The FIRE community has been educating the public in attaining financial independence and early retirement for a decade or so now. Whenever the topic arises it is sure to be followed by the exasperated rebuke, “We can’t all do this! Who will do the work if we all retire at 30? The economy will fail.”
The argument has a sort of logic on the surface. If everyone retired by their 30th birthday there could be a problem. A 50% savings rate could crush the economy! Right?
Or maybe not. A high national savings rate doesn’t harm the economy! The United States had a double digit savings rate in the 1950s and the economy roared. China and many other nations with vibrant economies have high savings rates. A low savings rate seems to be the real problem. In the U.S. we struggled more as our savings rate declined to its current low single digit home.
High savings rates don’t kill the economy; it provides a massive pool of ready capital to invest in infrastructure and future economic growth. No wonder our road, bridges, water and sewer works are subpar. The government decided it was good for the economy short-term to spike growth by encouraging excess consumption. As the savings rate kept declining less money was available for high speed rail and advanced internet services. And don’t even think of fully funding roads and upgrading the electric grid.
Price to the Rescue
Derek J. de Solla Price discovered an inverse relationship between how many people actually do most of the work in a given setting. Price discovered the square root of a group did half the work and the remaining members of the group did the other half. If you have a business with 10 employees, then 3 were doing half the work.
Here is where it gets scary. If you have 100 employees, 10 are doing half the work and 90 the other half! As an organization grows, incompetence grows exponentially while competence grows linearly! As the organization grows to 1000, thirty-two are doing half the work with 968 doing the remaining half! This is why it is so hard to grow a very large organization and keep it large.
Price’s law is visible in corporate America. In 1928 the Dow Jones Industrial Average expanded to 30 stocks. Of all the stocks on the original list, only one is still there: General Electric. The other 29 companies are either merged, bankrupt, dissolved or significantly smaller firms. Current financial difficulties at General Electric could soon remove the remaining holdout from the original Dow-Jones stocks. In less than 100 years every single one is off the list!
You don’t need as long a timescale to see Price’s law in action on the S&P 500. Of the ten largest stocks in the S&P 500, most were not on top a decade ago. Companies like Kodak, Sears, and Xerox are nowhere to be found at the top of the list, yet they were the crème de la crème at the height of the Nifty Fifty days of the early 1970s. A damning fact is the average stock in the S&P 500 spends an average of 30 years there. That’s it. Some make it longer, other less. But 30 years is all the leaders can manage on average to stay on top. This is why we buy index funds instead of individual stocks. Individual companies come and go, but as the economy keeps climbing, so does the size of the index.
A quick reader might be thinking of how to game this information to her advantage. A few ground rules are in order before we get cute.
According to the U.S. Bureau of Labor Statistics, on January 1, 2016 the U.S population was 322,810,000 and 157,833,000 were in the Civilian Labor Force. You read that right. Forty-nine percent of the total population is in the labor force! As you can see, a very large number of people are not engaged in any kind of formalized labor. Children, the disabled, military personnel, incarcerated and the retired are not part of the labor force.
Running 157,833,000 through a square root calculator gives you around 12,500. At first blush we might be tempted to believe 12,500 people are doing half of all the formalized work in the U.S. with 157,820,500 doing the other half of all the work. Now you know why you’re so tired. You’re one of the 12,500!
Except it doesn’t work that way. As much as you may want to believe you’re carrying an unfair labor burden (and you might be), the truth is far more than 12,500 people are doing half the work of the country.
Price’s law works wherever there is creative productivity. It is certainly possible a mere 12,500 people are providing half the creative productivity as long as you narrowly define “creativity.” Elon Musk is a hyper productive individual. But you can’t discount the workers building the cars!
While Price’s law works wonderfully when applied to baskets scored or city sizes or a single business, it fails to adequately disclose who is productive nationally. If only 12,500 provide half the nation’s GDP there are not enough producers to have at least one productive employee per successful company.
No, the Civilian Labor Force is not “creative productivity” and therefore we should not apply Price’s law. Price’s law explains what happens within an organization. Again, if you have 10 employees, 3 are doing half the work. Thirty percent of employees are kicking out half of the company’s creative production. It could be tax returns or widgets. The percentage contributing to half the company’s production declines to 10% when staff increases to 100. The bigger the company grows the worse it gets.
The Pareto Principle appears more generous in stating 80% of results come from 20% of the inputs. In other words, 20% of employees are doing 80% of the work; 20% of clients are providing 80% of the profits; and so on. In the end Price’s law and the Pareto Principle are explaining a similar reality.
Price is Saving the FIRE Message
Back to where we started. The FIRE community message is you can save half or more of your gross income, invest in index funds and retire early, some as young as 30. And then the economy drops off a cliff and nobody is around to get the work done.
Except Price told us what we needed to know! If 30% of the people in a small business with 10 employees are doing half the work, 70% aren’t getting shit done! And business owners, tell me I didn’t just hit the nail on the head.
If so many people are unproductive it is easy to have fewer people in the work force and still get all the work done. What we need to do is train employees to be like the minority producers (the square root guys).
How can we do that? First we need to look back at our error in assuming you can apply the square root of the entire nation’s work force and conclude 12,500 people do half the work. A business can be just like the national work force. If you have one huge group within a company Price’s law is going to crush you.
But then explain companies that are large? How come some outperform for very long periods of time?
The solution is simple. By breaking a huge company into smaller groups you can increase the number of productive people. A major corporation can act and perform as nimbly as a smaller company by organizing human resources appropriately.
Of course another issue arises. If some schmuck in accounting can’t get off dead center, how will a smaller group make her more likely to increase productivity? And the answer is: it doesn’t. Merely cutting a larger group into smaller groups will not have a meaningful effect on overall productivity of the firm. Unless you organize the smaller groups to focus on specific tasks.
Large groups tend to get less done because they take on too much. By breaking tasks into smaller sizes handled by smaller groups you can unleash before unrealized creative powers. And there is an example that proves it.
The Richest Guy in the Room
Just as the largest companies don’t stay on top forever, neither do the wealthiest people stay on top of the Fortune 500 list of wealthiest people on the planet. The 1% churns. A lot!
Don’t get me wrong. Warren Buffett was the richest guy on the planet for a while. Now that Jeff Bezos jumped in front, Warren isn’t looking for gainful employment to put food on the table. Bill Gates was on top for a while. Back in the day Rockefeller was on top. What I’m saying is the list changes for people just like businesses.
The insight Price gave us and the understanding we have of the Pareto Principle allows us to better use our human capital. People are the most important resource. But an employee struggling in a large group is far more likely to excel in a smaller group.
You’ve experienced this yourself. You go to a conference and attend a breakout session where 10 people are in the audience. A significant percentage of the people participate by asking questions and adding additional information. If the room fills with 50 people a smaller percentage get involved. The bigger the group gets the more likely you are to keep quiet. A few step forward, but fewer than in smaller groups.
Also, productive people in one setting will be less productive in a different setting. Smaller groups only work if effort is applied into providing the right environment in the smaller group so more people become interactive producers. This is the solution to the problem presented by detractors of the FIRE community.
The FIRE Community was Right All Along
It is possible for people to save more and invest the difference without killing the economy. We can be just as productive as a nation, as a company, as an individual. Even more so if we apply only a small amount of effort.
Reaching financial independence at an early age does NOT harm the nation. Quite the opposite; it makes us tremendously stronger! A nation wallowing in debt loses vibrancy. So do companies and people!
Fewer people need to work when the ones who are working are more productive. The end of formalized work doesn’t mean the end of productivity. Early retirement frees times to explore new ideas. Some of those ideas are the Tesla’s of tomorrow.
Spending down household savings accounts for conspicuous consumption does provide short-term economic growth. Then again, snorting cocaine gives you a high that doesn’t last either.
FIRE is the only way.
Wealth Building Resources
QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. Quickbooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.
A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.
The age-old question has flooded my in-box: Should I do my own taxes?
I try to give a short encouraging reply, but it always feels contrived. Normally I write: If you are comfortable preparing your own taxes you should at least see how the process works by trying. If you run into an issue or don’t know the tax law on a certain area of your return you can always call in a professional.
You may have already received a similar email from me if you asked the question. In the name of efficiency I should keep my reply in a file for a faster copy and paste. But I don’t. I write the thing out every time and it’s starting to sound like a broken record.
The short answer salves my conscious by answering a call from the dark. There real answer, however, is a bit more involved.
If I do this right you should be in a better position to determine if you should be doing your own tax return so pay close attention. I’m only going to say this once.
Either Way I Win
The reason so many people email me with “the” question is because they see I offer a DIY tax program on this blog. The banners and links are an affiliate program. I also get paid when I prepare a tax return. I win either way.
Don’t take this as an arrogant slight. My intention is to disclose my relationship to whatever decision you make. Someone in my profession is getting paid regardless.
My biggest concern when people prepare their own return is they think they know what they’re doing when they really don’t. I see self-prepared returns often enough to see some really ugly problems the IRS will take a serious interest in.
That doesn’t mean you should hire a pro. Many errors I see on self-prepared returns have nothing to do with tax law! Unreported income and missed deductions are the two biggest issues I see. This isn’t a tax law issue; it’s a sloppiness issue.
A recent return my office amended, the client reported all the rental deductions (except depreciation) but missed adding any rental income. It was a serious matter!
My first recommendation for you when considering preparing your own taxes involves organization. If your tax records are stuffed in a paper bag or scattered everywhere you probably need a tax pro to crack the whip. Guys like me are in a better position to make a judgment call on missing information. There are disclosures a tax professional can attach to a tax return telling the IRS how the situation was handled. If the tax pro uses a reasonable method it virtually avoids an audit on an issue with no clear answer. Remember, the last thing you want is to be in an audit going, “Ahhhhhhh . . . .”
Call in the Troops
There is nothing wrong with doing your own return to the best of your ability and then hiring a tax pro for the return you will file. (Read the last sentence again and again until it sinks in.) Yes, you might have two prep fees for the year: one for the DIY program (required when you print) and the accountant. But you will also see where you missed things.
An alternative is to hire a tax pro when you have a unique issue and then go back to preparing your return for a couple years. Some accountants hate this. I don’t. What you consider hard I consider a normal day at the office. My computer updates your personal information annually so when you come back is six years I just pick up where I left off. I probably have data you already forgot about allowing me to bring you back up to speed.
Finally, there is no harm in having a tax pro review your return prior to filing. Yes, you will be charged. You want to be billed for the review! A knowledgeable tax pro will demand payment for her time. Payment also increases the chances the tax pro will give your return the review it deserves.
Preparing your own tax return is scary for some people. It shouldn’t be. Most software, including the program on this blog, has plenty of help features. If you plan on preparing your own return I hope you consider the 1040 program links and banners here. (Man has to eat.) If not, no worries. (Zig Ziglar always said you must ask for the sale. I never argue with Zig.)
Even if you hire your tax work done, consider opening a file at 1040 (the DIY software here) and seeing how well you do compared to the pro. There is no cost until you print and/or e-file. You might be better at it than you think.
Regardless, you can always call in the troops if you find yourself in too deep. Hiring a pro if you are concerned about anything on your work is not a sign of weakness! At the very minimum you have a better understanding of what the accountant is doing on the other side of the desk.
Tax pros get it wrong, too! Much of what we get wrong is the result of a misunderstanding or outright lack of knowledge of your personal situation. You know you better than I ever can. If I don’t find the right questions to get the answers needed for an accurate return I’m going to get it wrong. Even practicing DIY preparation can open your eyes to additional tax liability reductions. No tax pro would ever be offended by that!
The Boss is Back
After several years of adjustment to a national footprint my firm is finally gaining traction. I’ve trained new staff, added new technology (something old guys set in their ways resist) and focusing on our niche, we are ready to accept a few additional clients this year.
I’m opening the gate (LOOK OUT TEAM!!! THE HERD IS LOOSE!) a smidge. Technology will free serious amounts of my time to work with more clients directly. Scanning technology enters virtually the entire return so my task is to review and organize the return for maximize efficiency and audit proofing.
Now that the computers will enter most data I stand a lower risk of a carpel tunnel relapse. (I never had carpel tunnel issues and hope to keep it that way.)
You don’t want to pay me for data entry services; you want me for my experience and tax knowledge. By unleashing the IT guys we can do more, better than before.
If you need an accountant, contact me. We aren’t the cheapest (just so you know up front), but I dig deeper than most accountants you’ve met. I don’t stop at a merely accurate return. I’m always looking for items missed. In short, I give every return moving through my office a proctology exam. Don’t worry. I have plenty of latex gloves.
Be prepared for a summer consulting session considering the new tax laws if my office handles your tax return.
I strongly encourage you to try your hand at preparing your own return. If you have a business or rental properties you might want to forgo the DIY option. A good tax pro will know many ways to cut your taxes the DIY programs can’t possibly ask in these situations. It is still a valuable exercise to walk through the process yourself, however, to see if there are things even the accountant didn’t ask.
If you start to feel uncomfortable you can always call in the troops.
An Even Better Game Plan
2017 tax year will look and feel like previous years. You can continue preparing your own return without much issue. The few changes from the TAX CUT AND JOBS ACT that do affect 2017 should be handled automatically by the DIY software (all of them, not just mine) as long as you enter the data correctly.
2018 is another animal. You might want to plan ahead. Secure an accountant for the 2018 tax return or at least have a consultation on issues pertinent to you.
Finding a qualified tax pro is hard to impossible. I feel your pain. I need to hire tax pros to do the work and face the same issues. But it’s not impossible.
Accountants will be under a lot of pressure over the next year as small business owners plan for the tax law changes affecting them. Time will be at a premium.
A summer consultation is probably a good idea. Be sure to provide the tax pro a copy of your filed 2017 return. Nobody has been shot amending a return to correct missed or incorrectly handled data except for three guys in Ohio, but they had it coming. (Sorry for picking on Ohio. I still love you guys. (Maybe I should have said Delaware.))
If you find yourself in too deep preparing your own return, call a tax pro! Yes, we are all busy during tax season. But nobody has ever been shot for filing an extension except for those three guys again from Ohio.
Oh, who am I kidding? Use good judgment preparing your own return or call me (or another tax pro). It’s your only hope, especially if you’re from Ohio.
The recently passed tax bill signed by the President is the largest change to the way Americans and businesses are taxed in over 20 years. Starting January 1, 2018 the new rules take effect, but there are several considerations before we retire 2017.
The biggest issues involve the changes to itemizing and the limitations placed on deductions of state and local taxes (SALT).
The First Issue
The standard deduction has been increased while personal exemptions have been eliminated. This means itemizing will be harder to do until the temporary provisions (corporate tax changes are permanent while individual changes are in effect until the end of 2025 where they revert back to the old rules) expire, are extended or made permanent.
People landing in the “zone” could face a modest increase in tax or at least find their itemized deductions of the past worth nothing extra on their tax return. The “zone” is defined as the amounts between the old and new standard deduction. Example: a married couple itemizes $19,000 per year. Under the old law the additional deductions helped reduce their taxes. Under the new law, with exemptions eliminated and the standard deduction $24,000, the value of those expenses in less than the standard deduction and will not lower their tax burden any further.
The Second Issue
The biggest issue is the limitation of SALT to $10,000 annually. Again, considering a married couple, if you are limited to $10,000 in SALT, where do you have enough deductions to itemize? Mortgage interest is a big one, but even that is limited to $750,000 of acquisition indebtedness versus $1 million under the old law, plus a small amount for home equity interest. (You read that right. Home equity interest is no longer deductible on January 1, 2018.) At today’s low interest rates taxpayers in states without high real estate prices will see less opportunity to itemize.
Charitable deductions are an option if you are inclined to contribute. At least the new law allows a deduction for cash contributions of 60% of AGI, up from 50%. Excess contributions to charity are carried forward up to five years, same as with the old law.
Medical deductions are back to the tax law from a few years back where expenses above 7.5% of AGI are allowed.
Some taxpayers will feel real pain from the loss of miscellaneous itemized deductions. Traveling sales people and others with large amounts of unreimbursed employee business expenses will feel the pinch.
Without a large mortgage itemizing gets difficult. And the allowable mortgage interest is curtailed. No matter how you look at it, itemizing will play a smaller role in the future of tax preparation.
2017 Planning Strategy
There is a one-time window to deduct SALT without limitations (with the exception of the alternative minimum tax and phase-out rules).
Many taxpayers will benefit from paying their property taxes before the end of the year (you can thank me later for giving you plenty of notice (I’ll blame it on Congress when you do)).
Since SALT is limited to $10,000 per year starting January 1, 2018, paying property taxes now are an advantage in high tax states.
Also consider paying your 2017 state estimated tax payment due in January before the end of the year. You can also make a 2018 estimated payment (ES) prior to the end of the year. You only need to pay the state ES payments early because only state taxes are deductible as an itemized deduction on the federal return. Pay as much as possible in 2017 for 2018 to maximize the benefit.
The alternative minimum tax (AMT) didn’t go away, but is, ahem, minimized for 2018 and after. Prepaying taxes can cause issues that mitigate the benefits. As a general rule, if you already are paying AMT the strategy I’m outlining may not work. If you aren’t paying AMT on your latest tax returns you might be okay unless you were right at the line. Covering AMT is beyond the scope on this short post. Talk to a tax professional if you have any concerns.
More Good and Bad News
I intentionally avoid business tax issues in this post, opting for advice beneficial to individuals, including year-end strategies.
As mentioned above, AMT is unlikely to be an issue for many taxpayers after 2017 as the exemption amount has been increased to $109,400 for married couples filing jointly and $70,300 for single and head of household filers.
The phase-out of itemized deductions has been suspended until December 31, 2025. Considering all the other limitations individual taxpayers face in the new tax bill, phasing out itemized deductions would be rubbing SALT in a wound. (Yes, I intended that pun.)
529 plans, the college savings accounts, have been expanded. After December 31, 2017 you can withdraw up to $10,000 to cover tuition (and only tuition) expenses for elementary or secondary public, private or religious school. (I want to see the politicians putty knifed off the ceiling a year from now when somebody (perhaps me) publishes the amount of tax avoided to send kids to a Muslim school. These will be interesting times, indeed.)
Personal casualty losses are limited to federally declared disaster areas. Uninsured losses outside declared areas are not deductible under the new law.
Exclusion for qualified moving expenses: Gone.
Exclusion for qualified bicycle commuting reimbursement: Gone. (Mr. Money Mustache will not be happy when he finds out.)
Alimony is still deductible for old divorces, but a divorce finalized starting in 2019 does not allow a tax deduction for alimony. Alimony is not reportable income for divorces starting in 2019 either. (I recently concluded a massive alimony case against the IRS after fighting for two years. We kicked the crap out of Revenue for a very sizable refund for my client. There is an outside chance it’s my fault they included this in the tax bill as a result.) (You know I’m kidding? Right?)
The health insurance mandate is gone in 2019.
The inflation index has been changed to the chained CPI-U. All you need to know about this is that Congress wants a smaller reported inflation number for tax issues so more money gets taxed in the future. Old tax guys like me know why President Reagan introduced indexing to taxes in the first place. Reagan must be turning in his grave!
The child tax credit goes from $1,000 to $2,000 and can be claimed to age 17 instead of age 16. There is also a new $500 temporary tax credit for non-child dependents, like older children and dependent parents. The phase out of the child tax credit has been increased to $400,000 for married filers and $200,000 for singles.
Good news! Student loan interest is still deductible up to $2,500.
Many readers will benefit from paying their property taxes this year instead of the due date in 2018. Making ES payments due in January 2018 in 2017 will avoid the limitations of the new tax bill.
You can also make 2018 ES payments in 2017 to take advantage of the old tax rules. (See note below.)
The New York State Tax Department emailed to remind me Governor Cuomo signed an emergency Executive Order allowing payment of 2018 property taxes in full or part in 2017. (See note below.)
We finish with Wisconsin, a weird tax animal if there ever was one. Wisconsin has a $300 property tax credit. If you double up property taxes allowing you to miss a calendar year with a property tax payment you will lose the property tax credit worth up to $300. Wisconsin residents need to consider the property tax credit when planning prepayments of property taxes for federal purposes. (Taxes can be so fun. And crazy.)
For New York you need to contact your tax receiver to determine your property tax payment options.
Wisconsin already has their 2018 ES forms out. Check your state tax department for ES forms.
As you can see, the new tax bill doesn’t do a lot for individual taxpayers. If you are lucky you hit it right and benefit. If your luck is less than reliable you might even see a tax increase. Most individual taxpayers will see only modest reductions in tax liability unless they have a high income.
In the near future I will present additional ideas to optimize personal taxes under the new tax bill. Unfortunately, the best ideas will go to business owners in the new world order.
Then again, if you give me enough time I might figure something out beneficial to all parties involved. There are a lot of holes in the Swiss cheese tax bill.
Note: I no more than hit the publish button and went to work when the IRS issued clarification on pre-paid property taxes. The IRS released a statement saying property taxes may be deductible if they are assessed AND paid in 2017. That means my idea of following the states who were allowing the activity by extending the strategy to estimated payments will not work unless you want to take your chances in Tax Court (not recommended).
Two kinds of clients scare me most. The first ask me as they pick up their tax return what they can do to lower their tax bill. The other requires a pry bar to get complete information out of them during the year.
Each of these clients scares me because I can’t give them a good answer. The first client is really asking what they could have done better last year when the answer makes no difference and the second client gives me reasonably accurate information (if I’m lucky) meaning my advice is only “reasonably” accurate.
The worst part is some tax breaks aren’t gentle phase-outs, but cliffs. One additional dollar of income can cost $500 of tax savings! Clients receiving the healthcare credit face several cliffs as their income crosses mile markers of the federal poverty level (100%, 200%, 300% and 400%). A small amount of additional income can result is a significant reduction in the credit causing a seriously higher tax bill.
Compounding the problem is where you take a deduction. A good example here is Health Savings Account contributions. You can pay the money yourself and take a deduction on Page 1 of Form 1040 or have your employer withhold from your paycheck and deposit the funds. The second way is usually better.
HSA contributions are an adjustment to gross income when you make the contribution yourself. When handled through a payroll deduction it reduces the W-2 and hence, total income. The further up the page a deduction is taken, the better. As you move down Form 1040 options for certain credits and deductions are reduced.
Prioritizing Your Tax Planning
Money is limited so you have to pick and choose which tax benefits to focus on. We will use a hypothetical client named Fawn to illustrate how prioritizing tax options can yield massive results.
Fawn is a single mother with a son approaching the age of majority. She works full-time and earns in the low to mid 30’s with overtime.
Fawn has several issues to consider. We will assume healthcare is covered at work or she doesn’t have a health plan from the Healthcare.gov site. We do this to simplify our illustration and to focus on three potential tax planning options: Earned Income Credit, Saver’s Credit and the Student Loan Interest Deduction.
The Earned Income Credit is on a sliding scale. It starts low, maxes out around $10,000 to $20,000 (depending on how many children you have), and hovers around this maximum plateau for a while before starting a slow decline as income climbs. Fawn’s EIC is slightly under $1,000.
Earning more money will reduce her credit. But, there is a way to earn more and still get a larger EIC. If Fawn has a retirement plan at work she can divert money to this fund so it never shows up on her personal tax return. An HSA run through payroll will have a similar effect.
EIC is generally calculated off Adjusted Gross Income (AGI) and earned income with some modifications. We will not go into all the possible issues affects Fawn’s return. What I want to make clear is the advantages of reducing income on certain areas of the tax return without giving up income. In short, I want you to have your cake and eat it too.
Choices are almost always available to reduce taxes and increase a refund if plan in advance. We can pick this apart deeper, but today’s point is concept. I want you to understand a simple concept. You don’t have to earn less to avoid the loss of credits.
When higher income increases taxes due and reduces or eliminates credits at a rate near or greater than your additional income it makes sense to stop earning unless you can break through to the next level where income goes up while taxes are muted. Or you follow my plan.
Bringing Together Disparate Pieces
Every action can have multiple effects! Diverting more money into a 401(k) can do more than just reduce your reported income on the W-2. Lower income means lower tax. It also means you might qualify for a Saver’s Credit! Think of that for a moment. The very act of saving might actually reduce your income enough to qualify you for a Saver’s Credit. Isn’t the tax code great!
There is still one more problem Fawn can’t figure out how to solve. She has student loans that just came out of deferment. The payments are small and will all go to interest for a while.
The new tax law working through Congress might eliminate the student loan interest deduction after this year so she wants to pay at least $2,500 to max out this year’s deduction. Unfortunately, all this retirement saving to maximize the EIC and Saver’s Credit has reduced her take-home pay to the minimum level she needs to cover basic bills.
The student loan interest deduction might also reduce state income taxes. This is an important deduction and since it might go away, Fawn wants to max out the benefit this year.
She can’t reduce her income more without keeping food on the table. Here is where tax planning leaves the comfort of Form 1040 and heads for the real world. Fawn needs $2,500 to pay at least the full amount of the interest deduction. (Remember, all payments will go to interest first and she has at least $2,500 of accumulated interest.)
Since Fawn started making token payments earlier in the year (let’s say $500) she has some of the deduction covered already. It would probably make sense to borrow money short-term to max out the student loan deduction. Her top dollar will probably be in the 15% tax bracket so the student loan deduction will benefit her $300 if she can come up with the remaining $2,000 to maximize the deduction.
Credit card is probably a bad idea here, but a car loan or help from family or a friend makes sense. Fawn could also approach her employer and ask him for a loan. If she explained her situation nicely, the employer might buy into the idea since it helps a valued member of his team and really costs him nothing more than a temporary loss of use of a small amount of money.
The Good Game
Gaming the system is one of America’s great pastimes. It can be very rewarding as long as you keep it legal.
The above example has plenty of holes and I took some liberty with the facts. I was careful not to get hung up on exact numbers. No matter what numbers I use, your situation will be somewhat different. I understand increasing her 401(k) investment helps the Saver’s Credit limits. It might also increase the credit from10% to 20% (or more) of the first $2,000. The student loan interest deduction could improve situations all around the tax return.
The point today is to look at your tax situation and examine it for un- or under-utilized deductions and credits and then start thinking outside the box.
There are many opportunities to manipulate your tax results legally! Adjusting your 401(k) contributions higher doesn’t reduce your take-home pay as much as the additional contribution due to lower taxes and potentially higher credits.
Normal people can do this; not just the self-employed or rich! HSA and 401(k) contributions are not a drain on the budget; they are necessary parts of a vibrant financial plan.
I focused on lower income earners this post. I get plenty of complaints I spend too much time on ideas reducing taxes for the self-employed and high incomers. Every income category has opportunities.
Whether you are a good client or one who wants to know how the past could have been better or only coughs up all the information needed during tax season, you can plan with purpose.
Fawn is not a hypothetical client (though her name was changed to protect the guilty); she is a living, breathing human being I’ve helped for a few years now. I modified her factset slightly for this post and because she reads this blog and is sure to remind me when she gets around to reading this post.
We ran the numbers and it paid to borrow money to take advantage of the student loan interest deduction. She can pay the loan in full (which her awesome employer did lend to her) by April 1st. Her increased refund will kill most of the loan.
The best part is she keeps the money, the added tax savings, no matter what happens in the future.
And if we get a new tax code we get to play the game with a few different rules. So hand me the dice; it’s my turn to roll.
The easiest way to invest in equities is with a mutual fund. The surest way to match market performance is to use index funds. Then there are times we get the urge to do things the hard way.
Of all investment classes the broad market has performed best. The stock market, for all its fits and starts, has outperformed over long periods of time without the need or risks of leverage to accomplish the goal.
A simple strategy of consistent investing in index funds has plenty of adherents in the FIRE* demographic. The reason for this is simple: it works! Depending on where in the market cycle you start, a decade to decade and a half if all that’s needed to fund your retirement. Start saving half you gross income at age twenty and by 35 you are ready to either retire or carve your own path in life.
The plethora of blogs in this demographic are a testament to the successful strategy of wealth building with index funds. What is often forgotten is that you are investing in real businesses even when using an index fund. And it’s business, not stocks, which create the real wealth.
If it takes a decade or so to create an adequate net worth to retire, business can get you there in a few years.
Buying an index fund is a sure way to enjoy average growth. Average is good in this case because the economy grows, always has grown and will continue growing into the foreseeable future. As productivity and other advances and new technology come online you are in for the ride because your index fund owns just about every winner in the crowd. You also own old school companies still growing and/or throwing off massive dividends. There are also a few stinkers in the crowd as some former success stories are headed for the exit.
With this in mind, intelligent people sometimes want to strike out on their own with a small percentage of their portfolio. If you possess the mind of an accountant and the discipline of a saint you can ferret out opportunities with the potential of outperforming the market.
And armed with this knowledge it becomes clear the pickings are slim when the market has been straight up for eight years. There are plenty of great companies, but most sell for a dear price, unworthy of additional investment unless available at some future date at a better price.
A Clear View of the Future
Exotic securities have been devised over the years to hedge various investments. These very same tools are easily used to gamble, ah, speculate.
Farmers have had futures contracts available to them since before the beginning of time. It makes sense for a farmer to use futures to protect their investment in an uncertain world. Agricultural products have thin margins and farmers know it. A small shift in commodity prices between planting and harvest can destroy a farm financially.
To limit the risk of prices changing, a farmer can sell his future corn crop in advance. It works like this: A farmer probably knows his input costs of fuel, seeds and fertilizer. He also knows if it makes sense to drill the seeds into the ground in the first place. If the input costs are more than he can expect at harvest he either needs to allow fields to lay fallow, plant a different crop or hope to Mother Mary prices turn around.
Even if the farmer sees current corn prices are higher than his input costs there are no guarantees prices will stay favorable. A drought can devastate his crop and prices tend to decline into harvest as more of the commodity becomes available.
To limit risk the farmer can sell his expected corn crop coming off the field in autumn before he even plants in spring! If prices go up the farmer loses on his hedge, but wins on the actual crop. In prices decline he loses on the actual crop, but profits from the futures hedge.
Futures contracts are a necessary part of farm living. Without the ability to hedge farmers are one, or at best two, bad years away from bankruptcy.
The same tools can be applied to almost any asset.
You Have Two Options
Before we start this part of the discussion I want to give a warning. This is more a case of do what I say, not what I do. I use some very advanced methods when protecting my investments and when buying them. This discussion is on options. I do NOT recommend options except to the most knowledgeable and astute investor! Consider the remainder of this post informational only.
If you are unfamiliar with options and how they work, here is an article on Investopedia and another from NotWallStreet. Do NOT let anyone, me, a broker, a TV talking head or internet article, talk you into options unless you know what you are doing. You don’t.
There are two options in the world: calls and puts. Like futures for a farmer, an investor can hedge her investments against the price on some future date. The market has been rallying hard for years. If you are worried about the market declining, you can sell your stocks or index funds and pay taxes on the realized gains or write covered calls or buy puts. Each action has its own associated risk.
Selling causes tax issues, but at least the damage is known. Covered calls only provide limited protection and if the market keeps climbing you are likely to lose out on future gains. A covered call might provide a few points in premium only. If the market decline is larger you will suffer paper loses. Buying a protective put is a cheap hedge and frequently the preferable route. If the market declines you gain on the put option; if the market rises or stagnates your only risk (loss) is the put premium.
But that is not what I use options for. I’d buy a LEAP call option on the S&P 500 if I got the same deal Warren Buffett did nearly a decade ago. (Buffett paid a small premium for an at-the-money S&P 500 index call with a 10-year time frame with the market off nearly 50%. I wanted the same deal but they showed me the door.)
I rarely use covered calls to generate premiums as the market likes to steal your stock when you do. I don’t speculate or gamble with options either.
The one time I love to use options is in a market like we’ve had the last several years. The market has been doing well for a long time and when I’m looking to buy an individual stock I sometimes use options. (You can use the same strategy with index funds, but I never do. I still invest excess capital into the index fund and wait like a good boy.)
The problem with today’s market is good companies are selling at too high a price. Now if I could pick up some Facebook (FB) at 100 or Apple (AAPL) at 140 I’d be excited. (FB last closed at 179 and AAPL at 170.15.)
Most stocks don’t have much of a premium for short-dated options way out-of-the-money. Some stocks do. The best way to show you how I spike my returns using options is to list what I have in my current portfolio.
First, when I sell naked puts I consider them long-term buy orders in companies I want to own more of when the price is too high. If the price comes down enough the options will execute and I’ll get my extra shares. If the stock doesn’t drop enough or advances I keep the premiums. I never use this strategy in a down market as I can just buy the stock without waiting.
Here are my current naked put holdings:
Company Sold Date # Sold Option Date Strike Sold $ Current $
AAPL 11/15/17 -2 Jun 15, 18 140 3.04 2.87
FB 6/9/17 -4 Dec15, 17 120 2.05 .01
FB 6/29/17 -2 Jun 15, 18 100 2.00 .30
MO 7/31/17 -2 Jan 18, 19 65 8.03 5.90
NFLX 5/25/17 -2 Dec 15, 17 130 4.05 .05
PM 10/30/17 -2 Jan 18, 19 90 4.33 5.25
TSLA 5/25/17 -1 Dec 15, 17 220 6.68 .26
If every stock declined to the strike price or lower I would be on the hook to buy $175,000 of stock! As you can see most transactions will expire worthless before the end of the year and I keep the premiums.
MO is the outlier. Option premiums are low for MO so I sold a LEAP out in January of 2019. I also bought more MO in the low 60s recently.
I am willing to buy each one of these stocks at the strike price should the market decline to those levels and probably will even without the naked puts.
There are two risks to consider. The first requires self control. You only sell naked puts in the amount you have current funds available to buy.
The second risk you can’t control. If the story changes and the stock crashes, you will end up buying back the put at a loss or owning shares in a company where the story is no longer compelling.
Simply put (pun intended), there is no risk free investment. Just wanted you to understand the two risks in this scenario.
The Cash Hoard and the Friends I Keep
Whenever I mention I use this strategy people ask why I don’t stay 100% invested all the time. My answer is, for the same reason Warren Buffett’s Berkshire Hathaway has around $100 billion in cash currently.
The truth is I like to keep my powder dry. I never have 100% of my money invested. There are a few nickels in my pocket when I walk around town to avoid vagrancy charges. As a business owner I need liquid working capital so I always have something tucked between the mattresses. I also like keeping some money available in case an unbelievable opportunity arises.
You do the same thing on a smaller scale. You might have an emergency fund. If so, it’s probably earning a whopping 1% while it waits for work to arrive.
Another brutal truth to why I keep a larger amount of cash laying around is because I am different than you. The higher your net worth the more liquid cash you will tend to accumulate during certain times of the year and during market overvaluations. I consider the current market overvalued.
Does my opinion of the market conditions change my core investing style? No! I max out all my retirement accounts (Mrs. Accountant’s too) and put it all in index funds. Those suckers keep getting filled.
When it comes to individual stocks I need to build a reserve to buy companies when they are on sale.
I’m not alone in using this strategy to generate income. Back in the 90s Intel (INTC) sold massive quantities of put options with the intention of using a down market to buy back shares. (I’m not sure if INTC still does this or not.)
Over the years INTC had such a large income stream from the naked puts they listed the income separately in their earnings reports and annual report. INTC’s intention was to structure the naked puts to force execution so they could buy back the stock and keep the premium. There was serious money in this for INTC.
I owned INTC for a few years back then. It wasn’t my favorite investment, but it had potential until my research discovered a terrible truth. I went back and reviewed over a decade of financials for INTC and discovered they bought back more stock than their entire earning over the previous decade and still had MORE shares outstanding. Such is the world (and risk to shareholders) of employee incentive stock option.
We’ll leave that discussion for another day.
A Steaming Pile of Schmoo
This was harder than I thought. Novices will be left bewildered and experts already understand the program. How do you present a complex idea like options in under 2,000 words? You don’t! I feel like I left a mish-mash of information. The information is accurate! The issue is communication. Did I get my message across?
There is so much more to this discussion than I could pack into one post. Naked puts are a viable investment strategy if used in a limited fashion, even if INTC used it to the nth degree.
Options in and of themselves are not bad. They do have the potential to cause great harm however and they are easy to abuse. Consider options the opioids of your investment portfolio. They reduce pain at first, but can do lasting damage when abused.
So why do I do it? Because if the market doesn’t decline I keep over $6,200 in premiums. The extra cash, added to an already growing stash, will come in handy when the market does decline and some companies become a steal.
Or I might be an addict beyond help. You decide.
* Financial independence, retire early.
Good fortune has struck the Accountant household again. Cash has piled up while the retirement accounts are maxed out. Significant funds were added to the non-qualified index funds and there is still cash waiting for investment.
I’m generally uncomfortable with too much uninvested cash. Never one to time the market (not that I haven’t tried, but my results were as expected) I like to get my army, called capital, into battle as quickly as possible.
In the last few weeks I added selectively to my portfolio, even adding a new name to the mix. Since I preach index fund investing so heavily it requires some explaining why I did what I did.
First let me introduce you to my new soldiers. I added to the ranks of Altria (MO) and Philip Morris International (PM). The name of the new platoon — wait for it — is Apple. Yeah, I know. Back in September I warned of the risks of owning index funds and individual stocks. My argument was simple. Buying certain big name stocks (companies actually; remember you are buying a fractional share of ownership in an ongoing enterprise) can overweight your portfolio. Since Apple comprises a whopping 3%+ of the S&P 500 weighting, buying more Apple stock on the side starts to make the ship feel a bit top-heavy.
Sometimes it’s best if you do as I say and not as I do. I have the luxury of a larger net worth so I can have a larger mad money account to play with. The only thing is these new purchases are in what I call a serious money account. The purchases are planned as very long-term holdings.
I have some explaining to do, kind readers. I’ll outline why I like Apple enough to buy even after a massive run-up this year and a market looking frothy. My reasoning for adding to my large amount of MO and PM follows the Apple discussion with my thoughts on two stocks I own but have concerns with: Netflix and Tesla.
The Case for Apple
Some people recommend diversification as a way to mitigate risk. I recommend diversification (index funds) because most people don’t know how to value a potential investment or don’t have time to do the evaluation.
My investing history has included a small number of companies with most of my money in mutual funds (index funds the last decade or so). Instead of diversifying to mitigate risk I research to mitigate risk. As long as I’m going to research I may as well do an in-depth analysis. If I do a good job and the investment is solid with an adequate margin of safety it makes sense to buy a lot of that investment.
Apple is a company I’ve watched for a long time. I made excuses as to why I shouldn’t buy it, but the story is too compelling to pass anymore.
Apple is a massive company. Normally companies so dominant tend to stagnate as competitors eventually pass them buy. The biggest market capitalization stock changes each decade. Today’s big names eventually wither and die. Anyone remember Eastman Kodak or Xerox? They’re both still around and publically traded. They were also darlings of another age. In 1973-4 they were part of the Nifty Fifty. Time has not been kind.
So why Apple? It’s a huge company; the biggest on the planet by many measures. Only a few enterprises have ever been bigger when adjusting for inflation. The Dutch East India Company was worth north of $7 trillion in today’s dollars so Apple has a ways to go to reach the milestone. The real reasons to consider Apple are margin of safety (they have a lot of cash), growing profits and a cult-like following.
A cult following is not a reason to own a company, but if the fundamentals are there with an adequate margin of safety a cult following becomes icing on the cake. As long as the veneer shines you can enjoy profits.
The main reason I bough Apple is the margin of safety. Take a glance at the chart of Apple’s cash position. The cash position is over $250 billion. After total debt is subtracted you still have over $150 billion as of September 30, 2017. This, by the way is the wrong way to look at Apple’s cash situation. When other liquid and short-term assets are included, Apple could retire 100% of its debt.
Therefore, a better way to view Apple’s cash position is to subtract the short-term investments to cover long-term debt and other liabilities. Inventory and receivables are enough to retire all liabilities, including long-term debt.
This leaves us with long-term investments and cash in the checkbook, revealing the true cash holdings of Apple: $201.3 billion. That is a massive pile of money!
The next step in valuing Apple is to check the price of the stock (what I can buy it for) against reported earnings per share of $9.21, the so-called P/E ratio. Apple’s P/E ratio as I write is 18.58. This means if earnings remained unchanged it would take a bit longer than 18 ½ years for Apple to earn enough profit to buy 100% of its outstanding stock as long as the stock price didn’t change.
An 18 P/E ratio for such a dominant and growing company is rather reasonable. Apple spends a pile of money buying back its own stock and in dividends to shareholders. But the pile keeps growing. These are good times in the world of Apple.
The dividend yield is 1.47%. This is slightly lower than the S&P 500 as a whole where the dividend yield is currently 1.86%. The earnings yield is 5.4% as I write. This means if Apple distributed all its profits as a dividend the yield to shareholders at the current stock price would be 5.4%. Also a good indicator.
So far we have an interesting scenario, but not enough to buy the stock! Before I open my checkbook I want a margin of safety. And that is where the cash hoard comes in.
The market cap of Apple is $878.5 billion with 5.1 billion outstanding shares.
The $201.3 billion in cash represents $39.47 of cash per share! At today’s closing price on November 16, 2017 of $171.10, cash represents 23% of the stock price!
Look at it another way. Suppose you buy a wallet or purse for $171.10 and when you get home you find $39.47 tucked inside the wallet. If the original price was good, it just got better!
Two hundred billion is a lot of safety margin and makes an Apple investment worth considering. However, I’m digging deeper. If 23% of the stock price represents cash in the bank, then the P/E ratio is less than indicated. If the cash portion of the stock price is removed from the listed price (remember you buy the stock and find a bonus $39.47 per share in cash) the stock price is really $39.47 lower. (If you think Apple is worth $171.10 per share as an ongoing enterprise and get $39.47 in cash along with the stock purchase, you really only paid $131.63 per share for Apple the company.)
This drives the P/E ratio lower by 23% to 14.29. Now the P/E is below the market average for a company with tremendous market power, growing earnings, a dominant market position and a cult following. With the safety of margin firmly in place I am ready to buy. So I did.
Of course my valuation research went much deeper than what I outlined here. To keep this post sane I abridged the content.
The Case for Altria and Philip Morris International
Tobacco seems a bad investment idea as more people quit smoking each year. However, investors forget the real fact the percentage of people who smoke is declining, but the increasing population keeps sales declines more muted.
MO and PM are dominant in their markets. PM was spun off from MO many years ago. MO has the U.S cigarette market and PM has the non U.S. markets.
I will skip the heavy analysis of these two companies. It takes a lot to get me to buy a new investment, but I’ll add to existing stock holdings when opportunity is ripe and as long as the story still resonates.
The margin of safety is smaller for MO and PM than Apple. However, virtually every company has a smaller margin of safety compared to Apple!
Let me sum up my reasoning for owning these two companies in the words of Warren Buffett. Buffett once said about MO, the product costs a penny to make and is addicting, what’s not to like? I think the reason Buffett doesn’t own MO is because he wants to protect his reputation. Your favorite accountant has no reputation to protect so I loaded the boat with MO and later PM.
Tobacco use as a percentage of the population has been declining since around 1964! MO and PM know how to navigate in this environment and have done so successfully for 50 years. Profits keep growing and the board of directors keeps paying out the majority of profits in dividends. Life is good for the owners of these two companies; not so much for the users of their products.
My buying trigger for adding to my large pile of MO and PM is the dividend yield on periodic market scares about the world ending for tobacco companies. When the dividend yield is over 4% I review the company prospects. If nothing has changes I add more shares. (In reality all I’m doing is reinvesting a portion of the accumulated dividends.)
There is also another interesting development at MO and PM. PM developed a smokeless tobacco product called iQOS. PM developed the product and recently licensed it to MO for sale in the U.S. Demand has been so high there are shortages of the product. And the profits are a lot higher than traditional cigarettes!
Revenues and profits look ready to accelerate over the next years and decade. Decades of stock accumulation in these two companies has been good for my wealth. And when their stocks go on sale I have a tendency to buy more.
The Problems with Netflix
As a disclaimer, I own Netflix and have made a lot of money on the stock. However, I am uncomfortable with my position.
I love the company and their product. Who doesn’t like commercial-free programming?
Netflix has a leadership position in their space, but lacks a margin of safety. When I bought Netflix years ago it was under the assumption they would turn a profit on their business model. I am beginning to doubt that is possible. And don’t believe their reported earning!
This year Netflix added a large number of new subscribers as in past years. However, their increased spending on new programming will increase so much as to consume the entire revenue from over a half million new subscribers! Yikes!
The increasing programming costs never seem to end and competition keeps popping up. Disney is pulling their titles from Netflix in 2019 to start their own streaming service at a “significantly lower price” than Netflix.
The worst problem for me is their accounting! Netflix amortizes their content programming costs over four years. This is insane! This one simple accounting gimmick allows Netflix to report a profit while cash-flow negative. Like I said, insane!
Here is how egregious their accounting method is. Take House of Cards as an example. They amortize the production costs from the first season over four years. Does this make sense? Not a chance! Most of the value from Season One of House of Cards ends shortly after the season went live. Considering the problems surrounding the main actor, Kevin Spacey, the value of those titles is impaired even further and faster.
A damning statistic reveals amortization of content expense is increasing faster than revenues. Past sins are catching up and it’s only going to get worse.
I’m not selling yet, but Netflix is on the watch list. I watch Netflix close for signs subscriber growth is slowing. If they can’t reach a cash flow positive situation before subscriber growth slows Netflix is in big trouble.
The Story of Tesla
Tesla is different from Netflix. Netflix is a one-horse show while Tesla makes cars, batteries, solar panels and solar storage. The finances for Tesla are stretched, as with Netflix, but with many more options for success.
I own Tesla and if the wheels don’t fall off — pun intended — the company will be wildly profitable. There are a lot of ifs right now. The Model 3 has production issues and the main man, Elon Musk, spreads himself thin at times running so many disparate companies.
I consider Tesla a mad money holding right now. Tesla is burning through cash and looks to do so for several more years. Musk doesn’t have much in the way of accounting gimmicks I disagree with, but he does use plenty of financing gimmicks to fund the company’s burn rate.
My Tesla investment is small. If the stock came down in price $100 or more I might add to my position. Might.
A lot of issues need resolution before I jump into Tesla deeper. Tesla is one of those companies which will either crash and burn leaving investors licking their wounds or they’ll end up bigger than Amazon. Musk is the right man with the right dream coupled with the right work ethic to get the job done.
Tesla is not for the faint of heart or to be purchased with the rent money. Just warning you.
One More Thing
Most people buy stock by placing a purchase order. So do I, most of the time.
However, there is a trick you can use to buy listed stock at a price less than the price quoted. But that is a story for our next post.
I had to do something to get you to come back. Besides, I talked enough for one post.
There are times thinking like an accountant determines how much of your hard-earned money you get to keep and how well your investments perform. Money isn’t the only thing accountants think about either. Time is more important than money by a long shot and plays into the equation every time.
This past week my oldest daughter asked if I would be helping with her tuition for next semester. I lollygagged as I didn’t want to think about it at the time. My daughter persisted, finally mentioning she wanted me to know about her tuition if I wanted to use a credit card to accumulate bonus miles or cash back.
Every year I generate cash and miles equivalents of around $10,000 per year. The whole family knows my love of these bonuses since they are tax-free and nothing motivates a tax guy like a five figure tax-free benefit.
I shrugged at the suggestion of getting another credit card for a bonus. Yes, tuition is nice spend to generate lots of cash back or miles. I did just that earlier this year. But I didn’t feel like it anymore.
Another credit card with a required spend would be a nice added bonus. However, I only undertake the process when I feel like it. Some days I am in full hack mode and other times I could care less. Since I don’t need more miles and the kitty is full, my desire is based solely on thrill.
It comes down to time. Tracking spending on a certain card takes a small amount of time. The rate of return is high, but I don’t want to do it! Call me a spoiled child (in the comments, please), but there are times my time is worth more than another $400 tax-free.
Earlier this year I went crazy on the system. I used several new cards to generate thousands in cash, free hotels rooms and miles. I hate traveling and business travel will take years to consume all the benefits I amassed this year. Like I said, I went ape.
I also discovered selling tradelines a year or so ago and decided that looked like fun (if not tax-free). After mild research (and a few hiccups) the ride started producing a revenue stream. The numbers were nice, even if taxable income.
Selling tradelines requires more time tracking each card involved and assuring you have at least something on each card involved. It started becoming a pain in the tail real fast. The money wasn’t worth it after a while. (My attitude changes over time. When I stop enjoying the process I go do something else; when my deviant nature bubbles to the surface I am all in. Until it grows old again.)
There is a danger in the FIRE (financial independence, retire early) community. We tend to research to the nth degree as we seek to maximize results with minimal risk.
But minimal risk may not be acceptable risk! As I went crazy on selling tradelines I ended up with one credit card cancelled. (Don’t cry for me. Plenty more where that came from.)
The danger part of tradelines was wasted time. Owning a business means I have plenty to spend on. Putting a few transactions on a dozen cards started being a real time consumer, however. If I didn’t have a tax practice and blog to manage I might find the time expenditure acceptable.
With tradelines you need to track when an authorized user is added to the card and when to remove them. More time is needed to track your payment so you get paid for the hassle investment of time.
The money is good, no doubt. Selling tradelines on a few cards can add a few hundred to the mad money account. A dozen cards can reap up to a thousand every month; sometimes more.
A good accountant would milk this thing for all it’s worth. I’m not every accountant.
A bird in the hand is worth two in the bush they say. And they are wrong! Free money from credit cards is a lot of fun, but your time is more precious! I will still harvest tradelines and credit card bonuses when I feel like it, but this is the boy in me playing. It isn’t maximizing results.
Or maybe it is! Picking every bone clean that happens in your path is insanity! Not only is time precious, but what you could do with that time can easily make more. Life is too short to waste on every hack. You must be careful which hacks you pick and choose.
Harvesting credit card rewards and selling tradelines at least makes you money as long as you don’t increase spending. The real danger comes when you only consider maximizing rewards in other areas of life.
Drugs might provide lots of utility as long as you realize it costs money and a piece of your soul with every purchase/use. An alcoholic drink now and again is fine for most people. But if you get confused with mild stimulants you can get in deep quickly. The jails are full of people who maximized pleasure without concern for long-term consequences.
Not to mess with your head, kind readers, but sex is good a few times a week, too. Seven times a day might sound funny, but you can do real damage. You don’t want to milk every last ounce of utility before you end the activity. (Bad choice of words.)
And now we get to the real risk of maximizing results applicable to everyone in the FIRE community. Every accountant knows (or should know) leverage is the best way to spike results. Public corporations do it all the time. XYZ, Inc. adds a pile of debt, buys back stock and watches earnings per share skyrocket.
Until it doesn’t.
Leverage is a double edged sword with the edge cutting you enjoying the advantage. You see, leverage has a built in cost. Interest is owed on each leveraged dollar, win or lose. Break even is a loss with leverage.
Investors figure this out early on. A thousand dollars can buy $2,000 of most listed stocks. If the stock increases 10%, your return is 20%, minus interest owed on the borrowed money.
Here is where it gets bad. If the investment declines the loss is also magnified! A 10% decline is a 20% loss on your original money, plus interest owed on the borrowed funds.
The worst part is staying power. Everyone knows broad market declines happen. Everyone should know the market always comes back given enough time. When you use leverage you don’t have unlimited time. Interest is accruing every day you have an outstanding balance on the loan. The market can outlast you when you use leverage.
Without leverage, all you need to do is wait. An individual stock might go down for the count. It happens. But the overall market is a reflection of the long-term growth trends of the whole economy. In time the market will reflect the continuing growth in technology, productivity and economic growth.
And only the unleveraged can outlast Mr. Market.
Most people use leverage at a far greater level than what is allowed to buy stocks, bonds and mutual funds.
I can hear your screams of innocents. You don’t buy stocks or mutual funds on margin* (good to hear), sell your tradelines (maybe you should) or use credit cards with or without rewards and bonuses (why not?).
However, I bet you borrowed money at least once in life on an investment virtually guaranteed to lose money: a vehicle loan. Ah, but that’s different, you say. No it’s not, says your favorite accountant.
Leverage is leverage. And leverage accentuates gains and losses. An auto loan creates the same leverage a stock investment does. The only difference is the size of the loan and the guarantee the asset will decline in value.
There is another leverage I bet most readers have used: the mortgage. But how can you afford a home without a mortgage, you protest? You might not. I’m not even asking you to buy your first (or any) home without a mortgage. What I want you to think about is the amount of leverage you are taking on and the potential consequences.
Real estate tends to be a good investment, except for 2008. As bad as the housing market was in 2008 and thereabouts, the only people who lost their home to the bank had a mortgage. Usually leveraged to 100% or more.
Some leverage can be a smart move, but leveraging any asset or investment to 100% or more is begging to have your head handed to you.
Think of it this way. You buy a $100,000 home with $3,000 down. (We will ignore closing costs and other items that muddy the water.) If the value of your new home goes up 3% the first year you doubled your equity in the home. A mere 3% decline and your home has no equity. None. Zero.
In most cases you are okay as long as you are current on your payments. That is a whole different issue. What does happen when you have no equity in your home is it requires you to come to closing with cash to sell the darn place. It removes the selling option for many people.
Massive leverage is common historically in real estate. In my office landlords are the number one group to declare bankruptcy. They are also the same group who has the highest net worth. What’s up with the dichotomy?
It all comes back to leverage. Those who abuse or overuse leverage find themselves in too deep to wiggle. When you lose the ability to move financially you are in death spiral. Even if you survive there will be significant damage done.
The Efficient Frontier
I hear business owners and those willing to cheat on their way to FI brag about a method they discovered to generate massive income and net worth growth. Before the words are out of their mouth I know they read a news article on using leverage to spike returns. The article probably highlighted a major corporation using leverage to maintain and grow returns.
With rare exception it ends badly and our victims need to start over or at least re-walk part of the path toward FI.
Accountants love to talk about efficiency and maximizing returns. And it is true I want you to think like an accountant. But just because thinking like an accountant is a good thing doesn’t mean accountants never have stupid ideas. Abusing leverage is one of these ideas.
I would never, repeat, never recommend a client to borrow funds to invest in the stock market. This includes option strategies to spike investment returns.
(Side bar on options: Options are not bad in and of themselves, but most people use them wrong. I have no problem using an option to buy a stock a lower price and collecting premiums or replacing a sell order with a covered call. However, if you use an option to buy stock you must have all the cash on hand. Otherwise you are only disguising massive leverage. The bad kind.
If you don’t understand options you have no idea what I just said. That’s okay. Someday I’ll write a post on options and the incredible risks to the foolish as well as using options as a hedging tool for your own investments. Stay tuned.)
Back to our show. A car loan is leverage and not the good kind either. I understand a loan is sometimes necessary. When this is the case you must make your leverage a DEBT EMERGENCY! When you have debt on a wasting asset all nonessential spending stops until the debt is gone.
The home mortgage is a bit different. I make exceptions to the rules for mortgaging a property, but only after careful consideration. Once again, remember 2008. It never happens until it does.
If your accountant tells you to leverage your business or investments, take caution. When he (a woman would never recommend such a stupid strategy) explains how leverage maximizes your gains, grab your wallet and run like the wind. Your accountant didn’t lie, but the risk assumed to take such a strategy is insane.
If your accountant, or anyone else, encourages excessive leverage on real estate or business, or any leverage on an equity (stocks, mutual funds, et cetera) position, remember the words of the dearly departed George Carlin:
“Do you know how you can tell if you have a stupid kid? Take him to the curb in front of your house and stand him there. If you come back in two weeks and he is still there you have a stupid kid.”
And a stupid accountant.
* borrowed money
I am a simple man with simple tastes living in a complex world. Once upon a time the world was a simpler place. We knew the food we ate and the road we traveled. We trusted the news and those who brought it to us. But simple is not in the nature of man.
Take the United States for example. The premise in the beginning was simple: freedom. But it wasn’t simple as soon as the words left the Founding Fathers’ mouths. Men wanted to be free while holding slaves. It led to Civil War. Women waited until 1920 for the right to have their voice heard.
But this story isn’t about morality. This story is about complexity and how quickly it enters life. A simple thought—freedom—was not as simple as it sounded. The nation needed to declare independence, fight a Revolutionary War and write a Constitution. And that was the simple part.
The Tax Code is the same. A simple concept—raise money to pay the government’s bills—turned into a colossus might quickly. For those reading thinking the tax situation was mucked up only recently, let me enlighten you.
President Franklin D. Roosevelt struggled with preparing an accurate return in the spring of 1938 (preparing his 1937 return) so badly he gave up and sent the Bureau (this was before the IRS) a check for $15,000 with a note that said, “I am wholly unable to figure out the amount of tax for the following reason:”
The President then gave an account of the income he didn’t know how to put on the return. He concluded his letter with, “As this is a problem in higher mathematics, may I ask that the Bureau let me know the amount of the balance due? The payment of $15,000 doubtless represents a good deal more than half what the eventual tax will prove to be.”
Try to pull the stunt President Roosevelt pulled with the IRS and see how far it gets you. Needless to say, penalties would be applied by today’s kinder and gentler IRS.
To top it off, this was back in the days when taxes were simpler! Sure, Form 1040 was four pages, but there were no schedules or additional forms to attach. The instructions for the entire return was two pages! It was so simple even the President of the United States couldn’t figure it out. And he signed the tax bill into law!
The Growth of Complexity
Nature is simple in its most basic components. Keep chopping stuff into smaller bits until you get to the smallest indivisible piece of matter, the atom. But, wait! The atom can be chopped up smaller still into electrons, neutrons and protons.
Whew! That could have gotten out of control with complexity. Oh-oh! Scientists have been busy busting up the itty bitty parts of the atom into even smaller elementary particles. Now it get complex.
Humans love adding complexity, too. It must be in our nature. (Go ahead and make a face.)
Complexity isn’t always a bad thing. Building an automobile or airplane is complex. Modern medicine uses complex procedures to find novel cures to disease.
But complexity can get out of control. When nature gets too complex we end up with cancers.
When people get too complex we get the modern Tax Code, economic system and monetary policy.
Original ideas start very basic, dare we say, simple. Within seconds the complexity is mixed in. This isn’t a character flaw. Riding a horse to church is a fairly simple process. Once automobiles entered the scene complexity followed. Not only are cars complex pieces of engineering, society now needs to deal with the millions of vehicles on the roads. Traffic lights are not there to annoy you, but to keep traffic flowing. How else do you get endless traffic to all its destinations?
I have made a living in the imaginary world of tax complexities. It’s paid the bills and gave me a good life.
At first it might seem a waste of an intelligent man’s life. Before you go down that road, consider: How would the government function without tax revenue? Our national defense, roads, bridges, public works projects and schools need funding to function.
I don’t work for the government; I work for you, protecting you from overpaying the government. And complexity is my greatest friend. The Tax Code is such a massive muddled mess you can drive a Mack truck through it. Given enough time you can find the answer to pay no tax for virtually every situation. Major corporations do.
Taxes aren’t the only area where complexity works in your favor. Machines and computers have made our lives so much easier that nearly everyone could work half the hours and not notice a change to their lifestyle.
You can see this in action within our own FIRE (financial independence, retire early) community with the plethora of side gigs and people retiring in their 30s. Our society is so rich a large number of people with very little effort can retire really young and travel the planet.
This brings up another complex area we can exploit: travel rewards. Once upon a time it cost money to travel. Today you can hack the system and get massive travel rewards to see the world for pennies on the dollar.
Get Rich by Getting Complex
You would think adding to the already complex mix would be your ticket to wealth. It isn’t. The trick isn’t more complexity; it’s breaking down the complex into small, easy to understand, components.
Complexity leads to error. How many product recalls do we hear of? How many times have governments and corporations been hacked? We can be too complex for our own good.
Take investing. You can go through all the hoopla trying to be the next Warren Buffett. You could be the next one! Or something as simple as an index fund can work miracles for your net worth without any effort on your part.
Credit card rewards are a massive mix of options sure to cause problems for those less than astute in the tracking of their credit card activities. Don’t pay the bill in full each month and trouble is sure to follow.
Yet, a simple spreadsheet can solve the problem. Several credit cards can be tracked simply to serve all your financial needs. Travel rewards are only the beginning. In a few weeks I have a side gig you are sure to want to hear about. I will show you a program where your credit cards could sprinkle $1,000 or more every month on you. You have to come back to learn this little side gig nugget. (Notice my talent at creating a cliffhanger? Hahaha!)
Taxes are the ultimate in complexity. Even this can be segmented into easier to understand parts. Maximizing retirement accounts is a simple and easy way to lower your tax burden. Investment property owners can take advantage of new tangible property rules to modify their tax outcome. Business owners can expense certain assets versus depreciation.
Play the Game
It’s all a game. The Federal Reserve manipulates money supply to manipulate the economy and prices. Congress can’t keep its fingers off the Tax Code for more than fifteen minutes.
Since life is a series of complex systems, both natural and manmade, why not use this to your advantage? Complexity isn’t going away. If anything it will get worse. Those who can break the whole thing down into the simplest parts will control the pot of gold.
Diet and exercise is a simple way to benefit the complex system called your body.
Investing regularly into broad-based index funds is the only proven way to match market returns over long periods of time. Forget Peter Lynch and Warren Buffett. Yes, you could be the next guy to perform miracles in the investment world, but odds are strong you will end up another schmuck who massively underperforms the markets with his dazzling displays in Fibonacci programs of complexity.
The index fund wins.
When I consult on tax and financial matters people always want more. The simple answer isn’t satisfying. Complexity always seems to be the right choice. It looks better. Lots of moving parts must be better. Complex must trump simple.
And then it ends in tears.
Complexity isn’t better. We live in a complex world. Simple solutions solve most problems.
The simplest answer—to stop worrying about things you can’t control—doesn’t seem right. But it is!
You will do wonders for your net worth when you find a way to break down the complex into simple components. This is where you will find massive financial opportunities.
When you get right down to it: I am a simple man who happens to enjoy seven layer cake.