Archives for January 2021

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Investing Blog Roundup: Beating TIPS Yields with I Bonds

While I Bonds aren’t exactly a secret, they don’t get the amount of coverage they deserve — especially in an interest rate environment such as today’s in which yields on the other type of inflation-adjusted bonds (TIPS) are negative, even all the way out to 30-year maturities.

Presumably, that lack of discussion is for a combination of reasons. Nobody makes any money promoting I Bonds. There are no mutual funds that own them. There’s an annual purchase limit. And a lot of people don’t really like dealing with TreasuryDirect.

But as Harry Sit points out, there’s one easy way to buy some I Bonds each year:

Recommended Reading

Thanks for reading!

Spending More Than 4% Per Year Can Be Safe

If you’ve read much about retirement planning, you’ve probably encountered the “4% rule” — the idea that, if you spend 4% of your portfolio balance in the first year of retirement, then adjust that level of spending upward each year in keeping with inflation, your portfolio will probably last through a 30-year retirement.

An unfortunate side effect of the proliferation of this concept is that people sometimes think that it’s automatically dangerous to spend more than 4% of your portfolio per year. In reality, there are plenty of cases in which spending more than 4% per year isn’t particularly risky — and even some cases where that’s the safest thing to do!

The “4% Rule” Often Involves Spending More than 4%

The idea of the 4% rule isn’t to spend 4% of the portfolio balance each year. Rather, the idea is to spend 4% in the first year of retirement, then adjust the dollar amount based on inflation going forward, regardless of how the portfolio performs.

As a result, even with the original 4% rule strategy, there are plenty of scenarios in which a person ends up spending more than 4% of the portfolio balance in a given year. (For example, any scenario in which the portfolio declines at all in Year One will result in spending more than 4% in Year Two.) Scenarios of that nature are already accounted for in the research that found that a 4% initial spending rate was reasonably safe.

Age Matters

Depending on your age, spending more than 4% per year can make perfect sense. As an obvious example, consider a 85-year-old widower. He doesn’t need his portfolio to last another 30 years. He might want to spend at a low rate, if his goal is to leave most of his savings to heirs, but he doesn’t have to.

Conversely, if you sell a business at age 35 and plan to be retired as of that point, living primarily off the portfolio, I would not suggest spending 4% per year. Given the super long time span that’s likely to be involved, it would probably be prudent to start with something more like 3% — or possibly even less.

Intending to Deplete the Portfolio

One long-time reader of this blog is unmarried, in her 60s, retired after a career with the federal government. Her home is paid off. And, in her own words, her savings are “modest, compared to what I would have tried to accumulate if I did not have a pension.”

Her plan is to spend about 10% of the portfolio balance per year, and I think that’s entirely reasonable. She plans to deplete the portfolio — that’s the goal. Spend the portfolio down while her health is still such that she can get the most enjoyment from the additional spending, and then live on the (not-at-all-trivial) pension for her remaining years.

Delaying Social Security

Finally, as we’ve discussed about a zillion times, delaying Social Security is typically advantageous for most unmarried people, for the higher earners in married couples, and in some cases even for the lower earner in married couples.

But delaying Social Security means spending down the portfolio at a faster rate in the meantime — often a rate in excess of 4%. And that scares some people.

But in reality, this is typically the safest thing to do.

You can carve out a separate chunk of your portfolio to satisfy the higher level of spending in early retirement, and put that money in something low-risk. (For example, build an 8-year CD ladder to satisfy the 8 years of higher spending until your Social Security kicks in.) In such a case, yes, you’re likely spending more than 4% in those years. But that chunk in question has almost no risk. And the result is a lower long-term spending rate once your Social Security does kick in. (Plus, in the event that you were to deplete your portfolio, you’d be left with a higher level of income than if you had not delayed Social Security.)

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Investing Blog Roundup: What’s Next?

It’s been one heck of a week, to follow what was, by any measure, one heck of a year.

In finance, one thing you eventually have to accept is that it’s impossible to predict what’s going to happen next. Lots of events look obvious, in hindsight. But lots of potential events that didn’t happen would have looked obvious in hindsight as well.

That feeling — unsure what’s about to happen, recognizing that some of the potential outcomes are dramatically different than other potential outcomes — feels particularly acute right now.

As always, thank you for reading, and I wish you well.

Recommended Reading

Retirement Tax Planning Error: Not Planning for Widow(er)hood

One of the most common retirement tax planning errors I see is specific to married couples: not accounting for the tax changes that will occur once one of the two spouses dies.

For example, using data from the SSA’s 2017 Period Life Table, we can calculate that, for a male/female couple both currently age 60 and in average health, there will be, on average, 11.3 years during which only one spouse is still alive. (That is, the expected period for which both spouses will still be alive is 17.4 years, while the expected period for which either spouse will be alive is 28.7 years. The difference between those two lengths of time, 11.3 years, is essentially the expected duration of “widow(er)hood” for the couple.)

Why This Is Important for Tax Planning

When one of the two spouses dies, there is generally a decrease in income, but it’s typically somewhat modest as a percentage of the household’s overall income — especially for retired couples who have managed to accumulate significant assets. What generally happens is that the smaller of the two Social Security benefits disappears when one spouse dies*, but the portfolio income is largely unchanged (unless the deceased spouse left a significant portion of the assets to parties other than the surviving spouse).

And, beginning in the year after the death, the surviving spouse will only have half the standard deduction that the couple used to have. In addition, there will only be half as much room in each tax bracket (up to and through the 32% bracket), and many various deductions/credits will have phaseout ranges that apply at a lower level of income.

In other words, there’s half the standard deduction and half as much room in each tax bracket, but the surviving spouse is left with more than half as much income. The result: their marginal tax rate generally increases, relative to the period of retirement during which both spouses were alive.

The tax planning takeaway is that it’s often beneficial to shift income from those later (higher marginal tax rate) years forward into earlier (lower marginal tax rate) years. Most often that would be done via Roth conversions or prioritizing spending via tax-deferred accounts.

It’s tricky of course because, as with anything dealing with mortality, we don’t know the most critical inputs. To put it in tax terms, how many years of “married filing jointly” will you have in retirement? And how many years of “single” will you (or your spouse) have in retirement? We don’t know. We can use mortality tables to calculated expected values for those figures, but your actual experience will certainly be different.

So it’s hard (or rather, impossible) to be precise with the math. But it’s very likely that a) there will be some years during which only one of you is still living and b) that one person will have a higher marginal tax rate at that time than you (as a couple) had earlier. So, during years in which both spouses are retired and still alive, it’s likely worth shifting some income forward to account for such.

Often the idea is to pick a particular threshold (e.g., “up to the top of the 12% tax bracket” or “before Social Security starts to become taxable” or “before Medicare IRMAA kicks in”) and do Roth conversions to put you slightly below that threshold each year. But the specifics will vary from one household to another. And the decision necessarily involves a significant amount of guesswork as to what the future holds.

*This is a simplification. There can be various factors (e.g., government pension) that would make the total household Social Security benefit fall by an amount more or less than the smaller of the two individual benefits.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

How are Partnerships Taxed?

The following is a modified excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

Partnerships themselves are not actually subject to Federal income tax. Instead, they — like sole proprietorships — are pass-through entities. While the partnership itself is not taxed on its income, each of the partners will be taxed upon his or her share of the income from the partnership.

Form 1065

Form 1065 is the form used to calculate a partnership’s profit or loss. On the first page, you list the revenues for the business, list the expenses for the business, and then subtract the total expenses from the total revenues. It’s exactly what you would expect.

On the second and third pages of Form 1065 you answer several yes/no questions about the nature of the partnership. For instance, you’ll be asked whether any of the partners are not U.S. residents, whether the partnership had control of any financial accounts located outside of the U.S., and other questions of a similar nature.

Schedule K and Schedule K-1

The fourth page of Form 1065 is what’s known as Schedule K. Schedule K is used to break down the partnership’s income into different categories. For instance, ordinary business income goes on line 1, rental income goes on line 2, interest income shows up a little bit later on line 5, etc.

After filling out Schedule K, you’ll fill out a separate Schedule K-1 for each partner. On each partner’s Schedule K-1, that partner’s share of each of the different types of income is listed.

EXAMPLE: Aaron and Jake own and operate a partnership. Their partnership agreement states that they’re each entitled to exactly 50% of the partnership’s income. If, on Schedule K, the partnership shows ordinary business income of $50,000 and interest income of $200, each partner’s Schedule K-1 will reflect $25,000 of ordinary business income and $100 of interest income. This income will eventually show up on each partner’s regular income tax return (Form 1040).

What’s important to note here is that allocations from a partnership maintain their classification once they show up on the partners’ individual tax returns. This is important because some types of income are taxed differently than other types of income. For instance, long-term capital gains (gains from the sale of investments that were held for greater than one year) are currently taxed at a maximum rate of 23.8%, and in some cases they are not taxed at all.

EXAMPLE: Aaron and Jake’s partnership buys shares of a stock, holds the shares for several years, and then sells them for a gain of $10,000. When Aaron’s $5,000 share of the gain shows up on his tax return, it still counts as a long-term capital gain (as opposed to counting as ordinary income). It will, therefore, be taxed at a maximum rate of 23.8%, even if Aaron is in a much higher tax bracket.

Similarly, deductions maintain their character when passed through from a partnership. For example, if a partnership makes a cash contribution to a qualified charitable organization, that contribution will maintain its character when it shows up on each of the partners’ personal returns. That is, it will count as an itemized deduction, subject to all the normal limitations for charitable contributions. (For 2021, there is a special rule that even people who claim the standard deduction can claim a deduction — of up to $300 or $600 if married filing jointly — for cash contributions to charity.)

Self-Employment Tax for Partnerships

Ordinary business income from a partnership is generally subject to the self-employment tax when it is passed through to general partners. This makes sense given the rule that we just discussed about income maintaining its classification when allocated to a partner on his or her K-1.

Deduction for Pass-Through Income

Because partnerships, like sole proprietorships, are pass-through businesses, profit from a partnership will also qualify for the deduction for pass-through business income. With a partnership, your deduction is for 20% of your share of the partnership’s profit, subject to limitations.

Allocated Profit vs. Distributed Profit

One thing that surprises the owners of many partnerships when their first tax season rolls around is the fact that partners get taxed on their allocated share of the partnership’s profit, even if nothing was distributed to them.

EXAMPLE: Michelle, Kayla, and Tim start a partnership. Their partnership agreement states that profit or loss will be evenly allocated to the partners.

In the first year, their partnership makes $60,000. However, they’re sure that their business could grow quickly if they had the capital. So, they decide not to distribute any cash to the partners. Instead, they make plans to use all $60,000 to buy new production equipment next year.

Despite the fact that none of the partners actually received any cash payout, they’re each going to be taxed on $20,000 of business income (1/3 of the $60,000 total). That is, each is taxed on his or her “allocated profit” of $20,000 rather than his or her “distributed profit” of $0.

[Note: Profits and losses in a partnership are not required to be split evenly between the partners. The partners can choose to split the profit or loss in any way they choose. It just makes the math in the examples easier if we give each partner an equal share.]

In Summary

  • Like sole proprietorships, partnerships are “pass through” entities. A partnership is not subject to federal income tax. Rather, its owners are subject to Federal income tax on their share of the profit.
  • Form 1065 is used to calculate a partnership’s profit or loss.
  • Schedule K is used to break down a partnership’s income and deductions by category. Schedule K-1 is then used to show each partner’s allocated share of the various types of income and deductions.
  • Income and deductions from a partnership maintain their original classification when they are passed through to a partner. For example, long-term capital gains will be taxed at a max rate of 23.8%, and ordinary business income is subject to self-employment tax.
  • For tax years 2018-2025, you can claim a deduction equal to 20% of your share of a partnership’s profit, subject to limitations.
  • Partners are taxed on their allocated share of the profit, regardless of how much of the profit is actually paid out to them.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

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.

LLC Tax Advantages and Disadvantages

The following is an excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

As far as federal income taxes are concerned, LLCs don’t really exist. The Internal Revenue Code — the body of law that outlines all federal income taxation — treats each LLC as if it were one of the other types of entities.

Specifically, unless they have elected otherwise, single-member LLCs (LLCs with one owner) will be taxed as sole proprietorships, and multiple-member LLCs will be taxed as partnerships. Because of this tax treatment, LLCs — like sole proprietorships and partnerships — are often referred to as “pass-through” entities.”

EXAMPLE: Kali owns and operates a restaurant as a sole proprietorship. She later decides to form an LLC for her business. The business will continue to be taxed as a sole proprietorship (for federal tax purposes at least).

EXAMPLE: Steve and Beth own and operate a winery. After learning about the potential dangers of unlimited liability in a partnership, they decide to form an LLC. The business will continue to be treated as a partnership for federal income tax purposes.

LLCs Taxed as Corporations

Sometimes, after forming an LLC, the owner(s) of the LLC will decide that they would benefit from being taxed as a C-corporation rather than as a sole proprietorship or partnership. When this happens, the owner(s) have two options:

  1. Form a corporation and transfer all of the assets from the LLC to the corporation, or
  2. Fill out a form (Form 8832) electing corporate tax treatment.

The second option is certainly the easier and less costly of the two.

The same thing can be done should the LLC’s owner(s) decide that S-corporation taxation would be beneficial. The only difference is that a different form (Form 2553) is used to notify the IRS of the election.

Disregarded Entities

If a single-member LLC does not elect to be taxed as a corporation, it is referred to as a “disregarded entity” because its existence is disregarded entirely as far as federal income tax is concerned. (That is, the LLC and its owner are considered to be one and the same.)

State Taxation of LLCs

Again, unless an election is made otherwise, LLCs will be treated as either sole proprietorships or partnerships for federal tax purposes. However, depending upon where your business is located, state income taxes might not work the same way.

For example, some states tax LLC directly on their income rather than (or in addition to) taxing the owners on their share of the income. For instance, in California, LLCs are subject to an $800 annual tax, as well as an income-based fee if the LLC earned more than $250,000 in California that year.

EXAMPLE: Braden runs a sole proprietorship in California for his part-time video production business. He earns roughly $3,000 per year from the business, and is considering forming an LLC. However, even with an annual income of only $3,000, a California LLC would still be subject to a tax of $800, or more than one-quarter of the business’s total profit. Braden eventually decides that the benefits of forming an LLC would be outweighed by this disproportionately large tax.

Before deciding to form an LLC, it’s definitely a good idea to find out precisely how your state taxes limited liability companies.

In Summary

  • For federal tax purposes, single-owner LLCs are treated as sole proprietorships, and multiple-owner LLCs are treated as partnerships.
  • An LLC can elect to be taxed as a corporation simply by filing a form with the IRS (Form 8832 for C-corporation tax treatment or Form 2553 for S-corporation tax treatment).
  • Some states do not tax LLCs the same way that the federal government does, so be sure to find out how your own state taxes LLCs before creating one.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

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.
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