Archives for January 2017

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Should I Prepare My Own Tax Return?

A reader writes in, asking:

“This is my first time having to file a tax return since getting a ‘real job’ and my head is spinning. Should I hire a CPA to do my taxes or is it better to use software for it myself? I’ve read that Turbotax guarantees the highest refund possible. Is it really better than hiring a CPA?”

Without a doubt, using a tax professional is the most reliable way to get the lowest tax bill. A key point here is that tax professionals use tax preparation software too, so using such software yourself does not provide you with any advantage over a professional.

That said, there are valid reasons for taking a DIY approach. Most obviously, you save on fees. Buying a download of TurboTax or other similar software certainly costs less than hiring a professional.

More importantly in my opinion though is that by preparing your own return for the first time, you’ll learn quite a bit about how income taxes work.

In my work, I frequently come across people who have been paying income taxes for decades, yet they don’t understand even the most basic income tax concepts (e.g., they misunderstand how tax brackets work, or they don’t know the difference between a deduction and a credit). Every year, they simply turn over all of their documents to somebody else who prepares their return, and so they go years without learning these things. Naturally, it’s impossible to make very good decisions about tax planning when you don’t understand the fundamental concepts.

In addition to allowing you to make smarter financial decisions, having a better understanding of income taxes allows you to be a more well-informed voter. It’s very common for politicians to propose various changes to our tax code (e.g., creating a new deduction or credit, or eliminating/changing an existing deduction or credit). If you don’t understand how the system works now, you can’t really understand the impact of proposed changes.

My point here isn’t that everybody should be preparing their own tax returns. It depends on your goals, and it depends on how complicated your return is. (If you’re already at the point where you have investments in taxable accounts, you itemize your deductions, and you have income from a rental property, then it’s going to be quite a challenge to prepare your own tax return if you’ve never prepared a return before.)

In summary, if you want to learn more about income taxes, you want to save on tax prep fees, and/or your return isn’t too complicated, those are all points in favor of preparing your own return. But it’s unlikely that your tax bill will be lower as a result of taking a DIY approach rather than hiring a professional. In most cases, the outcome that you’re hoping for with a DIY approach is that your return will turn out exactly the same as it would have if a professional had prepared it.


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:

"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!"

Diversification Isn’t (Necessarily) Necessary for Fixed Income

A reader writes in, asking:

“What are your thoughts on bond diversification? Is it ok to just do something simple like a treasury bond ladder or is it necessary to diversify bonds like you do with stocks?”

No, I really don’t think that diversification is necessary for the bond portion of an investment portfolio.

Several years ago, prior to switching to a LifeStrategy fund, the bond portion of my portfolio included nothing but Treasury bonds (via a single bond fund). And that didn’t bother me at all.

The goal for the bond part of my portfolio was (and still is, for the most part) simply to act as something that is unlikely to go down (by much) during a stock market downturn. CDs or Treasury bonds (regardless of whether or not they’re held in a mutual fund, and provided they aren’t long-term bonds) achieve that goal very well without any need for additional fixed income holdings.

When Diversification *Is* Necessary for Fixed Income

Just to be clear on this point, when it comes to fixed-income investments other than FDIC-insured CDs and Treasury bonds, diversification is important. That is, if you’re putting a significant part of your portfolio into muni bonds, corporate bonds, or international bonds, yes, you definitely want to diversify those holdings.

Diversification Isn’t a Bad Idea

For many investors though, the goal of their bond holdings isn’t only to act as “something safe.” They also hope to achieve some degree of “free lunch” via diversification. The general thought process is that if something has a low enough correlation to the rest of your portfolio while providing an acceptable return, adding it to the portfolio can result in reduced risk without a correspondingly large reduction in return.

This is the argument, for instance, that Vanguard makes in favor of international bonds in their funds-of-funds.

That’s a thoroughly reasonable line of thinking. And if things go according to plan (i.e., correlations and returns behave the way you hope they will) it will improve your results.

However, it isn’t necessary. And it’s not entirely obvious that it’s a clear improvement over an all-CD or all-Treasuries fixed income portfolio, because:

  • CDs offer their own sort of free lunch sometimes, if you can find longer-term CDs (that have relatively high yields due to the long term) with low penalties for early redemption, and
  • Corporate bonds (i.e., the most likely candidate for adding to an otherwise-Treasury bond portfolio as a diversifier) often have higher correlation to stocks than Treasury bonds do, so it’s not a sure bet that they will have the desired result.

The (un)Importance of Social Security Full Retirement Age

A reader writes in, asking:

“I read over and over that it’s ideal to wait until 70 to file for social security but that it’s important to wait until at least full retirement age. But what is special about full retirement age exactly? Am I wrong in thinking that it is not much better or worse than a year earlier or later?”

No, you are not wrong.

In terms of general Social Security rules, full retirement age is important because:

  • It’s the reference point around which your benefit is calculated (with a reduction for filing early and a bonus for filing later),
  • It’s the earliest date at which you can suspend benefits (though that’s much less frequently relevant these days after the changes made in 2015), and
  • It’s the point at which the earnings test is no longer applicable.

And full retirement age is often the best age at which to file for spousal or survivor benefits because:

  • It’s the point at which survivor benefits and spousal benefits stop growing (i.e., there’s no increase for waiting until 70), and
  • It’s the earliest date at which you can file a restricted application for spousal benefits (i.e., an application for just spousal benefits) for those who are still eligible to do so (i.e., anybody who was at least 62 years old as of 1/1/2016).

But, from the perspective of when to start receiving your own retirement benefits, full retirement age is nothing special. It’s just one of 96 possible months at which you can start taking benefits.

And in fact, of those 96 months, the first one and the last one (62 and 70) come up much more frequently than other months as the optimal time to start benefits.

If you could claim at any age (i.e., with delayed retirement credits earned for delaying beyond age 70 and with early claiming available prior to 62 — with an accompanying penalty), people in particularly good health would often want to wait well past age 70. And people in very poor health would often want to claim very early — perhaps in their 50s even.

But those aren’t options. So everybody who would be best served by claiming prior to 62 (if such were an option) will find “claim at 62” to be the best strategy. And everybody who would be best served by claiming later than 70 (if such were an option) will find “claim at 70” to be the best strategy.

In other words, yes, it is very uncommon that full retirement age happens to be the best answer for when to start receiving retirement benefits. (And for both spouses to start receiving retirement benefits at full retirement age is almost surely a mistake. In most cases, that would be a dominated strategy.)

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Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Why Forex (Foreign Currency Trading) Is Useless and Dangerous for Most Investors

A reader writes in, asking:

“I recently saw an article that said that forex trading was invented to be a risk reduction tool. The nature of the rest of the article gave me the impression that it was just fear-mongering. Make me scared about the fate of U.S. Dollars so I turn my money over to them. But if you could discuss the matter in an article on your blog I’d be interested to read it.”

In some cases — which are rare for individual investors — currency-related investment products can be helpful as a way to reduce risk.

Example: Theresa is a self-employed engineer. She lives in the US (and therefore spends pretty much exclusively in dollars), but the majority of her revenue this year will come from completing a project for a client in the UK — a project for which she’ll be paid £70,000. She anticipates completing the project in October. If she wants to, she could use currency futures to “lock in” the current exchange rate so that she knows how much the £70,000 will actually be worth to her (i.e., in dollars), thereby allowing her to budget her finances accordingly.

Most people, however, are paid in the same currency in which they spend. So there’s no need to offset any such risk.

In fact, for most individual investors, foreign currency trading is not only pointless but also harmful.

Firstly, investing in currency is a zero-sum game, before costs. That is, with forex, the investment you’re holding is a currency (or a derivative product whose performance is based on the price of a currency), and currencies do not actually earn any money. (This is quite different from stocks and bonds, which do on average earn money.) With a forex trade, if one party earns money, it is solely because the party on the other side of the trade lost money. And, after accounting for transaction costs, the total amount earned by the two parties is not zero, but negative.

Second, forex allows for degrees of leverage (i.e., investing with borrowed money) that are truly insane for an individual investor. Forex brokers typically allow for 50:1 leverage, meaning that for each $1,000 you invest, you can buy $50,000 of something by borrowing the other $49,000. Investing this much borrowed money wildly magnifies your results, whether good or bad. Of course, the fact that you can borrow huge amounts of money doesn’t mean you have to. But forex does give you the tools to absolutely destroy your finances in a hurry.

Finally, most individual investors don’t engage in currency trading. As a result, you’re engaging in a zero-sum game (negative, after costs) with people who are, in most cases, professionals. They likely have more experience, better skills, and more information than you have.

How Pensions and Social Security Affect Asset Allocation

A reader writes in, asking:

“I am a retired government employee, and I receive a pension to the tune of roughly $50,000 annually. I have a relatively low risk portfolio; it is a mix of stuff but roughly 20-25% is in stock with the rest in bonds or CDs. I recently met with an adviser who said that my pension is essentially a big bond so it’s a mistake to have such low risk holdings in my retirement accounts. This is the first time I’d heard of this idea before. What do you think?”

It is a very common idea for people to count their pension or Social Security income as a bond holding. Many financial advisors and writers suggest doing so. Industry luminary John Bogle suggests doing so as well.

Personally, I do not like the idea because:

  1. It is confusing to many people, and
  2. It encourages people to use higher-risk allocations in their portfolios as a result of their pension/Social Security income, when in many cases the correct approach is to do exactly the opposite.

Instead, I think it is easier and more helpful to think of a pension (or Social Security) as exactly what it is: income.

For example if you plan to spend $60,000 per year, and you have pension/Social Security income of $50,000 per year, then you only have to spend $10,000 per year from your portfolio. In other words, your pension/Social Security income allows you to use a withdrawal rate that is one-sixth the withdrawal rate you’d have to use if you didn’t have such income.

What this does is it allows you to choose from a broader range of asset allocation choices.

That is, you could say, “my pension satisfies my basic needs. Therefore, I can afford to shoot for the moon with my portfolio, taking a lot of risk in the hope of achieving very high spending or a large inheritance for my kids.” Or, just as reasonably, you could say, “my pension satisfies my basic needs. Therefore, I have no need to take risk in my portfolio at all. I’ll stick to very safe holdings like TIPS, I-Bonds, and CDs, so that I don’t mess up a good thing.”

Either approach can be perfectly reasonable, and the correct answer depends on your personal risk preferences.

It is a mistake, in my view, to say that a person should necessarily take on more risk in their portfolio as a result of having a large pension (or other safe source of income).

Separate Equivalent Units for Direct Materials and Conversion Costs

Equivalent units are often measured separately for direct materials costs as opposed to conversion costs (i.e., direct labor and manufacturing overhead). This is done because direct materials costs are often added entirely (or mostly) at the beginning of the manufacturing process, whereas conversion costs are incurred more evenly throughout the process.

EXAMPLE: Choice Chocolate Company is a chocolate bar manufacturer. In the production process, each bar of chocolate passes through three departments: mixing, molding, and packaging. The molding department doesn’t add any direct materials to the process. (In contrast, the mixing department adds materials such as cocoa butter, sugar, milk, etc.) So every single unit of production in the molding department’s inventory will be considered 100%-complete with respect to direct materials (because the department has no further DM costs to add to any unit). But the units will each have varying levels of completeness with respect to conversion costs.

When measuring equivalent units separately for direct materials costs and conversion costs, the overall process works exactly the same as we discussed in the book, except that in steps 2-5 each calculation is performed separately for direct materials and conversion costs instead of everything being lumped together into one calculation.

EXAMPLE: During the month of January, Choice Chocolate Company’s molding department completed 1,500 physical units and transferred them to the packaging department. At the end of the month, the molding department had 1,000 physical units in Work-in-Process inventory. Those Work-in-Process units are estimated to be 100% complete with respect to direct materials and 30% complete with respect to conversion costs.

Direct Materials Conversion Costs
Ending Work-in-Process 1,000 1,000
Percent complete x 100% x 30%
Equivalent units 1,000 300
Units transferred out 1,500 1,500
Percent complete x 100% x 100%
Equivalent units 1,500 1,500
Total equivalent units 2,500 1,800

From this point, the remaining steps of process costing would be followed just as discussed in the book, but with separate calculations for direct materials and conversion costs. That is, we would use our information about direct materials costs and direct materials equivalent units to compute a direct materials cost per equivalent unit. And, separately, we would use our information about conversion costs and conversion cost equivalent units to compute a conversion cost per equivalent unit. Then we would use those two separate per-unit costs to calculate the costs for the units that were completed and transferred out and for the units still in ending Work-in-Process inventory.

EXAMPLE: Let’s assume that, in steps 3 and 4 of process costing, the molding department calculates direct materials cost of $1.25 per equivalent unit and conversion costs of $0.75 per equivalent unit. How would the department know how much to reflect as the ending WIP balance and the amount transferred to the next department?

To calculate ending Work-in-Process, we see that there are 1,000 direct materials equivalent units at a cost of $1.25 per equivalent unit, giving us a cost of $1,250. And we see that there are 300 conversion cost equivalent units at a cost of $0.75 per equivalent unit, giving us a cost of $225. Therefore, our total ending Work-in-Process balance is $1,475 (i.e., $1,250 + $225).

That is, total costs in end WIP:
(1,000 x $1.25) + (300 x $0.75) = $1,475

To calculate the amount transferred to the next department, we see that there are 1,500 direct materials equivalent units at a cost of $1.25 per unit, giving us a cost of $1,875. And we see that there are 1,500 conversion cost equivalent units at a cost of $0.75 per unit, giving us a cost of $1,125. Therefore, our total cost of units completed and transferred out to the next department is $3,000 (i.e., $1,875 + $1,125).

That is, total cost of units completed and transferred out:
(1,500 x $1.25) + (1,500 x $0.75) = $3,000

To Learn More, Check Out the Book:

Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • Cost accounting terminology (fixed costs vs. variable costs, product costs vs. period costs, direct costs vs. indirect costs, etc.)
  • Cost-volume-profit analysis
  • Job order costing, process costing, activity-based costing
  • Budgeting and variance analysis
  • Click here to see the full list.
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