Tax and Saving

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Most of the tax information on the web is a mess. It’s confusing as it tries to apply to everyone, with varying situations, and is often written by non-engineers for non-engineers. I think my tax situation is common to people who have been in software engineering companies for most of their careers, and here are my notes

Assumptions and Hannah

You’re in the same boat as Hannah. A normal software engineer at big companies with the standard setup. Her company has a 401k. She makes more then she can contribute to a Roth IRA and Tax law is accurate to circa 2019.

Hannah assumptions:

  • Has a 401k with her company which she maxes annually
  • Ineligible for Roth deductions
  • Marginal tax rate of 35%
  • Long Term Capital Gains Rates of 15%

IRAs Non-Taxable Saving Accounts

An IRA is an account that grows tax free. The critical value of the IRA is the tax free growth. With money not in an IRA you have to pay tax twice 1) when you make the money 2) when the money grows.

IRAs have contribution limits, X, Y, Z

IRAs early withdrawal penalties

IRAs hardship withdrawal

TODO show calculation for Roth growth

TODO show calculation for IRA growth

Taxable income, and capital gains

Income is the money you make. That starts by being your wages, but as you get assets like stocks, bonds and houses, things get a big more complex. Let start with easy sources of income:

Wages + Bonus: What you’re paid at work, you pay the marginal tax rate. Interest on Savings and Bonds and Stock Dividends: What you’re paid to hold an investment (to assume the risk), you pay the marginal tax rate.

Capital Gains: If you have assets (houses, shares of companies), you may not get interest, but the asset can appreciate. You need to pay tax on those gains. In general capital gains can be short (STCG) or long term (LTCG), with short term being at the marginal tax rate, and long term having a tax benefits (Hannah: 15% LTCG, vs 34% marginal tax rate).

When retired, you need to get money out of your savings, which you can do by taking interest/dividends or by selling assets. When selling assets, you pay capital gains. This begs a questions, should you keep your capital gains inside or outside your IRAs (where they have tax free growth). Turns out

Should I hold my high risk/high return investments in my taxable or non-taxable accounts?

My high risk investments are already in non-taxable, should I sell them and swap them with my taxable account?

IRAs vs 401Ks

A 401k is a special IRA that is setup by your employee that has matching (good thing) but usually less choices of what you can invest in (bad thing). Otherwise, its a regular IRA.

IRA vs Roth IRA

IRA you pay no tax on the way in, but you pay tax on the way out. By contrast with Roth you pay tax before making a contribution, but then pay no tax on the way out.

Assuming your tax rate is the same, it doesn’t matter which you choose. If your tax rate goes up post retirement, you’re better off with a Roth, and if your tax rate goes down, you’re better off with an IRA. A few notes:

  1. Your tax rate can go up by moving to a state with higher state taxes (e.g. From WA w/0% state tax to HI w/TK% state tax).
  2. If you’ve saved a lot, your marginal tax rate might be the same, but your average tax rate (which will be on your retirement withdrawals) is most likely lower.

IRA and Roth IRA contribution limits

You’re limited to how much you can put in your IRA and Roth. Odds are you can’t put money into your Roth IRA because you make to much.

Back door Roth

Tax law is goofy. You can’t deposit money into a ROTH since you’re over the limit, but you can take money from your IRA and convert into a Roth IRA. But there’s a rub - the Pro-Rata rule.

The pro-Rata rule

Even though you are using after tax dollars to transfer money to the Roth IRA, you can’t do the math like that. The rules (arbitrary) state that the money you take over is in the ratio of your IRA before and after tax contribution.

529s

An education only after tax savings account. You put in money after tax, get tax free growth, and can use distributions for your kid or grand kids education.

Tracking

Back in the day mint was great, but now, I use Monarch Money. Took me a couple days to setup, and so far it’s been great!

I use:

I also pay all my credit cards and mortgages from a single account - so that’s my source of truth to make sure I’m not missing major stuff (and boy I often am).

Rates Taxes and Savings

Marginal vs Average Tax Rate

Taxes are like a step function. From 0 - K1 you pay rate t1, From K1 - K2 you pay rate t2, etc. The marginal tax rate is how much tax you pay on every extra dollar make, E.g. the tax rate in the maximum step. By contrast, your average tax rate is the total taxes/total income, which can be significantly less then the marginal tax rate depending on how far over the step function you are.

Short vs Long term capital gains

Short term capital gains are the same as income, but long term capital gains (assets held longer then a year) are taxed at a lower rate:

Below is tax rate by income in 2020.

Tax Rate Married Filing Joiningly
15% Upto 488K
20% Above 488K

Cash positions and high yield savings

Often, we think about holding cash, and think about holding it in a place with no interest. Keep this money in high yield bank accounts, which can give close to 2% (as of Dec ‘19) At Fidelity you can keep your core cash in a liquid low risk mutual fund SPAXX, however this has a 0.42% expense ratio, which will eat 25% - 50% of your earned interest.

No load index funds and ETFs

Funds with zero or almost zero fees. Usually a broad index fund like Fidelity’s FZROX and FZILX or an ETF like VTI and ITOT (Note these ETFs have a 0.03% fee, or 300/1,000,000).

ETFs and Mutual Funds (MF) differ primarily in how they handle Capital Gains and Dividends.

With an ETF, you pay all capital gains when you sell, meaning you have control to avoid short term capital gains, and potentially long term capital gains when you’re at 20% (vs 15%).

With MFs they need to have a capital gains distribution annually as they re-balance the fund. This matters because you need to pay the capital gains on behalf of the mutual fund at distribution time. The capital gains might be short term depending on when the fund bought and sold individual stocks.

Digging a bit deeper, it seems like there are Mutal Fund strategies to avoid capital gains distributions, but I didn’t make the time to understand how effective they are. If I understand this correctly, its possible FZROX is using a similar strategy as there were no capital gains distributions in 2020, though there were in 2018-2019.

It seems both ETFs and MFs need to distribute dividends, which are often taxed as income. I don’t understand why they can’t directly re-invest it.

Unexpected expenses

Stock options

I keep getting these words confused, here are my notes in case they are helpful to others. For these examples assume today a stock is 100$, and your options are for 30 days. In our example we’ll buy 1 option, but the standard size is 100 options.

Sell a Put Option

You guarantee to “buy at a particular price”. You will be given a low amount of money to guarantee you’ll buy at a particular price. This lets you make money if a stock rises.

Imagine you sell a put for 1$, for a strike price of 100$.

If the stock goes to 90$ in 30 days, the “put will be exercised”, and you’ll need to buy the stock for 100$. As a result, you’ll end buying the stock for 100$ instead of 90$ which is the market price. This means you bought stock for an extra 10$ (recall the stock is worth 90$ today), but since you were paid 1$ for the put it ended up **costing you 9$**.

If the stock goes up to 120$, the buyer won’t want to sell you the stock at 100$ (they’d lose 20$), so they let the put expire. This lets you **gain 1$** over the price of the stock.

Buy a Put Option

Allow you to “sell at a particular price”. You spend a low amount of money to be able to sell at a price. This protects you from a price drop.

Imagine you buy a put for 1$, for a strike price of 100$.

If the stock goes to 90$ in 30 days, you can “exercise the put” and sell the stock for 100$, making you 10$, for a price of 1$, netting you 9$.

If the stock goes up to 110$, you don’t want to sell at 100$ (you’d lose 10$), so you let the put expire. This lets you ensure you won’t lose any money (recall the option was at the strike price) **costing you 1$**

NOTE: You don’t need to own the stock to be able to make money in a put, in our example where the stock drops to 90$, you’d buy the stock at 90 for market price, and sell it for 100$, again netting you 9$

Uncovered vs Covered

As with buying a put option, you don’t need to own the stock to sell the option (this is an uncovered put), however this can cost you a lot of money. Imagine you sold a put option for 1$, but the stock drops 85$ to 15$, at this point you need to buy the stock for 15$, and then sell it for 100$, when this happens you’ll lose 85, and gain 1$, giving a net loss of 84$.

Selling your options early

You don’t need hold a put or call option for the entire duration, you can sell it early. This lets you tune your risk for reward early.

Put vs Call

Call is the inverse of puts, where you buy the right to “buy”, and sell the right to “sell”. see the table below.

Play safe - Guaranteed minimum value of unvested stock awards - buy a put

Imagine you have an grant of 100 stock awards, vesting in a year, for which you had a 10$ strike price - you then have 1000$ in paper money. You’ll need that money for your kids education, so you need to guarantee you don’t lose money, in that case, but a put.

The company can’t go up that high - sell a put

Imagine you have an grant of 100 stock awards, vesting in a year, for which you had a 10$ strike price - you then have 1000$ in paper money. You know the CEO and even though you think the stock will go up, you’re sure it won’t go up above 15$, in that case you can sell a put at 15$, and take some profit.

Summary

Imagine a 100$ stock, for which you buy/sell a put/call for 1$ with a strike price of 100$.

Type Direction You Price = 110 Price = 90
Sell Put Must Sell Gain 1$ Lose 9$*
Buy Put Can Sell Lose 1$ Gain 9$*
Sell Call Must Buy Lose 9$ Gain 1$
Buy Call Can Buy Gain 9$ Lose 1$

(*) Even though these are listed at 10$, the loss/gain is unbounded, so if the stock went up 99$ or down 99$ that would be what you need to pay.

Philosophy

The point of money

When seeing a financial planner, they asked me - what is the point of your savings? I said the point was making a big pile of money so I’d feel safe.

Yeah that was a mistake. Money is a tool. Use it to make your life better. Great uses are experiences with your children, investments in your health, and things that avoid a fight.

Retirment Ideas

  • Why don’t you retire already - An interesting take that you should retire as a sign of goodwill to the future generation.
  • Don’t focus on retirement, focus on financial independance (FI). FI gives you freedom and comfort regardless of your job.

What would you do for less money?

If you wouldn’t take a job for a pay cut, you probably shouldn’t take the job.

Making more vs spending more

See Parkinson’s law, which applies to both time and money. The task you have will expand to all the money (or time) available to it.

Does money make you happy?

Famous study, saying after 75K (maybe 200K now), extra money doesn’t make you happy. However, turns out that was flawed, the better model, whci I buy is more money is log linear to happiness.

E.g. every 10x inecease in money 2x in happiness. So going from 100K to 1M only doubles your happiness.

Fascinating, the impact of log linear money depends on your happiness paper

Believing the market only goes up

Keeping a mortgage you can pay of since interest rates are low

Generational wealth and camels

My grandfather rode a camel, my father rode a camel, I drive a Mercedes, my son drives a Land Rover, his son will drive a Land Rover, but his son will ride a camel - Sheikh Rashid bin Saeed Al Maktoum

What a great line. Difficulty breeds strength, which translates to an easy time for the kids, which leads to weakness, which leads to the cycle. Not sure the best way to handle this.

Timing the markets

Think you have a strategy or know something professional traders don’t? I’m skeptical, and the base rates are against you. This is especially confusing when the markets are out performing.

The correct strategy is buying no load broad spectrum index funds.

Remember:

Time in market beats timing the market.

The 3 types of rich

  1. Rich enough you don’t care the price of groceries
  2. Rich enough you don’t care the price of vacation
  3. Rich enough you don’t care the price of a car

How to trade money for happiness

  1. Money can lower the unhappiness

Above that. Buying crap won’t make you happy

5 things you can do

  1. Buy stuff - bringes least happine
  2. Buy time - time to spend with people love
  3. Buy expeiernces - experiences with people you love.
  4. Give it away to others
  5. Save it - Makes you feel secure (limited)

The unquenchable thirst

For the philisophicaly minded, from the Prophet:

For what are your possessions but things you keep and guard for fear you may need them tomorrow?

And tomorrow, what shall tomorrow bring to the overprudent dog burying bones in the trackless sand?

And what is fear of need by need itself? Is not dread of thirst when your well is full, the thirst that is unquenchable?

Other questions

  • How long should I hold my RSUs before selling?
  • If I have a pile of cash from selling RSUs, do I invest immediately or dollar cost average? -
  • Should I hold any bonds?
  • Where should I keep my emergency fund and how much?

How much is 1%

From ChatGPT

Absoulte

Year Top 1% Top 5% Top 20% Top 50%
2000 $280K $125K $65K $42K
2004 $300K $140K $72K $45K
2008 $345K $155K $78K $47K
2012 $394K $173K $91K $51K
2016 $450K $195K $100K $58K
2020 $531K $220K $110K $68K
2024 $632K $250K $120K $81K

Relative

Year % Gain 1% % Gain 5% % Gain 20% % Gain 50%
2000 — — — —
2004 7.1% (7.1%) 12.0% (12.0%) 10.8% (10.8%) 7.1% (7.1%)
2008 15.0% (23.2%) 10.7% (24.7%) 8.3% (20.1%) 4.4% (11.8%)
2012 14.2% (41.0%) 11.9% (39.3%) 16.9% (40.0%) 8.5% (21.3%)
2016 14.2% (62.5%) 12.4% (55.6%) 9.7% (52.7%) 12.9% (37.7%)
2020 18.0% (94.8%) 12.8% (74.0%) 10.0% (67.9%) 17.2% (61.7%)
2024 18.9% (134.3%) 13.6% (98.5%) 9.1% (82.2%) 19.4% (91.1%)

Other Resources

Visualizing the worlds money