if you're able to meet your spending needs with your untaxed long-term capital gains in lieu of retirement assets prior to age 70, giving the latter more time to internally compound tax-free. Retirement assets are also granted much more protection in bankruptcy, a kind of built-in insurance policy against sudden financial misfortune.These strategies can be quite complex, and I would not attempt to implement one without consulting a fee-only financial advisor, i.e. one who is not paid to sell you their firm's flavor of the week.Become a Patron!

What the media can't get right about retirement, and why

Become a Patron!A long-time reader passed along an article from the World Economic Forum's blog (yes, for some reason the World Economic Forum has a blog) titled "To retire at 65, American millennials need to save almost half their paycheck." While the article is absolute drivel, it's a good starting point to understand some things the business and financial press gets consistently wrong about savings.

The article itself makes no sense

The extremely thin premise of the article is easily dispatched with: relatively high stock market prices today suggest that future returns will be relatively low. That means projecting today's return on savings forward means today's workers will have to fund a relatively large portion of their retirement spending out of savings and a relatively small portion of their retirement spending out of dividends and price appreciation.I will make a simple observation about this thesis: retirement savings are accumulated over time, not with lump-sum contributions. The idea that "high prices today predict low returns tomorrow" only applies to this year's contributions. Next year's contributions will earn returns based on next year's prices, and contributions made 10 years from now will earn returns based on prices 10 years from now. In other words, assuming steady or rising contributions, today's prices tell you nothing about the lifetime savings rate required to achieve a given level of income replacement in retirement.To give a simple example, the 30-year Treasury bond rate reached a high of about 14.8% in 1981. Since $1 invested at 14.8% for 30 years yields $62.84, using the World Economic Forum's logic, a 35-year-old in 1981 could have invested just 0.8% of their salary each year in order to replace 50% of their pre-retirement income, since 30 years later, that 0.8% would have swollen to 50%.The problem is that 10 years later, the 30-year Treasury rate had fallen to below 8%, and the same 0.8% salary savings would replace just 8% of their salary 30 years later. The World Economic Forum is making the primitive mistake of projecting this year's expected returns forward to all future years.With the Social Security full retirement age already raised to 67 for my generation, even the oldest millennials have 25 or more earning years ahead of them; of course it's possible today's high stock market prices will continue for the next 25 years, but let's just say I have my doubts. And if we do have 2, 3, or 4 crises, recessions, or depressions between now and then, there will be plenty of opportunities to buy assets with expected returns just as high as they are low today.

The financial press doesn't get it: no one saves anything

In some ways it's unfortunate that we use the same verb in two radically different, almost opposite meanings: to "save," and to "save up for." To "save up for" is the most common and natural thing in the world, and virtually everybody does it. Whether you're saving up for Christmas presents, a new console game, a down payment on a house, or an anniversary dinner, the idea is the same: you set money aside every week or month, for a known or unknown period, and then you spend it, and it's gone. This is not fundamentally different from buying something on credit, it's just cheaper: with credit you get the object of your desire up front, then pay for it over time, while with savings you pay for it over time, then get it at the end.But "to save," let alone "to invest," means something totally different. It means setting money aside, for an indefinite period of time and for no definite purpose. This behavior is vanishingly rare because upon a moment's reflection, it makes almost no sense.First, setting money aside today comes with an obvious cost: that money could be spent instead. It's one thing to save up $300 for a new gaming console; it's another thing entirely to have saved $300 and then, instead of buying a new gaming console, keep saving instead!Second, the indefinite period creates obvious risks. I'm not talking about investment risks, since even most people who do save don't invest their savings. I just mean the risks of doing anything over time. Maybe you'll die before you ever spend any of your savings — you can't take it with you. Maybe you'll get divorced and "lose" half your savings to your former spouse. Maybe word will get around that you have savings and your friends and relatives will come around asking for a "loan."To put it as simply as possible, if saving were easy, the government wouldn't have to go to outlandish lengths to encourage people to do it. And despite those outlandish efforts, the only people who save are still the same people who would do it anyway: high-income professionals. Don't get me wrong, they're happy to take the government handouts, but the handouts are pure gravy.

The fantasy of the retirement "number"

Let's turn back to the underlying premise of the World Economic Forum post: the goal of retirement saving is to replace a certain percentage of your pre-retirement income by setting aside money during your working years. If you can project forward both your earnings trajectory and your investment returns (whether on a year-by-year basis or using the "starting year" fallacy described above), then you can determine the total balance you need to have in your accounts on the day you stop collecting a paycheck.But who could this model possibly describe with any degree of accuracy? The majority of people start collecting Social Security old age benefits on the day they become eligible, and have no savings or an amount that is simply inconsequential to their long-time retirement spending needs. Using the 4% rule, someone who has managed to accumulate the fantastic sum of $100,000 at retirement can only safely withdraw $333 per month to supplement their Social Security benefits, and if the money is kept in a risk-free account, the safe withdrawal rate must by definition be even lower.On the other hand, savvy high-income professionals pour vast sums into their pre-tax retirement accounts, 529 accounts, Roth accounts, HSA's, after-tax 401(k) accounts, and these sums accumulate so quickly they dwarf any conceivable financial needs in retirement.What the "retirement number" presupposes is that there's some group of people in-between, who can afford to save more than nothing, but less than the absolute maxima allowed in tax-advantaged accounts. And this group no doubt exists: there are a lot of numbers between $0, the amount saved by most people, and $19,000, the amount contributed by high-income professionals to their 401(k) plans in 2019, so in a country of 350 million souls there are certainly people contributing $1,000 and people contributing $18,000.Unfortunately, the first $1,000 you save does nothing for your retirement security (you'll still rely on Social Security old age benefits), and the last $1,000 you save does nothing for your retirement security (you'll retire wealthy no matter what).

Finance journalism is an ideological project

What all the above should make clear is that the relentless focus on this sliver of the population, the "in-betweeners," is not about personal finance, it is about ideology. Tax-advantaged investment accounts obviously provide the overwhelming majority of their tax benefits to the people who can afford to contribute the most money to them, and no benefit at all to people who can't afford to contribute anything.If retirement income security, or affordable higher education, were really public policy goals, then the money currently spend shielding the investments of the wealthy from taxation would go a lot further in boosts to Social Security benefits and public subsidies for higher education.But if you can create a mile-wide, inch-thick class of people who have contributed "something" to an IRA, 401(k), 403(b), or 529 plan, then you suddenly have tens of millions of people mobilized to protect those programs for the wealthy despite the trivial benefits they receive from them, and the ideological basis for cutting Social Security benefits and public higher education funding even further: anyone without sufficient retirement income should have raised their retirement contributions faster; anyone who can't afford to send their kids to college should have opened that 529 plan earlier.After all, the financial press was there all along telling you to, so you have no one but yourself to blame.Become a Patron!

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

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

What won't change: annuities and RMD's

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

The 529 backdoor

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

The "homeschooling" loophole

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

Changes to "stretch" IRA's

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

Conclusion

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

The backdoor VAT is an ideological project that must be defeated

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

What makes someone rich?

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

Americans believe that what makes you rich is money

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

The backdoor VAT is swallowing the tax code

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

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

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

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

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

Uber isn't afraid of a union

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

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

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

Uber isn't afraid of higher wages

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

It's all about the benefits

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

Conclusion: who is flexibility for?

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

Job protection, wage insurance, and universal benefits

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

Job protection

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

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

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

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

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

Wage insurance

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

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

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

Universal benefits

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

Conclusion

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