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Investing Blog Roundup: Taxes Made Simple, 2018 Edition

The 2018 edition of Taxes Made Simple is now available (print version here, Kindle version here).

The book has been updated to include many of the topics we’ve been discussing here on the blog over the last couple of months: the larger standard deduction, the new version of the home mortgage interest deduction, the new version of the deduction for state/local taxes, the new version of the child tax credit, and so on.

Recent Recommended Reading

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Worrying about Market Declines and High Valuations

A reader writes in, asking:

“The stock market’s tumble over the last week combined with the fact that stock valuations are still so high makes me wonder about the appropriate way to respond. Time to take some money off the table? I suspect I know what you’ll say, but I’m interested to hear anyway.”

The total U.S. stock market (as measured by the Vanguard Total Stock Market Index Fund, VTSMX) fell by less than 10% last week. If that made you super nervous, that’s a good indication that your stock allocation is too high. A 10% decline should not be a big deal — especially when it comes after a 9-year bull market during which the value of U.S. stocks rose by roughly 400%.

If a decline of less than 10% makes you nervous at all, imagine how you’ll feel about a 30%, 40%, or 50% decline. The goal of asset allocation is to craft a portfolio with which you’d be able “sit tight” (or possibly even rebalance into stocks) during a full-blown bear market.

Making Use of Market Valuations

It’s true that the stock market is still highly valued relative to historical norms. (This should not be a surprise, given the huge returns over the last 9 years.)

But how useful is that information for the purpose of predicting returns going forward?

The following chart shows the correlation between the S&P 500’s valuation (as measured by PE10) and its inflation-adjusted returns for periods of various lengths from 1926-2017. As you would expect, the correlation is always negative, which means that the higher the market’s valuation at any time, the lower we should expect returns to be going forward.

Valuations and Returns

But the correlation between PE10 and ensuing short-term returns has been pretty weak. For instance, the correlation coefficient between PE10 and 1-year returns is just -0.22. The correlation is quite a bit stronger if we look at 10-year real returns (-0.63 correlation) or 20-year real returns (-0.75 correlation).

In other words, valuation levels are not very good at predicting short-term market returns. They are much better at predicting longer-term returns.

But even if we have good reason to suspect poor returns over the next, say, 10 years, a 10-year period of poor returns could come in a lot of forms. The market could be roughly stagnant, with inflation taking a toll. Alternatively, we might see another 7 years of gangbuster returns, followed by a super bad bear market for 3 years. Or we might see a 2-year bear market, followed by 4 years of good returns, then another 4-year bear market. And so on. (Or, the next 10 years could be a period for which valuation isn’t even predictive in the first place! A negative 63% correlation is still far from perfect.)

Point being, we never know what’s about to happen in the near term. So valuations aren’t very useful for trying to “dodge” a bear market, so to speak.

But because they do have decent predictive power over the long-term, valuations are useful for questions such as, “how much should I be saving per year?” And, “how much can I afford to spend per year in retirement?”

And with today’s high valuations, we should expect pretty modest returns — suggesting that high savings rates (for those in their accumulation years) and low spending rates (for those in their retirement years) are probably prudent. This was true a year ago, and it’s still true today.

Investing Blog Roundup: “Floor and Upside” Retirement Planning

There are two broad schools of thought when it comes to funding retirement: one that plans to use volatile assets to fund the bulk of necessary spending (and which therefore focuses on “safe” withdrawal rates) and another that prioritizes locking in a safe “floor” of income before allocating retirement funds to volatile asset classes.

Dirk Cotton recently provided a clear walk-through of the “floor and upside” strategy that may be of interest to retirees and near-retirees.

Other Money-Related Articles

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What *Didn’t* Change as a Result of the New Tax Law?

Quick book-related update: The 2018 edition of Social Security Made Simple is now available (print version here, Kindle version here). The changes are minor, so I’m using the same ISBN as the 2017 edition, which means that the Amazon page will still show the 2017 publication date.

And the writing is finished for the 2018 edition of Taxes Made Simple. My estimate is that the book will be available in roughly 2-3 weeks.

The single topic that readers have asked about most often over the last month or so has been the new deduction for pass-through business income. To my surprise though, there has been another type of email that has been even more common: questions about various things that haven’t changed at all. That is, people want confirmation that certain things weren’t changed by the broad new tax law.

“Is Social Security taxation changing?” (Nope.)

“Has the premium tax credit changed?” (Nope.)

And so on.

So, with that in mind, here’s a non-exhaustive list of things that are essentially unchanged as a result of the new law. (I say “essentially” unchanged, because many of these these deductions/credits/etc. involve dollar amounts that are inflation-adjusted each year. And, going forward, they will be adjusted based on chained CPI-U rather than CPI-U.)

  • The calculation that determines how much of your Social Security benefits are taxable
  • Retirement accounts (aside from the new inability to recharacterize — undo — a Roth conversion)
  • Cost basis tracking/reporting (i.e., the proposed change that would have forced people to use the FIFO method for identifying shares did not occur)
  • The step-up in cost basis that occurs when property is inherited
  • The 3.8% net investment income tax
  • The 0.9% additional Medicare tax for high earners
  • Medicare and Social Security taxes in general (including self-employment tax)
  • Health Savings Accounts (HSAs)
  • Deduction for self-employed health insurance
  • Deduction for student loan interest
  • Itemized deduction for charitable contributions
  • American Opportunity Credit
  • Lifetime Learning Credit
  • Child and dependent care credit (not to be confused with the child tax credit, which has changed, and which in some cases can now be claimed for dependents other than your children)
  • Retirement savings contribution credit
  • Premium tax credit
  • Earned income credit
  • Credit for purchasing a plug-in electric drive vehicle
  • Residential energy credit (for purchasing solar panels or a solar hot water heater for your home)

Hopefully, this should wrap up our discussion of the new tax law — at least for now. I’m looking forward to discussing some non-tax topics in upcoming articles.

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 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!"

Investing Blog Roundup: Just Now Getting Back Into the Market?

“What should I do now, if I bailed out of the market in 2008?”

I hadn’t heard that question from anybody in a while, though I heard it all the time from readers from probably 2011 to 2015 or so. Jim Dahle recently gave a great answer for anybody who took their money out of stocks in 2008 and still hasn’t reinvested.

Other Money-Related Articles

Thanks for reading!

Small Business Entity Selection (2018, New Tax Law)

A reader writes in, asking:

“How does the new tax law affect the decision of how a small business should choose to be taxed?”

As a bit of background, for a business with one owner, the three taxation options are:

  • Sole proprietorship (or LLC taxed as such),
  • C-corporation (or LLC taxed as such), or
  • S-corporation (or LLC taxed as such).

And for a business with multiple owners, the taxation options are:

  • Partnership (or LLC taxed as such),
  • C-corporation (or LLC taxed as such), or
  • S-corporation (or LLC taxed as such).

Sole Proprietorship/Partnership Taxation

As before:

  • Income from a sole proprietorship or partnership is taxed at normal individual income tax rates, and
  • Sole proprietorship income (as well as partnership income if the partner is active in the business) is subject to self-employment tax (i.e., a tax of roughly 15%, to replace the Social Security and Medicare taxes that would be paid by the employee and employer if this were wage income instead).

What’s new is that those individual income tax rates are now, in most cases, lower for a given level of income than they would have been prior to the new law.

In addition, income from such businesses will also qualify for the new deduction for pass-through business income (subject to phaseouts), which makes sole proprietorship/partnership taxation somewhat more advantageous than previously.

C-Corporation Taxation

C-corporations are taxed at their own rate (now a flat rate of 21%, whereas before they had progressive tax brackets like individuals). Then, when they distribute income to shareholders in the form of a dividend, the dividend is taxed at 0%, 15%, or 20% tax rates depending on the taxpayer’s level of taxable income. The dividend may also be subject to the 3.8% tax on net investment income.

Previously, C-corporation tax treatment was not usually advantageous because of this double taxation (i.e., taxation of income at the corporate level, plus taxation of the dividend paid to the shareholders). While the new flat 21% tax rate means that C-corporation income over $50,000 will now be taxed at a lower rate than previously, the overall concept of double taxation still applies. And the net result is that C-corporation tax treatment will still be undesirable for most small business owners.

S-Corporation Taxation

Profit from an S-corporation:

  • Is taxed at individual income tax rates,
  • Qualifies for the new deduction for pass-through business income (subject to phaseouts), and
  • Is not subject to self-employment tax.

In other words, it’s the same as income from a sole proprietorship or partnership, but without self-employment tax.

However, S-corporations are required to pay their owner-employees a “reasonable” level of compensation (i.e., wages/salary) before there can be any profits. And such wages:

  • Are taxed at normal income tax rates,
  • Are subject to regular payroll taxes (i.e., Social Security and Medicare taxes that are essentially the same thing as paying self-employment tax), and
  • Do not qualify as pass-through income for the new deduction.

In other words, the wages themselves are not very tax-efficient. So the savings from S-corporation taxation only kick in once there is enough income from the business to pay a reasonable level of compensation to owner-employees and still have a sizable profit left over.

So, in short, for people whose income level is such that they would be in or below the 24% tax bracket (and therefore unaffected by the phaseouts for the new deduction for pass-through income) sole proprietorship/partnership taxation is now somewhat more appealing relative to S-corporation taxation, because all of the sole proprietorship/partnership income would qualify for the deduction, whereas the wages that the S-corporation would have to pay to the owner-employee(s) would not qualify for the deduction.

Of note, however, is that the opposite conclusion may apply for people in the phaseout range (as well as for non-service business owners who are past the phaseout range). That is, S-corporation taxation may be relatively more advantageous, because it would be advantageous to have the business pay wages to somebody (i.e., the owner-employee), to minimize the impact of the wage-related limit for the deduction.

More than ever, discussing the matter with a qualified tax professional is likely to be advantageous.

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