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## The Difference Between Exemptions, Deductions, and Credits

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

In short, the difference between deductions, exemptions, and credits is that deductions and exemptions both reduce your taxable income, while credits reduce your tax.

### Exemptions

Important note: for 2018-2025, exemptions will no longer exist. (This is one of the big changes from the tax law that took effect in 2018.)

For 2017, you were entitled to an exemption of \$4,050 for yourself, one for your spouse, and one for each of your dependents.

EXAMPLE: Kevin and Jennifer are married, with a combined income of \$80,000 in 2017. They have four children, whom they claimed as dependents. They were allowed six exemptions of \$4,050 each. As a result, their 2017 taxable income was reduced by \$24,300.

### Deductions

Deductions generally arise from your expenses. For example, a deduction is allowed for interest paid on student loans.

EXAMPLE: Carlos is in the 12% tax bracket. Over the course of the year, he paid \$2,000 in student loan interest. This \$2,000 decrease in his taxable income will save him \$240 in taxes (\$2,000 x 12%).

### Types of Deductions

Deductions are often grouped into two categories:

2. “Itemized” deductions.

Every year, you can claim all of the adjustments to income for which you qualify, as well as:

1. The itemized deductions for which you qualify, or
2. A fixed amount known as the “standard deduction.” (In 2023, the standard deduction is \$13,850 for a single taxpayer or \$27,700 for a married couple filing jointly.)

Here’s how it looks mathematically:

Total income (sum of all your income)
Standard deduction or itemized deductions
=  Taxable income

A key point here is that adjustments to income are always valuable, whereas itemized deductions are only valuable if and to the extent that they (in total) exceed your standard deduction amount. That is, if your itemized deductions in a given year are less than the standard deduction you’ll simply claim the standard deduction in that year rather than using your itemized deductions. And your itemized deductions will therefore not provide you with any tax savings.

Some common adjustments to income include contributions to a traditional IRA, contributions to a Health Savings Account (HSA), and interest paid on student loans.

Common itemized deductions include charitable contributions, the interest on a home mortgage, and medical/dental expenses.

EXAMPLE: Eddie is a single taxpayer. During the year he contributes \$3,000 to a traditional IRA, and he makes a charitable contribution of \$1,000 to the Red Cross. He has no other deductions, and his income (before deductions) is \$50,000.

The IRA contribution is an above the line deduction, and the charitable donation is an itemized deduction. Using our equation from above, we get this:

\$50,000 Total income
\$13,850 Standard deduction
= \$33,150 Taxable income

Important observations:

1. Eddie’s itemized deductions (\$1,000) are less in total than his standard deduction (\$13,850). As such, Eddie’s charitable contribution doesn’t provide him with any tax benefit, because he’ll elect to use his standard deduction instead of his itemized deductions.
2. Eddie’s adjustment to income provides a tax benefit even though he’s using the standard deduction.

Again, itemized/below the line deductions only help when they add up to an amount greater than your standard deduction. Adjustments to income, on the other hand, are always beneficial.

### Credits

Unlike deductions, credits reduce your taxes directly, dollar for dollar. After determining the total amount of tax you owe, you then subtract the dollar value of the credits for which you are eligible. This makes credits particularly valuable.

Credits arise from a number of things. Most often, they are the result of the taxpayer doing something that Congress has decided is beneficial for the community. For example, you are allowed a credit of up to \$2,500 for paying “qualified education expenses” for one of your dependents. If you meet the requirements to claim the maximum credit, your tax (not taxable income) will be reduced by \$2,500.

### “Pre-Tax Money”

You’ll often hear the term “pre-tax money,” generally used in a context along the lines of, “You can pay for [something] with pre-tax money.” This means one of two things:

1. The item is deductible, or
2. The item can be paid for automatically in the form of a payroll deduction.

The reason these situations are sometimes referred to as “pre-tax” is that you get to spend this money before the government takes its cut. This makes it more cost-effective for you.

You may, from time to time, run across people who are under the impression that something is free simply because it’s deductible or because they were allowed to spend pre-tax money on it. This is a severe misunderstanding. Being able to spend pre-tax money on something is more akin to getting a discount on it than it is to getting the item for free.

### Simple Summary

• Deductions reduce your taxable income. Aside from the standard deduction, deductions generally arise from your expenses.
• Each year, you can use either your standard deduction or the sum of all your itemized deductions.
• “Adjustment to income” deductions are particularly valuable because you can use them regardless of whether you use your standard deduction or itemized deductions.
• Credits, unlike deductions, reduce your tax directly (as opposed to reducing your taxable income). Therefore, a credit is more valuable than a deduction of the same amount.

 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,

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!"

## Capital Gains and Losses: Short-Term and Long-Term

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

When you sell something (such as a share of stock) for more than you paid for it, you’re generally going to be taxed on the increase in value. This increase in value is known as a “capital gain.”

The amount of gain is calculated as the proceeds received from the sale, minus your “cost basis” in the asset.

### What is “Cost Basis”?

In most cases, your cost basis in an asset is simply the amount that you paid for that asset, including any brokerage commissions that you paid on the transaction.

EXAMPLE: Lauren buys a share of stock for \$250, including brokerage commissions. She owns it for two years and then sells it for \$400. Her cost basis is the amount she paid for it: \$250. Her gain will be calculated as follows:

\$400 (proceeds from sale)
= \$150 (capital gain)

### Long-Term Capital Gains vs. Short-Term Capital Gains

The rate of tax charged on a capital gain depends upon whether it was a long-term capital gain (LTCG) or a short-term capital gain (STCG). If the asset in question was held for one year or less, it’s a short-term capital gain. If the asset was held for greater than one year, it’s a long-term capital gain.

STCGs are taxed at normal income tax rates. In contrast, LTCGs, are taxed at the same rates as qualified dividend income.

That is, for 2023, LTCGs are taxed at a 0% rate if they fall below \$44,625 of taxable income (\$89,250 if you’re married filing jointly). They are taxed at a 15% rate if they fall above the 0% threshold but below \$492,300 (\$553,850 if married filing jointly). And they are taxed at a 20% rate if they fall above the 15% threshold.

An important takeaway here is that if you’re ever considering selling an investment that has increased in value, it might be a good idea to think about holding the asset long enough for the capital gain to be considered long-term.

Note that a capital gain occurs only when the asset is sold. This is important because it means that fluctuations in the value of the asset are not considered taxable events.

EXAMPLE: Beth buys ten shares of a company at \$25 each. Five years later, Beth still owns the shares, and the price per share has risen to \$45. Over the five years, Beth isn’t required to pay any tax on the increase in value. She will only have to pay a tax on the LTCG if/when she chooses to sell the shares.

### Taxation of Mutual Funds

Mutual funds are collections of a large quantity of other investments. For instance, a mutual fund may own thousands of different stocks as well as any number of other investments like bonds or options contracts.

Each year, each mutual fund shareholder is responsible for income tax on her share of the net capital gains realized by the fund over the course of the year. (Each shareholder’s portion of the gains will be reported to her annually on Form 1099-DIV sent by the brokerage firm or fund company.)

What makes the situation counterintuitive is that, in any given year, the capital gains realized by the fund could vary significantly from the actual change in value of the shares of the fund.

EXAMPLE: Deborah buys a share of Mutual Fund XYZ on January 1 for \$100. By the end of the year, the investments that the fund owns have (on average) decreased in value, and Deborah’s share of the mutual fund is now worth \$95.

However, during the course of the year, the mutual fund sold only one stock from the portfolio. That stock was sold for a short-term capital gain. Deborah is going to be responsible for paying tax on her share of the capital gain, despite the fact that her share in the mutual fund has decreased in value.

Note how even in years when the value decreases, it’s possible that the investors will be responsible for paying taxes on a gain. Of course, the opposite is also true. There can be years when the fund increases in value, but the sales of investments within the fund’s portfolio result in a net capital loss. And thus the investors have an increase in the value of their holdings, but they don’t have to pay any taxes for the time being.

### Capital Gains from Selling Your Home

Selling a home that you’ve owned for many years can result in a very large long-term capital gain. Fortunately, it’s likely that you can exclude (that is, not pay tax on) a large portion — or even all — of that gain.

If you meet three requirements, you’re allowed to exclude up to \$250,000 of gain. The three requirements are as follows:

1. For the two years prior to the date of sale, you did not exclude gain from the sale of another home.
2. During the five years prior to the date of sale, you owned the home for at least two years.
3. During the five years prior to the date of sale, you lived in the home as your main home for at least two years.

To meet the second and third requirements, the two-year time periods do not necessarily have to be made up of 24 consecutive months.

For married couples filing jointly, a \$500,000 maximum exclusion is available if both spouses meet the first and third requirements and at least one spouse meets the second requirement.

EXAMPLE: Jason purchased a home on January 1, 2021. He lived there until May 1, 2022 (16 months). He then moved to another city (without selling his original home) and lived there until January 1, 2023. On January 1, 2023 Jason moved back into his original home and lived there until October 1, 2023 (9 months) when he sold the house for a \$200,000 gain.

Jason can exclude the gain because he meets all three requirements. The fact that Jason does not have 24 consecutive months of using the home as his main home does not prevent him from excluding the gain.

### Capital Losses

Of course, things don’t always go exactly as planned. When you sell something for less than you paid for it, you incur what is known as a capital loss. Like capital gains, capital losses are characterized as either short-term or long-term, based on whether the holding period of the asset was greater than or less than one year.

Each year, you add up all of your short-term capital losses, and deduct them from your short-term capital gains. Then you add up all of your long-term capital losses and deduct them from your long-term capital gains. If the end result is a positive LTCG and a positive STCG, the LTCG will be taxed at a maximum rate of 20%, and the STCG will be taxed at ordinary income tax rates. If the end result is a net capital loss, you can deduct up to \$3,000 of it from your ordinary income. The remainder of the capital loss can be carried forward to deduct in future years.

EXAMPLE 1: In a given year, Aaron has:
\$5,000 in short-term capital gains,
\$3,000 in short-term capital losses,
\$4,000 in long-term capital gains, and
\$2,500 in long-term capital losses.

For the year, Aaron will have a net STCG of \$2,000 (\$5,000-\$3,000) and a net LTCG of \$1,500 (\$4,000-\$2,500). His STCG will be taxed at his ordinary income tax rate, and his LTCG will be taxed at a maximum rate of 20%.

EXAMPLE 2: In a given year, Sandra has:
\$2,000 in short-term capital gains,
\$3,500 in short-term capital losses,
\$3,000 in long-term capital gains, and
\$5,000 in long-term capital losses.

Sandra has a net short-term capital loss of \$1,500 and a net long-term capital loss of \$2,000. So her total capital loss is \$3,500. For this capital loss, she can take a \$3,000 deduction against her other income, and she can use the remaining \$500 to offset her capital gains next year.

So what happens when you have a net gain in the short-term category and a net loss in the long-term category, or vice versa? In short, you net the two against each other, and the remaining gain or loss is taxed according to its character (that is, short-term or long-term).

EXAMPLE 1: In a given year, Kyle has:
\$5,000 net short-term capital gain and
\$4,000 net long-term capital loss.

Kyle will subtract his LTCL from his STCG, leaving him with a STCG of \$1,000. This will be taxed according to his ordinary income tax bracket.

EXAMPLE 2: In a given year, Christopher has:
\$3,000 net short-term capital loss and
\$6,000 net long-term capital gain.

Christopher will subtract his STCL from his LTCG, leaving him with a LTCG of \$3,000. This will be taxed at a maximum of 20%.

EXAMPLE 3: In a given year, Jeremy has:
\$2,000 net short-term capital gain and
\$3,000 net long-term capital loss.

Jeremy will subtract his LTCL from his STCG, leaving him with a \$1,000 LTCL. Because this is below the \$3,000 threshold, he can deduct the entire \$1,000 loss from his ordinary income.

EXAMPLE 4: In a given year, Jessica has:
\$2,000 net long-term capital gain and
\$4,000 net short-term capital loss.

Jessica will subtract her STCL from her LTCG, leaving her with a \$2,000 STCL. Because this is below the \$3,000 threshold, she can deduct the entire \$2,000 loss from her ordinary income.

### Simple Summary

• If an asset is held for one year or less, then sold for a gain, the short-term capital gain will be taxed at ordinary income tax rates.
• If an asset is held for more than one year, then sold for a gain, the long-term capital gain will be taxed at a maximum rate of 20%.
• If you have a net capital loss for the year, you can subtract up to \$3,000 of that loss from your ordinary income. The remainder of the loss can be carried forward to offset income in future years.
• Mutual fund shareholders have to pay taxes each year as a result of the net gains incurred by the fund. This is unique in that taxes have to be paid before the asset (i.e., the mutual fund) is sold.
• If you sell your home for a gain, and you meet certain requirements, you may be eligible to exclude up to \$250,000 of the gain (\$500,000 if married filing jointly).

 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,

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!"

## Does This Count as Market Timing?

“I am new to really paying attention to investing. Most sources seem to agree that market timing is a bad idea. But then I also have read a lot about buying I Bonds or TIPS because they have high interest rates right now. Why isn’t that market timing? Does market timing only involve stocks?”

“Does _____ count as market timing?” is one of the most common types of investing questions I’ve received over the years writing this blog. The answer, in my opinion, is that it doesn’t matter whether or not an investment strategy “counts as market timing.” All that matters is whether or not it’s a good idea.

Some people will apply the market timing label to any strategy that has anything to do with interest rates or market valuations, thereby declaring all such strategies taboo, despite the fact that there’s a huge variation as to:

1. The level of risk involved and
2. The probability of success.

To illustrate what I mean, let’s take a look at a few example strategies, any of which could be described as market timing, depending on who you ask.

### Strategy 1: Moving Between Cash and Stocks Everyday

Bob has determined that he cannot afford very much risk, but he still needs high returns to meet his goals. So he decides to move his entire portfolio between 100% cash and 100% stocks from day to day in an attempt to catch the best days in the market and miss the worst ones.

Bob’s strategy relies entirely on predicting what the stock market will do over very short periods, which is pretty much impossible. And if Bob fails, he could experience losses that he cannot afford. This type of market timing is clearly not a good idea.

### Strategy 2: Shifting Your Bond Maturities

At a time when interest rates are far below their historical averages, Steve shifts his bond allocation from intermediate-term bonds to short-term bonds. Steve’s thought process is that interest rates are likely to come back up in the near future, and he doesn’t want to experience the larger loss in value that would occur with bonds with longer duration. He plans to wait for rates to come back up, then switch back to intermediate-term bonds.

Steve’s strategy is essentially a guess that interest rates will soon go up. Predicting where interest rates will go in the near future is about as hard as predicting where the stock market will go in the near future. (So this is not, for example, a strategy that I would be interested in using myself.) But a key difference between this strategy and Bob’s strategy above is that if Steve is wrong (and interest rates do not rise any time soon), it’s probably not a disaster for Steve. He just misses out on the slightly-higher returns that he could have gotten by holding longer-term bonds.

### Strategy 3: Moving from Stocks to Bonds (Permanently)

Laura is planning to retire in the near future. At the time Laura is making the decision, the last couple of years in the stock market have been good and TIPS yields are high. Laura decides to shift a significant portion of her portfolio out of stocks and into a TIPS ladder.

Laura’s strategy is based on recent market performance and current interest rates, but it doesn’t rely on any prediction at all. It’s simply a decision that current rates are good enough to carry her through retirement with very little risk.

### The Point of “Don’t Try to Time the Market”

Because of the taboo we’ve placed on anything that could be described as market timing, investors are sometimes afraid to use all the available information when making their decisions. I do not think this is a good thing.

The point of the “don’t try to time the market” message is simply that new investors need to learn that it’s impossible to predict a) where the stock market is going next or b) where interest rates (and therefore bond prices) are going next.

But it can be OK to make financial decisions based on current interest rates or market values, as long as you don’t have to successfully predict where the stock market or interest rates are going next in order for the decision to make sense.

## Investing Blog Roundup: Are Target-Date Funds Good Investments?

When I speak with people who are early in their careers, by far the most common questions I get are:

1. How do IRAs and 401(k) plans work, and
2. Which fund(s) should I buy in my retirement accounts?

For question #2, target-date funds are always the first thing I bring up.

Christine Benz of Morningstar wrote recently that, “from where I sit, target-date funds have been nothing short of the biggest positive development for investors since the index fund.”

That’s my point of view as well. They’re not a good fit for every circumstance (most notably, they’re a poor fit for taxable accounts). But they are nonetheless, an absolute revolution of the investment industry, for the better of the client/investor.

## How I Actually Use Open Social Security

There are three factors that should be considered in the Social Security filing decision:

• Actuarial math,
• Longevity risk, and
• Tax planning.

Open Social Security looks at factor #1. It takes the user’s inputs — including mortality assumptions — and determines the filing age(s) that would be expected provide the greatest present value (i.e., greatest spending power) over your lifetime(s). But that still leaves factors #2 and #3.

Here’s the wording from the calculator’s “about” page:

The calculator runs the math for each possible claiming age (or, if you’re married, each possible combination of claiming ages) and reports back, telling you which strategy is expected to provide the most total spendable dollars over your lifetime.

Please note that this calculator should not be the only analysis you do, as there are various factors that it does not consider, such as:

The fact that delaying benefits reduces longevity risk and therefore may be preferable even in some cases in which it is not the strategy that maximizes expected total spending, or

Tax planning reasons or other unrelated reasons why it might be better for you to file earlier or later than the calculator suggests.

In other words, the idea isn’t just to take the strategy that the calculator spits out and automatically use that strategy. Rather, the idea is to take the suggested strategy as a starting point, and then see if there’s any reason to adjust.

### Longevity Risk

From a longevity risk point of view, delaying is usually the best decision. That’s simply because Social Security lasts your entire lifetime. So if you’re concerned about depleting your savings due to living a long time, delaying is usually wise from that point of view.

However, there are two cases in which that doesn’t apply.

Firstly, some people have essentially no longevity risk. That is, their desired level of spending relative to their accumulated assets is such that they simply aren’t going to run out of money, so a further reduction in longevity risk isn’t very meaningful.

And second, for some married couples (especially those in which one person is very ill or much older than the other), the longevity risk scenario that we’re concerned with isn’t actually the “both people live a long time” scenario but rather the scenario in which one specific person lives a long time. And in those cases, the strategy that best protects the person expected to live longer is usually not for both people to delay but rather for the lower earner to file early.

### Tax Planning

Tax planning is always case-by-case, but it’s usually a point in favor of waiting to file, for two reasons.

Firstly, benefits are themselves tax-advantaged. So waiting to file has the effect of increasing your tax-advantaged income.

And second, waiting to file often gives you a longer window of time to take advantage of Roth conversions. (The most common time for Roth conversions to make sense is in the window of years after retiring but before Social Security and RMDs have begun.)

### Accounting for All Factors

For most people, a reasonable approach is to look at the strategy suggested by the calculator, and then see how it compares to a strategy in which you wait somewhat longer (e.g., for married couples, a strategy in which both people wait to age 70 or a strategy in which the higher earner waits until age 70 and the lower earner begins their benefit in the same calendar year as the higher earner).

If a) the expected present value of that alternative strategy is, for example, just 1-2% lower than the expected present value of the suggested strategy and b) there’s a compelling reason to prefer the alternative strategy from a tax or longevity risk point of view, then it probably makes sense to use the alternative strategy.

Conversely, when the strategy that’s preferred from a tax or longevity risk point of view has a much lower expected present value than the strategy recommended by the calculator, then it often makes sense to go with the calculator’s recommendation.

 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,

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."

## Investing Blog Roundup: The 4% Rule (Actually 4.3%) with a TIPS Ladder

I’ve been studying retirement planning for roughly 15 years now, and throughout that time a constant topic of debate has been whether a 4% inflation-adjusted spending rate over 30 years (i.e., “The 4% Rule”) is actually safe. And most of the time, that question is impossible to answer except in hindsight.

However, Allan Roth recently demonstrated that with TIPS yields being what they are right now, a TIPS ladder can very safely satisfy a 4.3% real spending rate, over 30-years.