Tax Brackets

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Taxes are very daunting the first time you encounter them, and can be confusing even for those who deal with them all the time.

This post is meant to clear up a misunderstanding that is extremely prevalent.

That misunderstanding is about how tax brackets work. I have heard many times, from friends and clients alike, that they do not want to earn a certain amount of money because it will ‘move them into a higher tax bracket’. Usually what they mean can be illustrated in the following example:

If there were two tax brackets, one from $1-100,000, where income is taxed at 10%, and one from $100,000 and beyond taxed at 20%, they believe that if they earn $95,000, they will pay $9,500 in taxes and keep $85,500, but if they earn $105,000, they will be taxed at 20%, paying $21,000 in taxes and keeping just $84,000.

In fact, the way income taxes work, you will almost always be better off by earning an extra dollar. That’s because brackets don’t go away once you pass them. In our example-world, everyone who earns up to $100,000 pays 10% in tax, and if you earn over $100,000, you pay $10,000 in tax on the first $100,000 that you earned, and 20% on all of the other dollars. Our hypothetical $105,000 earner will pay $10,000 in tax on the $100K and $1,000 in tax on the next $5K, paying total tax of $11,000 and keeping $94K.

I should note that there are a few exceptions (two examples below, but certainly not exhaustive) to the rule of thumb that these ‘cliffs’ do not exist, a common one is the price you pay for medicare. Other exceptions that come to mind are for those receiving significant assistance (mostly near poverty lines or receiving disability benefits). In some cases increasing their income by $1,000 may reduce benefits or increase taxes on them by close to or more than that same $1,000.

Assuming no exceptions apply to you, you can relax, there are no magic earnings numbers you need to avoid because they will cost you money.

Of course, you may be less inclined to work extra for the second $100K if it is taxed twice as much. An economy-wide application of this concept is the Laffer Curve.


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Ah, compounding. Perhaps the most well known quote about compounding is an apocryphal one attributed to Albert Einstein.

Compound interest is the eighth wonder of the world.”

-[Almost certainly not] Albert Einstein

Regardless of the provenance of the quote, the gist is mostly correct. Compound interest is so powerful that it is very difficult to properly do compounding math in one’s head. The ‘rule of 72’ helps us with approximations. The rule says that if you divide 72 by the rate of return, the result is the amount of years it takes something to double. So for instance, if something returns 10% per year, we expect it to take 72/10 = 7.2 years to double. The actual answer is 7.28 in case you’re curious.

This is quite a bit shorter than the simple 10 you might get from saying that 100% return is doubling, and there are 10 10%s in 100% and therefore it will take 10 years.

Assuming 10% annual returns (which I’ll note is quite high), that means if you invest a dollar for 7.5 years you expect it to double, for 15 you expect it to quadruple, for 22.5 it will be 8x what you invested, and 30, 16x.

30 years is still shorter than many working careers and retirements, if you start working at 25, you might have savings invested for 35 years until you’re 60, and again for another 35 if you live till you are 95.

This is why compound math is so important.

It is also very important to understand when compound math is being used to trick you. I have seen many life insurance policies pitched to people around 30 years old that guarantees to be worth seven times what they put in by the time they are 80. This can sound great. However, if you crunch the numbers, you’ll find that an investment that increases seven-fold over 50 years has given you a return of under 4% per year. Not so attractive, perhaps.

Compound returns are why it can be so valuable to start investing early. A couple with $500,000 invested at age 40 and earning 7% per year will see that number grow to $2.7 million at age 65 with no further savings. If it takes you ten more years, only reaching that $500,000 by age 50, at age 65 you’ll have about $1.4 million.

In fact, to catch up to the same $2.7 million as the couple that reached $500,000 by 40 and didn’t save any more, the couple with $500,000 at 50 would need to save $53K per year from age 50 until 65.

Efficient Markets

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Efficient markets. Business schools spend entire semesters trying to teach their undergrads to understand this concept, and they still mostly fail. But I’m going to teach it to you here.

Imagine there is a company that runs amusement parks. They make an entirely predictable profit year in and year out. There is nothing surprising about how well they do financially. Everybody loves their parks and always will. They are only open in the summers.

If this company were publicly trading their stock, it would be tempting to think that you could buy their stock in April, just before they start to make money, and sell it in September, before they hibernate for the winter.

However, because everybody knows that they only operate in the summer, the price of their stock is not going to go down in the winter when they make no profit, because it is not a surprise. They are also not going to have their stock increase in price in the summer because they are making money, because that’s what everyone expects them to do.

Sticking to my Tesla theme for examples: at time of writing, Tesla’s market cap is $53 billion. General Motors’ market cap is $55 billion. What can we take away from this information? More or less, we can infer that the market believes the expected value of Tesla as a company is equal to the expected value of GM. Now, perhaps Tesla is riskier, and actually the expected value is higher than GM’s, but the current price is lower because we need a higher expected return to be willing to take on that risk.

However, at the very least, we can learn that if what we personally believe the outcome will be is that Tesla will become just like GM (no small feat from here, since GM sells 10 million cars every year, and Tesla has sold about 300,000 cars in their existence), we should probably not think Tesla is a particularly attractive stock (unless we think both GM and Tesla are very attractive, but you get the point).

To think Tesla is a very attractive stock relative to GM, we have to believe they will be a more profitable company than GM going forward.

Back when Tesla was a $5 billion company, this wouldn’t necessarily be the case. You could believe that Tesla was bound to become about half the size of GM, and that it would make a very handsome investment indeed.

It is very important to understand how the expectations of the market can be inferred by the current price. And there is another angle of the efficient markets hypothesis!

When news comes out, often people are tempted to sell their stock if it is bad news or buy a stock if it is good news. They are overlooking a key part of how efficient markets work.

Let us say that Tesla is trading at $300 per share.. If great news about Tesla comes out, pretend Uber has ordered 1 million Teslas asap for their automated car project, should I rush to my trading app and buy Tesla?

Let’s talk about what happens the moment before and the moment after that news comes out.

The moment before Tesla announces the great results about the Uber deal (and often these happen when markets are closed), shares are trading hands at $300 per share. The moment after the deal is announced, shares will likely be trading higher. All people with outstanding orders to sell their Tesla stock at $310 per share will likely cancel those standing orders and move the price at which they will sell up.

So at 3:59PM, right before the market closes and before the information is known, Tesla is trading at $300. The deal is announced at 6PM, and by 9:31 the next morning, trades are happening at $330 per share. There need not be any trades anywhere between $300 and $330. If everybody agrees what this deal will do for Tesla as a company, no opportunity is created to buy or sell the stock and make a quick buck.

If you understand these two ideas, that market expectations can be found in a price (at least an approximation of expectations), and that if information is known publicly, that is does not create an opportunity for arbitrage, congratulations, you now have a better understanding of efficient markets than most finance majors.

Risk vs. Return

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Understanding the risk vs. return trade-off is something that takes people in finance entire careers. It is an always developing understanding.

To see some beautiful thoughts developed over some of those aforementioned careers, check out this post by Nassim Taleb and this one by Howard Marks.

Here I’m going to focus on much simpler definitions and relationships.

If you are to take a risk, you have to be rewarded for it. The more risk, the more reward you will demand. This is true for people and also for markets. This is the reason why companies and countries with good credit ratings can sell bonds that pay lower interest rates.

However, it’s important to remember that something that is riskier, won’t necessarily return more over any given time period. In fact, by definition, if it would, it would be less risky. The only return that is higher for riskier assets is the expected return.

In fact, a brief digression. A common example of this principal bleeding into the world is that something can be ‘too good to be true’. In investing, something that looks (or is claimed by a salesman) to be low risk, but promises high returns, is probably a sign that there is hidden risk somewhere.

Using the same example as in my bond primer post, Tesla has both bonds and stock that you can purchase. If you buy the bonds, you expect a lower return, and also a lower variance in the potential outcomes of the investment. You may expect to get 7% return, and a bad outcome is that you lose 10% of your investment, while a good outcome is that you get 10%. In fact, with bonds, the best case outcome is almost always known and capped ahead of time. If you buy Tesla stock, you may expect to get 20% returns, but you may very well lose all of your money, or have returns much higher than 20%. This is risk.

As discussed in the purpose of investing, even if you can get higher returns, you may prefer a lower expected return and lower risk portfolio, especially if both will accomplish your goals equally well.

What is a Bond?

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To many, when they think of bonds, they think of what a retired person’s portfolio is made of. Safe, boring, perhaps low return.

What’s important to understand is what a bond actually is. An example:

If you need to borrow $1000 and I have $1000 and we agree that you’ll pay me $50 per year while you have my money, and in 5 years, you’ll pay me back my $1000, the contract that says you owe me is essentially a bond.

There are plenty of groups that like to borrow money. Governments, corporations, etc.. Some have more risk in their ability to pay you back than others. The risk that you might not get paid back in part or in full is called ‘credit risk’. The US government is generally considered the safest place you can lend your money to. They can of course, just print it if they need to pay you back.

However, there are companies with dubious credit who are looking to borrow money. For instance, Tesla has recently raised cash by selling bonds. Bonds under a certain rating are called ‘junk bonds’ or ‘high yield bonds’, sort of the bond world equivalent of ‘robber barons vs. captains of industry’.

Now, using Tesla as an example, you can buy a bond issued by Tesla or buy Tesla stock. What’s the difference? As we explored with stock, you are an owner and are entitled to a share of the profits. However, before profits are calculated, debt has to be paid! So if you buy Tesla bonds, and Tesla sells just enough cars to pay the bonds, but doesn’t have any profit left over after that, the bond holders will get paid, but the stockholder’s won’t have any profits to distribute or reinvest in their company. Taken to an extreme, when a company goes bankrupt, the bondholders are paid back first before the stockholders get a dime.

So yes, a bond can be very safe, very risky, Very short-term, or very long. As long as you understand the idea; that you are lending money to somebody in exchange for interest in the meantime, you understand a bond!

What is a Fund?

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Most people have heard of a fund. Mutual fund is the most common kind, exchange traded funds (ETF, for short) are close behind.

What you want to understand about a fund, is that it can be made of anything. A fund is really just a sort of holder for actual investments that the fund owns.

When somebody tells me their investments are in “mutual funds”, this doesn’t actually tell me anything about the types of investments they have. A mutual fund can own stocks, bonds, a particular sector, particular geography, you name it.

Similar to stocks, it helps to know why they exist to understand them. Back in the days before Robinhood, it cost a lot to buy shares of stock, and often you had to buy a “round lot”, 100 at a time. This was onerous and expensive, and with information about stocks hard to come by, assembling a portfolio was difficult and expensive.

Enter the mutual fund. A group of people pool their money to buy many different securities, usually stocks and/or bonds, and to have a manager manage it. That’s all it is.

You can have a fund that buys the 500 biggest US companies, and that’s all it does, or you can have a fund where the manager is trying to outperform a target (usually called the “index”). You can have a fund that only invests in biotechnology, or a fund that only invests in bonds from Japan.

A fund is just a convenient way to own a whole bunch of things at once.

What is a Stock?

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A lot of people get intimidated talking about stocks, but I’ve found that most people fundamentally know what a stock is: a fractional ownership in a company.

Things start to get a little fuzzy from there, so I like to first talk about why stocks exist as we know them today. This won’t be a history lesson about joint-stock companies, but rather why you can even buy shares of McDonald’s or Nike in the first place.

Imagine you own a company that sells books. Hard to believe. Pretty soon you are selling a zillion books and making great money, and reinvesting all of that money back into your book selling company. But now, instead of just selling books, you’re selling everything. And people are buying it, and you’re making even more money.

Now, if you want to sell some or all of your company to someone else, you can. But you’ve gotta find a person and make a deal. Far better if you can just sell some to anyone that wants a piece.

Why would you want to sell? Maybe you want some cash now for yourself or your family. Maybe the selling business is great now, but who knows if it will last forever? Maybe you want to get some cash to reinvest in the selling business. It doesn’t matter: if you want to trade a piece (i.e., a share) of your company for cash, you need to sell stock.

Different countries have come up with standards that a company must meet in order to be able to trade shares on public exchanges. They are mostly built around transparency and reporting requirements. If you are going to be able to sell your shares to Joe Public, you have to at least open your books to him.

But I digress. You’ve sold some shares. What now?

Now the owners of all of the shares are entitled to their share (pro-rata) of the profits of the company. When you own stock, you own equity. However, that puts you last in line for those profits. Have people you borrowed money from? If the company stops making money, they have first dibs on the stuff it owns. Risky.

So you own something that might have some nice returns, but if it does poorly, the value could potentially evaporate. So why buy it? Well, at some point the price reaches a level where the future returns the investor expects are enough to compensate him for the risk. So he buys.

When you buy stock, you are literally purchasing a fractional interest in the company. If you buy all of the stock, you own the entire company. That’s actually how it works.

So to recap: stocks are part ownership in a company. They are risky. You buy them because you expect them to have good future returns.


The Savings Hierarchy

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By the time people get into their 20s and 30s and have figured out how to live within their means, they usually arrive at a daunting question: Where should I save my money?

In general, there is a hierarchy of where you should save.

#1 is to get your 401(k) (or 403(b)) match if your employer offers one. It’s very unlikely that this isn’t the best use for your savings because you’re getting an immediate return from your employer.

#2 is where it starts to get tricky, but for me, the next priority is an emergency fund. Everyone’s emergency fund needs are different, but 3 months of expenses is a good place to start.

#3 some might flip this with #2, and depending on the specifics, I might agree. Pay down your high interest debt. What’s high interest? Anything over 8%. Maybe even 6 or 7.

#4 if you have an HSA, max that out, the limit isn’t even that high. If you make the contributions direct from your paycheck, you get to avoid payroll taxes.

#5 max out your Roth IRA. The limit is $5,500 per year, if you really needed to get at it, you could probably withdraw most of it without penalty. It’s money that will never be taxed again, and you’ll probably end up with much more pre-tax money than Roth money in retirement.

#6 head back to the pre-tax retirement account (401(k) or 403(b). Tax deferral is worth a lot. There’s a decent amount of room here; $18,500 per year as of writing. You may want to skip to the next before maxing it out if you have goals earlier than retirement.

#7 taxable investment account. This is apparently the best kept secret in personal finance. You’d be amazed how many people don’t realize you can take cash that would otherwise be in your checking or savings account and invest it in stocks, bonds, or funds. If you’re a high earner that needs to save a lot to get to retirement, you’ll need to get familiar with how this kind of account works.

If you can get all the way to the point where you get your 401(k) match, have an emergency fund, have no high interest debt, max your HSA, max your Roth IRA, max your pre-tax retirement account, and are saving in a taxable account, congratulations. You’re probably crushing the retirement checkpoints.

Changing Your Brain, Tax Season from the Inside, Donor Advised Funds, and more w/ Jeremy Runnels and Kevin Bruns [Episode 4]

On this pod I’ve got Jeremy Runnels, CFP, talking about the fiduciary rule, quantifying the value of tax deferred accounts, how the choices we make literally change our brain.

Then I’ve got Kevin Bruns, CPA, to talk about what tax season is like for an accountant, the effects of the new tax law, and a buck hunter segment on donor advised funds. The audio gets a little louder at 29:10 when Bruns’ segment starts.

Special thanks to the weekend reading for the h/t on the articles Jeremy and I discuss.

Topics and Timestamps:

0:30 Jeremy Runnels on the fiduciary rule.

7:30 Quantifying the value of tax deferred accounts.

14:15 Changing your brain with decisions.

17:40 Predictive Processing

21:20 Kitces Pod Jeremy mentions.

29:10 Bruns comes in — warning, the audio is a little louder here.

30:00 Tax Season from an accountant’s perspective.

35:50 Practical effects of the new tax law.

38:35 Buck Hunter segment on Donor Advised Funds.