Archives for January 2016

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Do Target Retirement Funds Automatically “Buy Low, Sell High”?

A reader writes in, asking:

“Like you, I like the idea of ‘all in one funds,’ specifically the Vanguard Lifestrategy series. I have a significant portion of my IRA in Lifestrategy Moderate Growth. What I’ve wondered about is how those funds handle rebalancing during the type of market volatility we’re experiencing now-i.e., is it done on a continual basis, as new cash comes in and distributions go out? Or quarterly? Is it inherent in these fixed-ratio funds that they will, to some extent at least, ‘buy low and sell high?'”

Vanguard’s LifeStrategy and Target Retirement funds use daily cash flows into (or out of) the fund to rebalance the portfolio. Beyond that, further rebalancing only occurs if the fund’s allocation strays outside of a certain target range (which Vanguard does not publish). You can find a bit more info in this interview with Vanguard’s John Ameriks.

And, I would not say that it is inherent that the funds-of-funds will automate a “buy low, sell high” process. In periods during which the market exhibits momentum (as opposed to mean reversion), the funds’ daily rebalancing will actually harm performance rather than help it.

For example, if the stock market continues to drop slowly but steadily for an extended period, an investor in a LifeStrategy fund would experience greater losses than an investor who had a DIY allocation that was originally identical but never rebalanced over the period. (Reason being that the LifeStrategy investor will keep rebalancing into stocks every day, only to see them decline further.)

And the same thing happens if the market goes up steadily for an extended period. That is, the LifeStrategy investor will constantly be selling stocks, only to see them move up further, and he/she will therefore underperform the DIY investor who doesn’t rebalance over the period.

But the opposite can happen as well.

If a decline turns out to be a steep but short-lived dip, the investor in the LifeStrategy fund will have gotten to buy some shares “on sale” whereas the DIY investor who didn’t rebalance will not have purchased any such “cheap” shares.

And if a brief rally occurs during a bear market, the investor in the LifeStrategy fund will have sold some stocks at the temporarily-relatively-high price, whereas the DIY investor who didn’t rebalance will not have done so.

In short, during periods in which the market heads relatively steadily in one direction, frequent rebalancing (as you would experience in a LifeStrategy or Target Retirement fund) will generally underperform a strategy that involves less frequent rebalancing. Conversely, during periods in which the market rapidly bounces back and forth, frequent rebalancing will usually outperform a less frequent rebalancing strategy.

Is Tax Planning a Good Reason to Delay Social Security?

A reader writes in, asking:

“I have a Social Security strategy that I have not read of or heard about. I am interested in your feedback. Given the size of my tax-deferred accounts, when I am 70 1/2, RMDs will make it such that I will pay tax on the maximum 85% of my Social Security benefits regardless of when I start benefits. I am considering taking benefits at age 62, so I can pay no taxes on the benefits for 8 years, then pay the full tax on the benefits at age 70 1/2 and beyond.”

Unfortunately, tax planning with regard to Social Security is a very case-by-case sort of thing.

Also unfortunately, a comprehensive analysis tends to be very time-consuming. In my opinion, the only way to do it appropriately is to use actual tax planning/preparation software and run through several years of simulations using Strategy A and several years using Strategy B, then compare the results (often in a spreadsheet). When I see people trying to do a DIY spreadsheet-only analyses rather than using tax software, they often end up leaving out something important (e.g., a credit for which they’re eligible in one case, but not in the other — or a tax to which they’re subject in one case but not in the other).

As such, I am convinced that this is one of the areas in which working with a financial planner can be most worthwhile.

With the above caveats, I would say that tax planning tends to be a point in favor of delaying Social Security, for two reasons.

First, each dollar of Social Security income is, at most, 85% taxable. So if a person has the option to, for example, spend down their IRA to delay Social Security and the net result is $100,000 less of IRA distributions over their lifetime but $100,000 more of Social Security benefits, that ends up being a “win” from an after-tax perspective.

Second, increasing the portion of one’s income that is made up of Social Security often results in a smaller portion of Social Security being taxable (because only 50% of benefits are included in the “combined income” figure that determines Social Security taxability).

That is, for many people, delaying Social Security results in:

  1. a larger portion of their lifetime income being made up of tax-advantaged dollars of Social Security and
  2. a smaller portion of those Social Security dollars being taxable.

But the above points don’t always apply. For instance, for the reader who wrote in with the question, it appears that even if he delays benefits and spends down tax-deferred accounts in the meantime, 85% of his benefits will still be taxable.

And there are other factors involved as well. Ultimately, the best claiming strategy often depends on whether there are other tax breaks you’re looking to qualify for or other taxes you’re looking to avoid. For instance, for a person who retires prior to age 65 and who will be buying health insurance on the exchange, keeping “household income” very low until Medicare eligibility kicks in may be very desirable, as Affordable Care Act subsidies can be quite large. And that typically means delaying Social Security (at least until 65) while spending primarily from taxable accounts and Roth accounts.

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Topics Covered in the Book:
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  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
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Can I Take a Loan from my IRA?

A reader writes in, asking:

“A friend recently told me that he took a loan from his IRA so he could take money out for a short time without having to pay penalty. I had never heard of that, so I called Vanguard and asked about it. They said that only 401k accounts have loans, not IRAs. Is that true? Was my friend wrong?”

The Vanguard representative is correct that IRA accounts do not have loan provisions, whereas many 401(k) plans do have such an option. (For more on 401(k) loans, see this MarketWatch article from Elizabeth O’Brien.)

Perhaps your friend was talking about the ability to “borrow” from an IRA by using the 60-day rollover provision.

To back up a step, there are two ways to move money from one IRA to another:

  1. Via a direct “trustee-to-trustee transfer,” in which you never have possession of the money, as it goes directly from one financial institution to the other, and
  2. Via a “60-day rollover.”

With a 60-day rollover, the first financial institution sends the money to you, and as long as you deposit an equal amount of money into an IRA within 60 days from the day you receive the distribution, it will be treated as if the distribution did not occur.

The 60-day rollover option exists so that you can move money from one retirement account provider to another. But it can also be used as a sort of short-term “IRA loan” mechanism, because it’s possible to simply deposit the appropriate amount of money back into the same account (rather than into an IRA with a different financial institution).

There is, however, one very important point to be aware of: You can only do one such 60-day rollover per year. So if you have executed such a rollover within the last year, you cannot “borrow” from your IRA in this manner, because you would not be able to put the money back into an IRA. (That is, the distribution would simply count as a normal distribution, potentially subject to the 10% penalty.) Similarly, if you do “borrow” from your IRA in this manner, you won’t be able to do so again within the next year, nor would you be able to do a normal 60-day IRA-to-IRA rollover during that period.

Of note, the one-per-year limit does not apply to:

  • Roth conversions (i.e., rollovers from a traditional IRA to a Roth IRA),
  • Direct trustee-to-trustee transfers, or
  • Rollovers involving an employer-sponsored plan (e.g., from a 401(k) to an IRA or vice versa).

Also, the one-per-year limit is no longer one rollover per IRA per year as it used to be, but rather one rollover per year regardless of how many IRAs you have.

Tax Changes: Protecting Americans from Tax Hikes Act of 2015

Late last month, Congress passed (and President Obama signed) the Protecting Americans from Tax Hikes Act (“PATH Act”) of 2015. The Act makes quite a lot of changes (click the previous link to see the full list), but from a personal finance standpoint, the most important thing it did was to make permanent several tax breaks that were expiring in the near future (or already expired in some cases).

Expired Provisions Brought Back

With regard to investing, likely the most important change is that the ability to make “qualified charitable distributions” from an IRA is now permanent. (It had previously expired at the end of 2014.)

With a qualified charitable distribution, a taxpayer over age 70.5 has his/her RMD for the year distributed directly to a qualified charitable organization, and the distribution satisfies the annual RMD requirement while being excluded from gross income. The benefit is that this is an exclusion from gross income rather than an itemized deduction (which is what you would ordinarily get for a charitable donation). This is relevant because it means that:

  • This income will not be included in your adjusted gross income (which plays a role in determining many things such as how much of your Social Security benefits will be taxable and whether you qualify for numerous credits/deductions), and
  • You can take advantage of this tax break even if you use the standard deduction.

Another tax break that had expired in 2014 but which is now brought back and made permanent is the ability to elect a deduction for state and local sales taxes instead of state and local income taxes. (This is of course particularly helpful for people who live in states with no income tax.)

Finally, the increased exclusion for employer-provided mass transit benefits is now made permanent. (Prior to the passing of this Act, the monthly limitation would have reverted to a $130 limit beginning in 2015. With the passing of the Act, it will be $250 for 2015 and $255 for 2016.)

Scheduled-to-Expire Provisions Made Permanent

Another important change is that the American Opportunity Credit is also made permanent. (It was previously scheduled to expire at the end of 2017.) The American Opportunity Credit is a credit of up to $2,500 per year for paying qualified higher education expenses for yourself, your spouse, or your dependent.

Similarly, the “enhanced” version of the child tax credit (which is simply a change to the calculation of the child tax credit that increases the amount of credit many taxpayers receive) is now made permanent rather than expiring at the end of 2017.

Likewise, the “enhanced” version of the earned income credit (which increases the amount of the earned income credit for married taxpayers and taxpayers with 3 or more children) is now made permanent rather than expiring at the end of 2017.

Changes to 529 Plans

The Act also makes two important changes to 529 accounts.

First, the definition of “qualified higher education expenses” for 529 accounts has been expanded to include the cost of computers, related equipment, software, and internet access if such equipment is to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution.

Second, for 529 ABLE accounts (for disabled individuals), the residency requirement has been eliminated. Previously, a beneficiary was required to use the plan established by his/her state of residence.

Again, to be clear, these are just a few of the provisions which I am assuming are most likely to be relevant to a large number of readers. There are many provisions in the Act that I have not mentioned. If you’re interested in perusing the full list, see here.

For More Information, See My Related Book:


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:

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LLC vs. S-Corp vs. C-Corp (The 3-Minute Version)

One question business owners frequently ask is which legal structure is right for their business. So which is best for you? Let’s take a quick look.

Sole Proprietorships and Partnerships

There isn’t necessarily anything wrong with operating your business as a sole proprietorship or partnership, but you need to be aware that you will have unlimited liability for business debts. In other words, if your business is sued for any reason, the plaintiff will be able to come after your personal assets, not just business assets.


First, there are no tax advantages (or disadvantages) to forming an LLC. In fact, forming an LLC won’t change a thing for federal income tax purposes. Single-owner LLCs are taxed just like sole proprietorships, and multiple-owner LLCs are taxed just like partnerships.

You should, however, be aware that forming an LLC might subject your business to additional state taxes. Certain states (California for instance) subject LLCs to “franchise taxes” in addition to a typical income tax.


S-Corporations have the ability to provide some tax savings as a result of the fact that profits from an S-Corp are not subject to self-employment tax. However, before you’re allowed to distribute any profits, you are required to pay any owner-employees a “reasonable salary.” This salary will be subject to Social Security and Medicare taxes (which total the same amount as the self-employment tax). As such, the tax savings only take effect once the business has a pretty sizable income.

Also, you should be aware that S-corporations are significantly more complicated from a tax and legal standpoint than LLCs. So if you form an S-corp, know that you’re going to be spending a great many more billable hours with your accountant/attorney.


Unlike most other business structures, C-corporations are taxable entities. This means that the corporation itself is taxed on its income (as opposed to other structures which simply pass the income along to the owner(s), who are then taxed on it).

If you don’t plan to distribute all of the profits from your business, you might benefit from forming a C-corp and utilizing a strategy known as “income splitting.” The idea is to split the business’s income so that part of it is taxable to the corporation and part of it is taxable to the corporation’s owner(s), thus putting them each in a lower tax bracket than they’d be in if either one was earning all of the income.

The big disadvantage to C-corp taxation is that distributions of profits (known as “dividends”) are subject to double taxation. In other words, the corporation is taxed once on its income, and then the shareholders are taxed upon any dividends they receive.

Also, like S-corporations, C-corporations are more complicated from an accounting/tax/legal standpoint than sole proprietorships, partnerships, or LLCs. As such, C-corp owners tend to incur fairly high legal and accounting costs.

For More Information, See My Related Book:


LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

Solo 401(k) Contributions: Employee or Employer?

A reader writes in, asking:

“I have a solo 401k at Vanguard. There’s no way I will hit the total contribution limit for the year, so should I be making employer or employee contributions to the account?”

As background information, if you are a business owner with a solo 401(k) — sometimes referred to as an individual 401(k) or self-employed 401(k) — you can make two types of contributions to the account:

  • An “employee” contribution, limited to $18,000 ($24,000 if age 50 or over) for 2016, and
  • An “employer” contribution, limited to 25% of your net earnings from self-employment (if you are a sole proprietor or LLC taxed as a sole proprietorship) or 25% of your compensation (if you are an owner-employee of an S-corp or LLC taxed as an S-corp).

Solo 401(k) for Sole Proprietors

For a sole proprietor, pre-tax (i.e., “traditional”) contributions (whether they’re employee or employer contributions) will be deducted on line 28 of Form 1040 under “Self-employed SEP, SIMPLE, and qualified plans.”

Because pre-tax employer and employee contributions are deducted in the same way, neither one is more tax-efficient than the other.

That said, because employee contributions can be Roth or pre-tax, whereas employer contributions can only be pre-tax, if you want to make pre-tax contributions, it often makes sense to make them as employer contributions (to the extent possible), thereby saving your (more flexible) employee contribution space, in case you decide that your further contributions should be Roth rather than pre-tax.

Solo 401(k) for S-Corporation Owner/Employees

If your business is taxed as an S-corporation, contributions that you make as an employee would reduce the amount of wages that would appear in box 1 on your W-2 — and therefore the amount of wages that show up on your Form 1040. Note that they do not reduce the amounts that show up in boxes 3 and 5 (“Social Security Wages” and “Medicare Wages”). In other words, these contributions reduce your income tax, but they do not reduce your payroll taxes.

Employer contributions to the solo 401(k) would show up on line 17 of Form 1120S as “Pension, profit-sharing, etc., plans.” This would reduce the amount of income from the S-corporation that would be passed through to you as the owner, thereby reducing your income tax. But, because this income is not subject to payroll taxes in the first place, these contributions will not reduce your payroll taxes.

In other words, for an S-corp owner-employee, employer and employee pre-tax solo 401(k) contributions are equally advantageous (just as they are for a sole proprietor). Though again, by prioritizing employer contributions, you preserve your more flexible employee contribution space, in case you decide you want to make Roth contributions later in the year.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."
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