Archives for February 2016

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Does Tax-Loss Harvesting Occur within Funds of Funds?

A reader writes in, asking:

“I’ve read on your blog and elsewhere that funds of funds are not tax efficient because they don’t allow for tax loss harvesting. But doesn’t holding a target retirement fund achieve tax loss harvesting anyway since when one of the funds inside the portfolio goes down it causes a loss, which offsets the gains? And I guess I have the same question with regular index funds. Don’t they achieve tax loss harvesting because some stocks are going down while others are going up?”

In short, the answer to both questions is “no.”

In order for tax-loss harvesting to occur, you have to actually sell the holding that has gone down. That’s what makes for a capital loss in the eyes of the tax code. Simply holding an investment that has declined in value isn’t a capital loss.

Why All-in-One Funds Don’t Usually Tax-Loss Harvest

Let’s look at the Vanguard LifeStrategy Moderate Growth Fund as an example. The fund’s targeted allocation is as follows:

  • 36% Vanguard Total Stock Market Index Fund,
  • 24% Vanguard Total International Stock Index Fund,
  • 28% Vanguard Total Bond Market II Index Fund, and
  • 12% Vanguard Total International Bond Index Fund.

For the fund to tax-loss harvest it would have to sell one of these holdings after a decline. But it’s unlikely to do that because:

  1. When a holding is down, the fund usually has to buy more of it in order to get back to the targeted allocation, and
  2. The fund cannot decide to substitute other similar funds in the way that an individual investor can (e.g., selling Vanguard Total Stock Market Index Fund to tax-loss harvest, then buying Vanguard Large-Cap Index Fund as a temporary substitute).

Why Regular Index Funds Don’t Tax-Loss Harvest (Very Much)

With a regular index fund, buying and selling within the fund happens primarily as a way to either use up cash inflows or satisfy redemptions. And in each case, the buying/selling will generally be approximately proportional to the existing allocation in the fund. For example, if an S&P 500 index fund currently appropriately reflects the S&P 500 and it needs to raise a significant amount of cash, it cannot simply choose to raise the cash by selling one stock that is down recently — otherwise the fund would no longer reflect the index that it is trying to track. Instead, the fund has to sell a little bit of everything.

That said, when the fund does “sell a little bit of everything,” if the fund manager is conscientious about taxes, he/she will usually make a point to sell the shares that have the highest cost basis (thereby realizing the largest loss or smallest gain possible). But this is not the same level of tax savings that an investor could achieve if he/she was willing to sell all of a given holding when it is down and substitute some other similar holding.

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Social Security Administration Releases Guidance on New Rules

The Social Security Administration recently released two “emergency messages” to its employees regarding the changes to the Social Security rules that occurred as a result of the Bipartisan Budget Act of 2015.

For the most part, there’s little news in the memos. They say the same things that we’ve been discussing here for the last few months. Specifically:

  • You will be affected by the new deemed filing rules (which eliminate the “restricted application” strategy) unless you were at least age 62 as of 1/1/2016, and
  • You will be affected by the new rules regarding voluntary suspension (which affect various “file and suspend” strategies) unless you request suspension of your benefits prior to 4/30/2016.

Divorced Spouse Benefits

One thing that is particularly interesting, however, is what the voluntary suspension memo says about ex-spouse benefits. Specifically, it says that, even for people affected by the new rules, if a person suspends his/her retirement benefit, that will not stop an ex-spouse from receiving a spousal benefit on that person’s work record.

The reason this is noteworthy is because it’s directly contrary to the text of the law itself. The law states, “In the case of an individual who requests that such benefits be suspended under this subsection, for any month during the period in which the suspension is in effect […] no monthly benefit shall be payable to any other individual on the basis of such individual’s wages and self-employment income.” [Bolding is mine.]

“Any other individual” is pretty explicit. So it’s interesting to see the SSA stating that ex-spouses will still be able to receive spousal benefits during the period of suspension based on the work record of the person whose benefit is suspended.

I’m not sure what to make of this. Perhaps the SSA has insider knowledge that further legislation is coming (and is expected to pass prior to 4/30/16) that will insert an exception for ex-spouses. Or perhaps the SSA has just decided — of its own volition — that the law doesn’t make sense as it is written, so they’re not going to enforce it.

Better-Informed SSA Employees

Aside from the above discussion about spousal benefits for divorced spouses, the other reason these memos are noteworthy is that they mean that SSA employees have finally at least been exposed to the new rules. That said, because the rules are still very new, mistakes and misinformation on the part of SSA employees is still likely to be more common than it would be for other, unchanged topics. So it’s a good idea to be especially diligent with double-checking any information you receive (from the SSA or otherwise) before relying on it for decision making.

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Is It Better to Be Taxed as an Employee or Independent Contractor?

A reader writes in, asking:

“I just started a new position and the company is letting me decide whether I want to be taxed as an employee or an independent contractor. What factors should I be considering in order to make this decision?”

Firstly, we need to back up a step, because this question sets off some alarm bells.

It is the facts and circumstances of the work relationship that determine whether a worker is an employee or an independent contractor. Generally speaking, the more control the business has over the worker, the more likely it is that the worker is an employee rather than an independent contractor. (IRS Publication 15-A has more details.)

In other words, if the facts and circumstances of the work suggest that you are an employee, the business cannot simply decide you are an independent contractor and handle everything accordingly. And in fact many employers get in trouble with the IRS every year as a result of having misclassified their employees as independent contractors.

The key point here is that, in the event that you really do have a choice between being an independent contractor or an employee (i.e., it is not simply a case of the business misunderstanding the rules and thinking that they can treat you as either one without any substantial difference in the work relationship), there are going to be factors other than taxation involved.

So What Are the Tax Differences?

From a tax perspective, there are both pros and cons regarding the tax treatment for independent contractors as compared to employees.

As an employee, you are responsible for paying Social Security and Medicare taxes in the amount of 7.65% (2.9% for amounts beyond the current Social Security earnings limit), and your employer pays a matching amount. As an independent contractor, you have no employer, so you get stuck with both halves of the bill (in the form of a 15.3% self-employment tax).

Another disadvantage of being an independent contractor is that it requires somewhat more administrative work. You’ll have to fill out Schedule C along with your Form 1040 every year to calculate the profit or loss from your business. In addition, because nobody will be withholding taxes from your income, it will (in most cases) be necessary for you to make estimated tax payments throughout the year.

On the other hand, one advantage of independent contractor tax treatment is that your work-related expenses will be business expenses, which will save you money on income tax as well as Social Security and Medicare taxes. In contrast, as an employee, unreimbursed work expenses are generally itemized deductions, meaning that you get no value from them if you use the standard deduction each year. In addition, they’re in the category of itemized deductions from which you must subtract 2% of your adjusted gross income before even being allowed to include them as an itemized deduction. (See the instructions to Schedule A for more information.)

An additional advantage of being an independent contractor is that you’ll have additional retirement plan options available to you. Most importantly, you’ll be eligible for a solo 401(k) — alternatively referred to as an individual 401(k) — for which the contribution limits are quite high.

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Politics and Investing Don’t Mix

Fear is a powerful sales tool.

A sales technique that I’ve seen more and more of recently is the exploitation of a person’s political views in order to instill fear and, ultimately, sell undesirable financial products. The pitch goes something like this:

  1. [Political event X] just happened or is likely to happen.
  2. As a result, the economy will take a nosedive.
  3. You should buy my product to protect yourself.

The technique is popular because it’s effective.

The technique is popular because it can be used to appeal to just about any set of political views. (To appeal to people with left-leaning political views, the pitch is typically something to the effect of the market being rigged by the financial elites. To appeal to people with right-leaning views, the pitch is often about over-taxation, over-regulation, or excess government spending.)

And the technique is also popular because it can be used to sell just about anything. For example:

  • The economy is going to hell, and that’s why you should buy gold.
  • The economy is going to hell, and that’s why you should buy my market-timing newsletter.
  • The economy is going to hell, and that’s why you should buy this annuity.
  • The economy is going to hell, and that’s why you should invest in my hedge fund.

The fact that this approach can be used to pitch just about anything — as well as the fact that it can be used to appeal to either of two directly contradictory sets of beliefs — is precisely the reason you should never trust it.

In order for the pitch to work out well for you, the pitch-person has to get their political prediction right, they have to get the resulting economic prediction right, and they have to be right (and honest) that the product they’re pitching is indeed a good solution in a scenario in which the economic prediction turns out to be right.

That’s what’s necessary in order for it to work out well for you. In order for it to work out well for them, they just have to convince you to buy in the first place.

Transferring an IRA and 401(k) in a Divorce

A reader writes in, asking:

“My divorce was finalized a few weeks ago, and I am supposed to receive a portion of my ex-husband’s IRA and 401k. Are there any specific rules to follow as far as how to move the money from his accounts to my IRA? Or does he just take the money out, write me a check for the appropriate amount, and I deposit the money in my IRA?”

Yes, there are specific rules to follow. And it’s important to note that the rules are different for IRAs than for employer-sponsored retirement plans. Let’s talk about IRAs first.

Transferring IRA Assets in a Divorce

Publication 590-A speaks to transferring an IRA after a divorce. There are two key points here.

The first key point is that there are two ways to do it:

  1. Change the name on the account (in cases in which the entire account is being transferred to you), or
  2. Move the money via a direct trustee-to-trustee transfer, in which the money is sent directly from one financial institution to the other.

A check written to you is a problem, because it does not fall under either of these options. That is, it is not possible to do a “rollover” in which the money is sent to you, then you put it into your own IRA. It has to be a direct transfer from one financial institution to the other (i.e., from the custodian of your ex-spouse’s IRA to the custodian of your IRA).

The second key point is that the divorce decree (or a written document incident to such decree) must specifically state that you are supposed to get this interest in your ex-spouse’s IRA.

Transferring 401(k) Assets in a Divorce

The rules for an employer plan — such as a 401(k) or 403(b) — are different.

First, rather than the divorce decree needing to state that you’re supposed to get an interest in the account, it has to be a “qualified domestic relations order” (QDRO) that states that you get an interest in the account. Also, it’s critical that the order includes certain specific pieces information in order to qualify as a QDRO.

Second, with an employer plan, a rollover is possible. That is, as long as there is a QDRO ordering that you get the part of the account in question, the plan can make out a check to you, and you can then deposit it (i.e., “roll it”) into your IRA — though you only have 60 days (from the date you receive the distribution) to do so.

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