Archives for October 2009

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Foreign Tax Credit

A solid understanding of the foreign tax credit can help minimize your investment-related taxes. What’s the foreign tax credit? The IRS explains it this way:

“If you paid or accrued foreign taxes to a foreign country on foreign source income and are sub­ject to U.S. tax on the same income, you may be able to take a credit for those taxes.”

In short, the idea of the credit is to eliminate double taxation on foreign income.

Example: You earn $500 in foreign dividend income over the course of the year and you pay $100 in foreign taxes on that income. You can claim a $100 credit for foreign taxes paid, thereby reducing your U.S. income tax obligation by $100.

Important note: Unless you meet three requirements, there is a limit to the credit you can take (please see IRS Publication 514 for details on the limit). The three requirements are as follows:

  • Your only foreign income is passive income (passive income being things like dividends, interest, and rents),
  • Your qualified foreign taxes for the tax year are not more than $300 ($600 if married filing jointly), and
  • All of your gross foreign income and the foreign taxes are reported to you on a payee statement such as a Form 1099-DIV or 1099-INT.

And now the fun part: How can you put this knowledge to use?

Use it to help determine your asset location.

Funds held in a retirement account–like an IRA or 401(k)–do not qualify for the credit even if they’re funds that would qualify were they held in a taxable account.

Does this mean that you should only buy international stock funds in taxable accounts rather than retirement accounts? No. Not at all. The benefit from tax-deferred or tax-free growth far outweighs this little credit.

If, however, you’re simply deciding which fund to hold in your retirement account (domestic stock fund vs. international stock fund) and which fund to hold in your taxable account, then it’s probably best to tax-shelter your domestic stock funds before tax-sheltering your international stock funds.

Claiming the Credit

Generally, you have to file Form 1116 to claim the foreign tax credit. If, however, you meet a few requirements (the same as the requirements listed above to avoid the limitation on the credit), you can simply enter your foreign taxes directly on Form 1040, line 47.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Are We Qualified to Invest on Our Own?

A recent Get Rich Slowly post asked whether one should stop investing for retirement in order to pay off debt. It’s an important question, and one that I’ve attempted to tackle before. But what I really want to talk about are the comments that were left on the GRS post.

They’re frightening. And I’m not saying this just to be snarky (though, admittedly, I do partake in a little snark from time to time).

Some people were attempting to mathematically justify paying down debt rather than taking advantage of a fully vested, 100% employer match. Now, if you gain a valuable psychological benefit from paying down debt, that’s fine. Go for it. But how somebody could argue that a 20% return is mathematically superior to a 100% return escapes me.

Other commenters argued that, if an investor is young, it’s better mathematically to invest for retirement, rather than to pay down debt–even if there’s no employer match to be gained, and even if the interest rate on the debt is higher than the rate of return from investing for retirement.

“The Horsepower to Do the Math”

This all reminded me of an article William Bernstein wrote a few months back, where he argues that most people just aren’t qualified to invest on their own. Bernstein estimates that less than 10% of the population has “the horsepower to do the math.” He elaborates,

“Fractions are a stretch for 90% of the population. The Discounted Dividend Model, or at least the Gordon Equation? Geometric versus arithmetic return? Standard deviation? Correlation, for God’s sake? Fuggedaboudit!”

I’m inclined to think that his estimate is overly pessimistic. (Is it really that hard to explain correlation?) And I’ve always thought investing mistakes aren’t caused by a lack of math skills so much as by a decision process that’s not based on math at all. (“I’ll just hold this stock until it gets back to where I bought it,” for example.)

But I may be wrong. Thoughts?

Vanguard Investors Outperform Fidelity Investors

Russell Kinnel, director of mutual fund research at Morningstar, recently compared investor returns at Vanguard to investor returns at Fidelity. His study is interesting because it looks at investor returns (aka “dollar-weighted returns“) rather than investment returns (aka “time-weighted returns”).

A brief example of dollar-weighted returns

If Mutual Fund ABC earned a 25% return in Year 1, then lost 20% in Year 2, its effective annual return over the two years would have been 0% (because it would be back exactly where it started).

If, however, the fund had doubled in size at the end of Year 1–due to investors chasing performance and buying the fund after a great year–its dollar-weighted return would be significantly below 0%, because the performance in Year 2 would be weighted twice as heavily in the calculation. In short, dollar-weighted returns measure how the investors performed rather than how the investments performed.

What did Morningstar’s research show?

The study showed that Vanguard investors earned greater returns than Fidelity investors over the last 10 years. But that doesn’t really mean a great deal to me. It could simply be the result of Vanguard’s larger funds being in more successful asset classes than Fidelity’s.

What does interest me, however, are the two following facts:

  • As usual, mutual fund investors underperformed their own investments across the board.
  • Vanguard’s investors underperformed their investments by a smaller margin than Fidelity’s investors.

Why do we underperform?

We underperform because we try to time the market, and we (usually) fail. We chase performance–both in terms of hot asset classes and in terms of hot funds–and it destroys our returns.

Why do Vanguard investors perform better?

My hypothesis is that it has to do with the core philosophies of the two companies. As a company whose success has been based on index funds, Vanguard’s core tenets are minimizing costs, diversifying, and buying and holding.

In contrast, Fidelity, at its core, is about active investment. Many of their own fund managers turn over their portfolios more than once per year. It wouldn’t be terribly surprising to learn that their investors do something similar.

Kinnel has a similar opinion:

“It’s possible that the performance gap also has something to do with each firm’s message to investors. Vanguard preaches long-term investing and goes so far as to warn investors away from hot-performing funds…Fidelity also preaches long-term investing, but it sometimes nudges people to invest based on short-term results.”

What can we learn here?

Surely, some people will look at this study and see it as evidence of an opportunity to outperform the market. They’ll draw the conclusion that we must learn to “be fearful when others are greedy and greedy when others are fearful,” as Warren Buffett would say.

To me, the lesson is slightly different. I see it as another piece of evidence that our predictive abilities are decidedly lacking. After all, nearly every single one of those people who underperformed sincerely believed that he was going to outperform.

“I am above average!” is the battle cry of underperformance.

The Oblivious Investor is 1 Year Old

Today (10/26/09) is The Oblivious Investor’s first birthday. 🙂

A few statistics of interest:

  • 285 posts,
  • ~ 600 subscribers,
  • 1,359 comments,
  • Currently getting ~ 230 first-time visitors each day via search engines, and
  • 2 new books launched.

On growth and goals:

I’m happy with that level of growth. I can’t say whether or not it exceeded my expectations, because I didn’t have any. This being my first blog, I had no clue what to expect. Similarly, I don’t know what to expect by the end of year two. 1,000 subscribers? 2,000? 3,000? No idea really.

I’m comfortable with the fact that this blog will never be comparable to Get Rich Slowly or The Simple Dollar in terms of readership. It focuses on too narrow a niche for that to happen. That is, it only appeals to people with a serious interest in investing. And within that group, it only appeals to people who don’t mind the fact that I openly criticize activities such as stock picking, market timing, etc.

Giving thanks where due:

The blog has been an absolute blast to write so far. And with a growing group of people reading and participating in the discussion, it’s becoming more fun as time passes. So thanks to all of you for reading, and thanks to everyone who has participated in the discussion whether via comments, email, or replies on your own blogs.

Also, to everyone who has helped to share this blog (and its ideas) with others, whether by linking to it, tweeting about it, stumbling posts, or good old-fashioned word of mouth: Thanks!

Similarly, I’m quite grateful to everybody who has helped with the two books, whether linking to them, reviewing them on Amazon, or, of course, buying them. 😀

Where we go from here:

For my part, I’ll be continuing to write on a regular schedule, most likely on a range of similar topics. But a large part of where the blog goes from here is up to you. For example:

  • How quickly it spreads/grows is primarily a function of how many of you are compelled to share it with others.
  • In terms of topics, if you have something you’d like me to cover or questions you’d like me to address, please let me know.

Thanks again, everyone. I’m looking forward to year #2. 😀

Review: The Bogleheads’ Guide to Retirement Planning

455579_cover.indd I’ve read books that are intended to be “all you need to know about personal finance.” And I’ve read books that are intended to be “all you need to know about investing.” But The Bogleheads’ Guide to Retirement Planning is the first book I’ve read that’s “all you need to know about planning for retirement.”

Note the distinction: This book is not about saving/investing for retirement. It’s about planning for retirement (and everything that’s a part of such planning). The best part about the book, in my opinion, is the breadth of topics covered. The chapter-by-chapter table of contents should give you an idea of the scope:

  1. The Retirement Planning Process
  2. Understanding Taxes
  3. Individual Taxable Accounts
  4. IRAs
  5. Defined Benefit Plans (written by fellow blogger, The Finance Buff)
  6. Defined Contribution Plans
  7. Single-Premium Immediate Annuities
  8. Basic Investing Principles
  9. Investing for Retirement
  10. Funding Your Retirement Accounts
  11. Understanding Social Security
  12. Withdrawal Strategies
  13. Early Retirement
  14. Income Replacement
  15. Health Insurance
  16. Essentials of Estate Planning
  17. Estate and Gift Taxes
  18. Seeking Help from Professionals
  19. Divorce and Other Financial Disasters
  20. Meet the Bogleheads

Phew!

The chapters average 16 pages in length, so you get a little more than just a high-level introduction to each topic, while at the same time avoiding details that are unlikely to be important to more than a small number of readers. Also, the authors conclude each chapter with suggestions for additional reading, making it easy to research a particular topic further should you so desire.

A Few Discussions I Particularly Enjoyed

(In chapter 11) Social Security strategies: By intelligently planning when to begin taking Social Security payments, you can significantly increase your expected lifetime payout. (This goes double for married couples, as the planning opportunities increase when there are two spouses involved.)

(In chapter 9) How asset allocation should be affected by your other assets: For example, if you have a pension that pays out a fixed amount every year, that’s roughly equivalent to a large bond holding, so perhaps you should have a heavier stock allocation than other investors. Also, if your pension is not indexed to inflation, perhaps your other bond holdings should be in TIPS so as to provide some inflation protection.

(In chapter 7) How to shop for Single Premium Immediate Annuities: SPIAs can be used to offset the risk of outliving your income, but shopping for annuities is tricky business. Being an informed customer helps you avoid getting ripped off.

Would I Recommend the Book?

It depends. If you’re still quite young, there’s a lot of material here that you don’t need to worry about just yet. I’d suggest starting with something different–perhaps some combination of the following:

If, however, you’re starting to think seriously about getting all the retirement planning specifics nailed down, then I can’t recommend The Bogleheads’ Guide to Retirement Planning highly enough. It’s the only book I’ve seen so far that covers all of the different topics involved in planning for retirement.

ETF List: The Best (Low-Cost) ETFs

Quick note: This article focuses on ETFs from the perspective of a buy & hold investor. If you’re looking for information for more active investors, I’d suggest signing up for a Morningstar account. (It’s free.)

Last week’s post on the best/lowest-cost index funds went company-by-company. One of the nice things about ETFs is that all you need is a discount brokerage account somewhere, and you can pick and choose between ETF providers–no need to stick with just one company.

In that vein, this week’s comparison of ETFs  is sorted by asset class rather than by company. Really, it’s just a shopping list of sorts: The lowest-cost ETFs that I’ve found for each asset class. If you know of others that should be added (or any that should be replaced with something else), please feel free to share. 🙂

Update: Because of the fact that Vanguard now allows investors to trade Vanguard ETFs with no commissions in a Vanguard brokerage account, I’ve used Vanguard  ETFs wherever possible. (In most cases, they have the lowest expense ratios as well.)

Domestic Stock ETFs

Asset Class Name Ticker ER
Total Stock Market Vanguard Total Stock Market ETF VTI 0.07%
Large-Cap Blend Vanguard S&P 500 Index ETF VOO 0.06%
Large-Cap Value Vanguard Value ETF VTV 0.14%
Large-Cap Growth Vanguard Growth ETF VUG 0.14%
Small-Cap Blend Vanguard Small-Cap ETF VB 0.14%
Small-Cap Value Vanguard Small-Cap Value ETF VBR 0.14%
Small-Cap Growth Vanguard Small-Cap Growth ETF VBK 0.14%

International Stock ETFs

Asset Class Name Ticker ER
Developed Markets:
Large-Cap Blend Vanguard Europe Pacific ETF VEA 0.15%
Large-Cap Value iShares MSCI EAFE Value Index EFV 0.40%
Mid-Cap Value WisdomTree Interntnl SmallCap Div DLS 0.58%
Emerging Markets:
Large-Cap Blend Vanguard Emrg Mkts ETF VWO 0.27%
Emrg & Devlpd Markets:
Large-Cap Blend Vngrd FTSE All-World Ex-U.S. ETF VEU 0.25%
Mid-Cap Blend Vngrd FTSE AW ex-US Sm-Cap ETF VSS 0.40%

Bond ETFs

Asset Class Name Ticker ER
Short-Term Bond Vanguard Short-Term Bond ETF BSV 0.12%
Interm-Term Bond Vanguard Total Bond Market ETF BND 0.12%
Interm-Term Gov’t Vanguard Inter-Term Gov’t Bond ETF VGIT 0.15%
Long-Term Gov’t Vanguard Long-Term Gov’t Bond ETF VGLT 0.15%
Long-Term Bond Vanguard Long-Term Bond ETF BLV 0.12%
TIPS iShares Barclays TIPS Bond TIP 0.20%

Alternative Asset Class ETFs

Asset Class Name Ticker ER
REITs Vanguard REIT ETF VNQ 0.13%
Precious Metals (Gold) SPDR Gold Trust ETF GLD 0.40%

Too Much of a Good Thing

In my opinion, that very same flexibility–the ability to buy 800 different ETFs from one discount brokerage account–is also the danger of ETF investing. It’s easy to get carried away tinkering with your portfolio, when the reality is that most of us would be better served by simply buying a handful of ETFs and holding them as long as we can.

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