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Thinking of buying a house in SD in 2016?  Think twice.

Thinking of selling a house in SD in 2016?  Call the real estate agent right away!


By Daniel Harris, RIA Tuesday March 29, 2016


Earlier this month, I interviewed Edgard Espinoza of Keller Williams realty.  You can find his contact information here:  I’ve interspersed some of what I learned from Edgard with some objective facts on our real estate market.


The State of the San Diego Market


This is a seller’s market.  There is less than 2 months of active inventory on the market.  Edgard says that the average home is on the market for just 30 days before it sells whereas during his 17 years in real estate a home would typically be on the market for 4-6 months.  In my view, when homes are selling 4 times faster than normal that is overwhelming evidence of a seller’s market. 


Are there any neighborhoods left where the buyers have any leverage?


Edgard suggested looking at areas south of the 8 and in East Chula Vista for neighborhoods that are improving, in his view, but are far enough out that the competition from buyers is less intense.


What type of financing options are available and is financing hard to come by?


Edgard said most homes are being bought either in all cash deals or through FHA 3.5% down loans.  He says the financing is readily available for qualifying buyers. 


According to the FHA, their recommended standards are as follows for a 3.5% down payment loan:

  • Your monthly housing expenses and debt should not exceed 31% of your monthly gross (pre-tax) income

  • Your total monthly payments from all sources of debt should not exceed 43% of your monthly gross (pre-tax) income


However, Edgard says in practice he’s seeing lenders being far more lenient than FHA recommended standards.  Although there are no guarantees, he thinks you may be able to get an 3.5% down loan if:

  • Your total monthly debt payments are less than 55% of your monthly gross (pretax) income

  • Your FICO score is 620 or higher

  • You have two full years of verifiable income that would be within this 55% total monthly debt to income ratio


In all these cases you’ll be paying mortgage insurance because you bought without putting a 20% down payment.  From what I’ve seen mortgage insurance can run from 0.80% to 1.5% per year and you’ll have to keep it on for the life of the loan unless you can refinance later (you shouldn’t count on this).


My take on the housing market


Housing is an issue that hits close to home for our family.  I feel like my wife Linda is an expert on all the houses in the neighborhoods we are considering.  Although we have our down payment money ready, we haven’t bought and I can tell that this is sometimes very painful for Linda.  We get questions from family and friends all the time about when we plan to buy – which I can tell bothers her a lot.


But to move ahead in a place like California you have to do something to give your family an edge.  This might involve working harder to get a good education and a better job, it might involve saving at a higher rate or investing in more productive assets or it might involve controlling costs.  Often it’s a combination of two or three of these things.  With such high home prices in California, it can be really important to control your housing costs.


Typically you can buy a home that is 2 or 3 times your family’s gross income and be pretty safe.  If you stretch beyond that you can find yourself financially strained even though the banks will happily loan you the money.  In the long run, the high fixed monthly costs of the housing can reduce your ability to save for other goals and slow you down.  This is why nearly 3 out of every 4 people who live in million dollar homes aren’t millionaires (and are often worth substantially less).


The challenge is that our home prices are as high as they’ve been in the last 40 years relative to rents and income (the 2000’s housing bubble excepted).  The range from high to low on housing prices in San Diego can be 30% so you can potentially get a 30% bigger or better house for the same money by waiting.  That’s compelling.


Unfortunately, the wait periods can be long as the housing cycle in San Diego has historically ran for 12-15 years.  Nationwide the housing cycle is even longer, running about 18 years.  If 2012 was the trough in San Diego it could be another 8 to 11 years before home prices are very cheap again.  And, for us, we have to think about our kid who will be in school in 5 years – do we really want to be renters when he starts school?


Our plan is to wait until home prices drop to average levels to look.  That involves an 18% drop in price relative to rents and income (we are currently 18% above historical prices).  So the median home price wouldn’t be $531,000 it would be $446,000.  That’s almost a $100k difference.


My advice to you is to not be a buyer in this market unless your family need to own the place greatly exceeds your ability to wait and rent.  Overpaying by 18% can put you in a bad position financially – but I understand why some people need to do it. My advice is to buy 18% less space than you were planning so the damage will be less bad when the market turns down eventually.


If you have a rental house or condo – the advice I typically give is to list it.  There is incredible demand for real estate currently and the asset is overpriced according to most objective measurements.  Demand can be fickle – it often comes and goes and you can’t count on it being there when the time is right in your life to sell an asset.  You may be able to get an unusual amount of profit out of the property today by selling and unless you can yield 4% on your property after taxes and expenses – you probably can do better in managed real estate in the public markets, in my judgment, with less risk. 


So in short, I generally advise selling real estate assets and not buying real estate assets at the current time.  With just two months of active inventory any property you do own could move extremely quickly and you will probably have lots of competing bidders running up the price for you.


And of course, my caveat is that if you aren’t a client, I don’t know your exact situation so you have to do your own analysis and come to your own conclusion.  But I have a sense that if you look at the facts objectively, you’ll see this as an unusually good time to sell San Diego real estate assets.





My take on variable annuities – why I think the typical long term investor in this product may lose up to half of their inflation adjusted principal if they stay in it for the rest of their lives


By Daniel Harris, RIA, Sunday March 27, 2016


This is the third part of a three part article on annuities.  Part 1 covered immediate annuities and part 2 covered deferred fixed annuities.  This part covers the most complicated annuity product out there (and the worst deal in my view), the variable annuity.  A variable annuity, in my view, combines all the bad features of an immediate or deferred fixed annuity, with a really high cost investment account for investments you can usually buy elsewhere for around 1/3 the price.


A variable annuity is an incredibly complicated instrument, but in general three things are going on.


1)  There is usually a bond like component that will invest in the 5 Year Treasury, or similar bond, subtract 1.25% off it’s interest and pay you that for 6 or 7 years.  Typically, it has a minimum payment of 1% and a maximum payment of 3%. 


2)  It has a stock like component that increases in value through investments in mutual funds.  You’ll generally be charged between 0.55% and 2.71% in fees per year for owning mutual funds, which is often 3 times the price you may pay for similar investments outside of a variable annuity.


3)  After your account has accumulated, you can turn it into an annuity (similar to the immediate annuity described in part 1), and they will slowly pay you back the value of your account over time.  It’s called variable because the payment is based off your investment value and it can either be a fixed percentage of your investment value at the time you annuitized or it can vary in payment from year to year (you decide).  You have to pay about 1% a year in fees for the annuity component of the contract, and as I understand it, you pay these fees even before you annuitize the contract.


Let’s look at each area more in depth


The Bond Like Component


The insurance company doesn’t do anything special here, they just buy 5 year US Treasury bonds, which you can buy for free from most online brokers or from a Treasury Direct Account.  They charge you 1.25% for this service plus they guarantee to pay at least 1% interest on this part of your account.  The problem is their guarantee is paid for by a cap of 3% on the 5 Year Treasury Rate.


You can go around the insurance company and just buy 5 Year US Treasury Notes for free if you want a guaranteed return on your income. 


The Stock Like/Mutual Fund Component


In your variable annuity, there is a variable account where you can select from a menu of mutual funds. 


Now before we talk about the costs, I want you to know that according to Dalbar and BlackRock the average American investor only earned about 2.5% per year on their mutual funds before inflation from 1995-2014.  They earned 0.25% after inflation.  So most investors don’t do much better than inflation – which is a problem in the high cost variable annuity investment account.  The “low” cost annuity for the top selling variable annuity company, costs 0.55% to 2.71% in fees per year for the investments alone which is as much as 3x the fees for similar investments outside of variable annuities. 


If the average person earns 2.5% on their money before inflation and they pay up to 2.71% in fees – they actually will generate a negative return on their variable account before inflation.  Subtract another 2.9% for the long term inflation rate and the typical investor should lose between 1% and 3% of their money each year in the variable account, in my opinion. 


Since virtually identical investments can be had on the private market at lower prices outside the annuity structure, there is no benefit to the variable account in the annuity in my opinion.


The Annuity Component on your variable account


The third part is the insurance component.  Once you’ve potentially lost 1 to 3% of your principal per year on the variable account due to the excessively high fees, now you have a chance to annuitize the payments. 


You stop paying into the variable annuity as this point and they “annuitize” or convert your own assets into a stream of payments.  As with the almost all annuities, I think you should expect to lose money at this stage on an inflation adjusted basis. 


Based off the immediate annuity rates, I think when your contract gets “annuitized” you should expect only be paid out between ½ and 1/3 of the value of your investments.  I’m basing this off what their immediate and deferred fixed annuity rates currently are.  The insurance company should keep the rest of your money. 


There are many different options on how to annuitize a variable annuity: immediate, deferred, joint and survivor, life plus a set number of years – but basically inflation adjusted to the annuity rates are grossly unfair to you in my opinion. 


After getting gouged on the fixed return portion of the annuity, then paying up to 3x in fees on the investments, I think you should expect to only get ½ to 1/3 of whatever your investments are worth after all that gouging.  I think you’ll probably receive only about 50 cents on the dollar invested (on an inflation adjusted basis) after all the fees are deducted.


So why do people buy these products?


I think people have bought variable annuities for three reasons. 


1)  They believe they are earning interest on their money, when really their own money is just being paid back to them slowly over time (and I expect that they will usually lose 50 to 66% on the distributions when you account for inflation at current rates).


2)  They are fearful of the fluctuations in the stock market – without realizing that the investments in and outside of a variable annuity are largely the same – except the ones in a variable annuity can cost 2x or 3x what an identical investment costs outside of a variable annuity


3)  They are enamored with the idea of “tax free income” without realizing that they’d actually have more money if they just paid the taxes.  Looking at the pricing and the annuity rates, I believe that the typical investor will only receive around 50 cents of inflation adjusted lifetime income for every dollar they invest in a variable annuity.  You shouldn’t pay taxes on these investments – because you actually lose principal on an inflation adjusted basis in most cases, according to my assessment.


Insurance is virtually never taxed by the IRS, because its payments are considered a return of premium and because you usually pay more in premiums than you receive in benefits.  However, unlike a term or a disability insurance product which is only a slight money loser – I expect most variable annuities will lose around half of their inflation adjusted value over time, simply because the fees and low annuity rates should overwhelm whatever growth most investors will produce with their portfolios.


If I’m already in a variable annuity – what should I do?


In general you can usually surrender a variable annuity without penalty after about 6 or 7 years.  The exact surrender penalty period will be stated in your contract with the insurance company or in the prospectus.  If I owned a variable annuity and was clear of the surrender penalty period, I would surrender the annuity.




Why I think your odds of making money on a deferred fixed annuity are 1% to 30% (depending on the product) (inflation adjusted) at current rates and why I think that you will likely lose between 29% and 93% of your inflation adjusted principal on deferred fixed annuities at the current rates.


By Daniel Harris, RIA, Friday March 25, 2016


This article is the second part of a three part series on annuities – one of the most complicated financial products that investors can buy.  Annuities are complicated because you must account for inflation when analyzing them and unlike bonds you don’t earn interest on them, but rather you are slowly paid back your principal over time.  At current rates you’ll need to live to be between 87 and 100 years old, to make money on your deferred annuity, according to my projections.  Only a small percent of men live that long and so it is a bet heavily favoring the insurance company.


Part 2 – The Deferred Fixed Annuity – a plain vanilla product with a waiting period


Deferred Fixed Annuities


A deferred fixed annuity works just like a plain vanilla immediate annuity except you give the insurance company your money today but they don’t start paying you back until some future date.  They will have to pay you for the rest of your life.  Let’s look at New York Life’s rates on deferred annuities as of 3/17/16.


Age 55 – Distribution Payments Deferred for 10 years – 9.10%

Age 65 – Distribution Payments Deferred for 10 Years – 10.30%

Age 75 – Distribution Payments Deferred for 10 Years – 12%


Once again, these look like great rates.  But there are two catches to the deal.  First, you’ll likely lose a quarter of your money to inflation in the first decade that they aren’t paying you.  Second, these rates have to be reduced by inflation once they do start paying you.  So you are actually worse off buying deferred annuities compared to immediate annuities despite the higher rates.


I can’t say this enough: you have a huge loss to inflation in the first ten years that they don’t pay you.  $100,000 compounding at -2.9% a year (the historical inflation rate) after ten years is only worth $74,506 – so you lose $25,494 in that first decade that they don’t pay you. 


Second, their payments have to be adjusted back for inflation (by subtracting 2.9% a year from their rates) and the payments aren’t on $100,000 that you paid in, it is on the $74,506 that you have left after a decade with no payments.  The reason is that you’ve lost purchasing power forever and once they make payments they are doing so on devalued money that is only worth about 75% of what you put in.


Here are some real life examples of what you likely give up and what you get on these products.  I have to say “likely” because the two unknowns are 1) rate of inflation and 2) how long you will live.  But if you use the historical rate of inflation as a proxy for the actual inflation rate and use average life expectancy you can see what the trade off is for most investors.


Original annuitant payment Age 55, insurance annuity payments begin at Age 65 – (inflation adjusted payout of 6.2% of your devalued investment per year)


The average investor will get the inflation adjusted equivalent of $4,619 per year for 15.38 years or $71,040 of their $100,000 back (adjusted for inflation).  So, the average investor loses and 29% of their initial investment on this deferred annuity accounting for inflation.  You would probably need to live to be 87 years old to make money on this deferred annuity.  Unfortunately, 70% of 55 year old annuitants will die before 87. 


So the insurance company should win the bet with 70 out of 100 annuitants and the typical losing bet will cost the annuitant 29% of their (inflation adjusted) principal on this investment.


Original Payment Age 65, insurance annuity payments begin at age 75 – with the inflation adjusted payout of 7.4% of your devalued investment each year.


The average investor will get the inflation adjusted payout of $5,513 per year for 7.66 years or $42,229 back on their initial investment of $100,000 (inflation adjusted).  So the typical investor will lose 57.8% of their $100,000 investment when you account for inflation.  You must live to be 94 years old to make an expected profit on this investment.  Unfortunately, 91% of 65 years old do not live to be 94. 


So the insurance company should win the bet on 91 out of 100 annuitants and the typical annuitant should lose close to 58% of their inflation adjusted investment on this deferred annuity product.


Original Payment Age 75 – insurance annuity payments begin at age 85 – with the inflation adjusted payout of 9.1% of your devalued investment paid back to you per year


The average investor will get the inflation adjusted payout of $6,780 per year for 0.94 years.  Let’s just round it up to 1 year.  So the typical investor on this deferred annuity exchanges $100,000 for a single $6,780 (inflation adjusted payout from the insurance company).  This means the typical investor loses roughly 93% on their money when they buy this annuity.  In order to earn a profit, on this deferred annuity, you’d need to live to be 100 years old.  99% of 75 year old men do not make it to 100. 


So the insurance company should win the bet on 99 out of 100 annuitants and the typical annuitant should lose about 93% of their inflation adjusted investment in the deferred annuity.


So what is the take away on deferred annuities?


The rates are too low to have a chance of doing well on a deferred fixed annuity unless you live to be somewhere between 87 and 100.  You have somewhere between a 70 percent chance and a 99 percent chance of losing money on these investments.  When you do lose, the losses usually won’t be small.  I expect that the typical investor will lose somewhere between 29% and 93% of their inflation adjusted investment on a deferred fixed annuity at these rates. 


You might think – well that’s just the price of insurance.  It isn’t.  For example, insurance companies will sell a young person term insurance who has a 7% chance of dying within the policy period at a price of about 9% of the death benefit (inflation adjusted).  Disability insurance also usually only charges a few percentage points above the actual risk of the event happening.


While insurance companies need to charge a few percentage points more than the risk to cover their costs of administration, litigation, claims processing and sales commissions, they don’t need to make a 29% to 93% profit off of you.  These products are terrible deals at the current prices, in my opinion, and I believe the evidence clearly shows that you should avoid them if at all possible.


What happens if I already have an deferred annuity?


You may be trapped.  Personally, I really hate doing business with companies that trap their investors unnecessarily.  However, New York Life has some fair priced term and disability products – they just give you a bad deal on annuities (as do all their competitors so I’m not picking on NYL).  It’s really the product that is bad, in my opinion, and not necessarily any one particular insurance company.


Here are the basic rules of getting out of an annuity.  First, some immediate,  deferred or variable annuities you may sometimes surrender the annuity with a penalty charge.  You likely won’t get all of your money back and for some you may not be able to get anything back.  It will say in your contract with the insurance company what your rights are.


Second, you may be able to sell your annuity on the secondary market.  To get out, you’ll sell it at a discount to what you paid but you may be better off this way depending on the price a buyer is willing to pay for it.  If you do either of these actions it can be taxable and it will definitely bring a 10% penalty if you do it before you are 59 and ½. 


The only reason to trap someone with surrender fees and high penalty charges, in my view, is because one day they will discover that they bought a crappy product, so the product needs high walls to keep them in otherwise they would exit the product as soon as they realized what they bought. 


Although I use their products, I have a pretty strong distrust of insurance companies.  Given what I know about them, I never give them the benefit of the doubt and I don’t think you should either.  If you want any independent analysis of your options, and are an incoming client of our firm, we’d be happy to lay out your options free of charge.




Why I think you have less than a 4% chance of making a profit on your immediate annuity at current rates (when you account for inflation) and why I expect that you will lose between 48% and 65% of your inflation adjusted principal on this investment.


By Daniel Harris, RIA, Wednesday March 23, 2016


An annuity is a financial product that guarantees a certain amount of income for a period of years or the rest of your life.  It’s sold by insurance companies or the insurance divisions of financial companies.


In this three part article this week, I’m going to explain the three types of annuities that are most common: immediate fixed annuities, deferred fixed annuities, and variable annuities.  These products are not always presented fairly by the people who sell them and so I’m going to give you what I believe to be an honest explanation of how they work by using their own prospectuses and published rates as evidence.  


Part 1 – Immediate Annuities


The Plain Vanilla Annuity – An Immediate Annuity


In an immediate annuity you give an insurance company a lump sum of money, and in exchange they provide you with a fixed amount of your money back each year for the rest of your life. 


According to my research, New York Life is the second largest fixed annuity provider in terms of the volume of sales or direct annuities.  They put their current rates on their website for fixed annuities so I’ll use their numbers.  Here is what they are currently paying as of 3/17/16.


Age 65 – 5.80% of what you paid them annually for the rest of your life

Age 75 – 7.10% of what you paid them annually for the rest of your life

Age 85 – 8.80% of what you paid them annually for the rest of your life


Because it is a return of your own money – you don’t have to pay taxes on a fixed annuity payout to you.  As is typical with insurance, most policyholders pay the insurance company more in premiums than they receive back in benefits when you account for inflation and the opportunity cost of money.


You need to make two critical adjustments to the payout rates you see from the insurance company to fairly represent what you are giving up and what you are getting.  If you don’t make these adjustments, your analysis is going to be inaccurate.


First, you must deduct the historical cost of inflation from the payout rate.  Historically inflation is 2.9% and you always need to subtract that number from an annuity payout to see what you are truly getting.  While you give them $100k today they give you that money back slowly over time and each decade a dollar is worth about 25% less – so they are paying them back in less valuable currency than you paid them.  Second, you have to look at your life expectancy to see how long they are likely to pay you for.


New York Life’s Fixed Annuity Rates (adjusted downward for inflation and accounting for life expectancy)


Age 65 – 2.9% of what you paid them annually for the rest of your life x 17.66 years (they likely pay you 51.2% of your money back (2.9x17.66=51.2%))

Age 75 – 4.2% of what you paid them annually for the rest of your life x 10.94 years (they likely pay you 45.9% of your money back (4.2x10.94=45.9%))

Age 85 – 5.9% of what you paid them annually for the rest of your life x 5.81 years

(they likely pay you 34.3% of your money back (5.9x5.81=34.3%)


In all of these cases, you should expect to lose nearly ½ to 2/3 of your money on these deals with the insurance company (inflation adjusted).  The bet is heavily in the insurance company’s favor if you look at the payouts and the odds of dying. 


I used New York Life’s product because it is a real life example and they publicly disclose their rates.   I also picked New York Life because their annuities sell so well – this is a product customers have been buying.  I suspect if they really knew the odds of the bet they were making with the insurance company, they would never buy this product at these low rates. 


How long would I have to live to make on my fixed annuity at the current rates (adjusted down for the historical rate of inflation)?


A 65 year old male would need to live to be 99.4 years old to break even on the immediate annuity when you account for inflation


According to the Social Security Administration, only 1.6% of 65 year old men alive today will live to be 99 years old.  So 1.6% of investors will likely make money on this investments and 98.4% of investors will likely lose money on the investment.


A 75 year old male would need to live to be 98.8 years old to break even on the immediate annuity when you account for inflation


Similarly, only 3.1% of 75 year old men alive today will likely live to be 98 years old.  The evidence indicates that you have a 3.1% chance of making money on this investment and a 96.9% chance of likely losing money on this investment.


A 85 year old male would need to live to be 101.94 years olds to break even on the immediate annuity when you account for inflation


Finally, only 1.7% of 85 year old men alive today will likely live to be 101 years old.  Therefore, you likely have a 1.7% chance of making money on this investment and a 98.3% chance of losing money on this investment.


As you can see one of the best immediate annuity products on the market, offers a mere 3.1% chance of making money and a 96.9% chance of losing money.  Moreover, when you do lose money it will likely be a lot.  Most investors are expected to lose between 48.8% to 65.7% of their (inflation adjusted) principal over the next 5 to 18 years.  This makes investing in stocks or real estate look like a low risk proposition as those kinds of loses are rare in stocks or real estate – but according to the analysis this would absolutely typical for an investment in an immediate fixed annuity at current rates.





Winning the Tax Game: The element of tax planning that matters most but is most commonly overlooked and four other practical but rarely used rules for lowering your taxes

by Daniel Harris, RIA, Tuesday March 22, 2016


Part 2


This is a continuation of the earlier article on this topic.  We’re talking about four practical tips for tax planning. 


3)  The IRS doesn’t give out tax deductions for free – most of the so called “advanced” strategies generally involve transferring away some or all of your ownership or control or increasing your personal liability


Recently the Wall Street Journal profiled a doctor who was excited that his oil well investment saved him $44,000 in taxes based off his $44,000 investment in the oil well.  The article did point out that the investment was in a joint venture (an unincorporated entity) and the doctor exchanged unlimited personal liability for a $44k tax write off.  To save $44k in taxes, he was putting his entire net worth at stake – not a smart decision.


I often hear that things like life insurance or annuities are tax free.  The reason is that you transferred the asset away to the insurance company and they give some of it back to you over time.  On an annuity, if you live to be 100, you might win the bet even accounting for inflation.  For the other 99% of the customers, usually what you get back is less than what you paid in when you account for inflation. 


For life insurance, if you are one of the few people who die right away you win the bet, but if you live to a normal age you almost always pay more in than you heirs receive in the death benefit when you account for inflation and the time value of money.  It would be really wrong to tax you on what was basically an economic loss. 


Similar things result when you give you assets to charity.  The charity, which owns the asset can do whatever they want with your business – you transferred your ownership to them and the new owner runs the show.  One of the estate lawyers I know for the “dynastically wealthy” ($100 million and up) said that clients are often shocked at how ruthless charities can be once they’ve gotten control of an asset. 


These maneuvers may make sense – but before you do them make sure you understand what you are getting and what you are giving up.


4) All asset transfers aren’t equal – gifts in a recession go a lot further because you can transfer more of a stock or a company within the tax free limits when asset prices are depressed


If you ever thought of gifting assets, the best time to do it is a recession.  You can gift very valuable stock or discounted interests in a family business or real estate without violating the $14k annual gift limit, and you can use a Grantor Retained Annuity Trust to transfer the highly likely appreciation on distressed assets while avoiding gift tax for those above the $10 million estate tax limits.  A recession is the best time for estate planning maneuvers.


In conclusion…


The tax game is not complicated primarily because the rules are either written clearly in the statute or publicly available from the rulings of the tax courts.  I’ve looked at the strategies and I believe that there are no tax secrets.  The desire to save on taxes is so intense and widespread that information about what works spreads like wildfire.  Most things that are packaged as tax “secrets” simply do not work and fall apart when challenged or have a big  “catch” to them.


You’ll need experts (a lawyer, perhaps a CPA, and a business valuation expert) to do the maneuvers but which maneuvers to do are usually obvious.  If it works for Christie Walton or Sheldon Adelson (two billionaires) – it will likely work for you.  Find someone with a bigger tax problem than you have and see what they do. 


With that said, pay attention to the environment you are in.  You can do your own analysis, but my research indicates that we are in a low tax environment.  Should you really be using the pre-tax option or should you use the Roth post-tax option where possible?  Should you really be trying to get out of taxes in this environment or should be realizing capital gains at these low rates?  Knowledgeable investors know their tax history and work with someone who knows that information.  The more you know, the better position you’ll be in to succeed in keeping your taxes low not just in one year, but over your entire lifetime.





Winning the Tax Game: The element of tax planning that matters most but is most commonly overlooked and four other practical but rarely used rules for lowering your taxes

by Daniel Harris, RIA, Tuesday March 22, 2016


This is a two part article covering the most important part of tax strategy and four common sense but often overlooked parts of a good tax strategy.


Part 1


Many investors have a knee jerk reaction to always defer their taxes until a later time.  However, the best tax strategy, in my opinion, is to defer taxes when current tax rates are higher than average and pay taxes when tax rates are lower than average.


In practical terms, many families pay 1-2% less in taxes under today’s tax system than they have historically.  Why would you defer your taxes when you are in a low tax environment?  If you defer your taxes the likely outcome, in my view, is that you’ll pay more in total taxes than if you just paid the taxes today.


If it makes sense not to defer taxes (i.e. to use the Roth over the Traditional (pre-tax) option) are there other tax ideas I should know about?


There are four basic common sense rules to taxes that I think you should keep in mind.


1) It only takes one year to get to long term capital gains – after that investment taxes are not a relevant consideration and what is best from an investment point of view should run the show


One thing most people don’t know is there is a dramatic difference between the average return on most assets and the return after a period of distress.  For example, an asset that usually earns 7% a year over 50 years may return 12% a year in the first five years after a period of distress.  If you hold it for longer the return will usually drop back down to 7% a year.  So there isn’t a compelling investment reason to hold investments for 50 years since this just lowers your return and has no tax benefit once you’ve gotten past the one year holding period.


2) A tax deferral has no economic value on it’s own


There are two tax strategies: tax avoidance and tax deferral.  Tax avoidance is almost always a good idea as long as the investment produces a good enough return that you are better off than you would be after tax with the alternatives.  Examples of tax avoidance are retirement accounts, 529’s and municipal bonds – which avoid capital gains or income taxes.  A more advanced version is a grantor retained annuity trust where estate taxes are sometimes avoided on the appreciation of a stock.


Most strategies that are pitched as tax avoidance strategies are actually tax deferral strategies.  That’s a huge difference.  You still have to pay back the taxes with a tax deferral it’s just pushed back to a later date if you ever sell.  Examples are real estate, oil wells, timberland, annuities, and life insurance.  You don’t have to pay tax initially on these strategies because the IRS usually correctly assumes that you won’t get all of initial investment back and if you do you’ll be taxed on whatever you wrote off as “recapture.”


Tax deferral is a hard concept to grasp but here are the three rules:


1)  A tax deferral from one period with the same taxes to a future period with the same taxes has no economic value.  Whether you pay tax today or pay it later, you’ll have the exact same amount of money.  Therefore, tax deferral is a wash in normal tax rate period.


2)  A tax deferral from a low tax period say 28% to a normal or high tax period, say 29.3% or 32% creates negative economic value and you lose money because you deferred.


3) A tax deferral in a high tax period say 32% to a normal or low tax period, say 29.3% or 28% has positive economic value and gives you more money because you deferred.


What really matters in all of these situations is what the tax rate is when you first get the income and whether that amount is higher or lower than normal.  In high tax periods it makes sense to defer, in low tax periods it makes sense to realize income.  That’s my opinion on the topic.




Investing around the world for yield – foreign stocks and bonds – How are they taxed?

By Daniel Harris, RIA, Tuesday March 15, 2016


When you own foreign stocks or bonds, you have to deal with the tax system of two countries: the country the stock or bond is based in and the U.S. tax system.  But don’t be afraid, the calculations are simple and most tax software and virtually any accountant can quickly handle these issues for you. 


When you use an accountant, they will look at your 1099 and allocate your foreign tax deduction or credit to each country’s income stream.  Your 1099 will show how much foreign tax you paid, but it won’t assign it to individual countries, which is a necessary piece of information.  That part has to be done by hand.


If you use the tax software, you’ll need to go through the 1099 and assign dividends and interest to the country that produced them.  So there is a small extra step involved – but it often takes less than 5 minutes a year to do this manual part.  Your 1099 will assign the dividends to each fund, stock, or bond, but you’ll need to say on the tax forms which country that stock, fund, or bond invested in.


Some countries withhold tax on dividends to U.S. citizens and others do not.  Where there is a foreign tax withholding, you can take a tax credit or tax deduction to offset your U.S. taxes by what you already paid to a foreign government.  You don’t need to file a tax return with a foreign government and you only need to file your normal U.S. tax return so long as the assets are held at a U.S. based financial firm.  You don’t have to do a FACTA filing for foreign securities held at U.S. brokerage firms.


Unfortunately, foreign dividends are not eligible for qualified dividend tax treatment (a 15% tax) and instead are taxed at your ordinary income rate at the federal level.  In California, the tax is the same for foreign and U.S. dividends.


For example, a California couple making $150k will pay their ordinary income rate: 15.93% in Federal taxes and 6.27% in California income taxes on their foreign stock dividends.  If they had owned U.S. stocks they would only pay 15% in Federal taxes and still owe 6.27% in California state taxes.


So essentially the cost of investing in foreign companies to collect the dividends is merely an extra 0.93% in Federal taxes.  So if you can earn more than 0.93% in extra income from foreign stocks, you might be better off investing in overseas stocks. 


The Impact of Tax Treaties and Asset Placement


Some countries like the U.K., Canada, Singapore and India have tax treaties with the United States where no tax is withheld by their country on foreign dividends.  It is often best to place a dividend from a country with no foreign tax withholding in an IRA because the dividend is never taxed.  For most other countries, it is often best to place the asset in a taxable account since you can use the foreign tax credit to reduce the U.S. taxes – which would be imposed at the ordinary income rate.


What kind of after tax yields can a California based investor get by going overseas? 


As you can see, most foreign countries pay higher after tax yields on their stocks than you can obtain from either popular stock or bond indexes in the United States.


After Tax Yield on Foreign Stocks in a Taxable Account

Switzerland 4.25%

Australia 4.10%

South Korea 3.77%

Singapore 3.70%

Germany 3.21%

United Kingdom 3.15%

Spain 3.07%

Russia 2.52%

Turkey 2.20%

Canada 1.95%

U.S.A. Stocks (S&P 500) 1.88%

U.S.A. Bonds (Aggregate Bond Index) 1.88%

U.S.A. Stocks (Total Stock Market Fund) 1.46%

Mexico 1.26%

France 0.47%

Vietnam 0.25%

Sweden 0.14%


Yield on Foreign Stocks in a Retirement Account

Singapore 4.76%

United Kingdom 4.05%

Australia 3.69%

Switzerland 3.55%

South Korea 3.52%

Spain 3.19%

Germany 3.04%

Russia 2.75%

Canada 2.51%

Turkey 2.40%

U.S.A. Bonds (Aggregate Bond Index) 2.42%

U.S.A. Stocks (S&P 500) 2.39%

U.S.A. Stocks (Total Stock Market Fund) 1.86%

Mexico 1.46%

France 0.46%

Vietnam 0.32%

Sweden 0.13%


My two caveats


First, this article reflects my understanding of the tax code as it pertains to foreign dividends and interest.  If you are thinking of acting on this information, you should first do your own research and/or consult your accountant to get their take on the tax issues.


Second, even more important than the tax issues, I need you to recognize that when

you invest for income you are exposing yourself to prospect of capital gains or losses.  Income is only half the story and your investment principal is at risk with virtually any income investment.  So make sure you are looking at the whole picture of the likely capital gain or loss on your income investment before you make any investment commitment.




“How are my employer stock sales taxed: ISO’s, Discounted Company Stock Purchase Programs (ESPP), RSU’s and other types of employer stock purchase programs”


By Daniel Harris, RIA, Wednesday March 9, 2016


Continuing our focus on taxes this week, many of you receive employer stock or options as part of your employee compensation.  Ever wonder how it is all taxed? 


As usual, let me give you this caveat.  This article reflects my personal understanding of the tax code.  I believe the descriptions are accurate but you should do your own research or consult a CPA before making any decisions based off the interpretation of the tax rules described in this article.


Incentive Stock Options (ISO’s) [held for two years after the grant date and one year after the exercise date]


Incentive Stock Options are the most taxed advantaged form of employer stock.  You must wait two years after the grant date and one year after the exercise date to sell your stock.  If you wait this period, all of the gains above the exercise price will be treated as long term capital gains (15%-20% Federal), (3.8% Net Investment Income Tax for households above $250k) and (1-13.3%) in California tax.  


So the maximum marginal tax on these gains is 37.1%.


Incentive Stock Options [Held for two years after the grant date, but sold within a year or the exercise date]


Two things will happen if you sell your ISO within a year of exercising it.  First, you’ll pay ordinary income taxes on the gains above the exercise price.  This can amount to as much as 56.7% in taxes on the gains between the exercise price and the sale price.


Second, you’ll owe ordinary income tax and payroll tax on the difference between the exercise price and the stock price at time of exercise.  So if you had the right to exercise at $10 a share when the stock was trading at $25 per year – you’ll have to treat that $15 difference as compensation and report it on your W2.  With payroll tax, you may pay as much 60% of this income back in taxes.


So the maximum marginal tax on these gains are between: 56.7% and 60%.


Nonqualified Stock Options


Here you will pay ordinary income on the difference between the grant price and the exercise price.  So if the shares at granted to you at $5 a share and you exercise them when the price is $10 a share – you’ll owe ordinary income on $5 a share.  Any gains above $10 a share will treated at the long term capital gains rate if you hold them for a year or the short term capital gains rate if you hold them for less than a year.


Discounted Stock Purchases in Employee Stock Purchase Plans


If you work for a public company, often you can buy stock for 10-15% discount to the current price of the stock.  To get the best tax treatment you need to not sell until two years after the offering date and one year after exercise. 


If you do this you’ll have to report the discount you receive on the shares as compensation and will pay payroll tax and your ordinary income tax rate on it.  For example, if in January of 2015 you enroll in a program to buy shares when the shares at $15 per share and when you exercise in June of 2015 the shares at $25 a share but you get them at a 15% discount of the $15 price or $12.75 per share.  You’ll need to report the $2.25 as compensation and pay ordinary income tax and payroll tax on it (up to the 60% in taxes).  Because you paid tax on it, you’ll add the $2.25 per share to your basis so your actual basis in now $15 a share.  If you sell the share in January of 2018 for $50 a share, you’ll pay the long term capital gains rate on the $35 on gains. 


In total you’ll pay up to 37.1% in taxes on the gains and up to 60% in taxes on the difference between the exercise price and the grant price.


Restricted Stock Units


Restricted Stock Units are treated as compensation at the time they are vested or given to you.  Because it is compensation, the value of the RSU may be taxed at up to 60% in California (39.6% Federal, 13.3% State, 7.65% Payroll Tax).  As a result, RSU’s are the least taxed advantaged version of employee stock compensation.


So should we sell or exercise our employer stock options?


There is both a valuation issue and a tax issue involved.  In general it’s very important to meet the two year holding period from the grant date and the one year holding period since the exercise date.  That’s the tax component.


However, even more important is the valuation component.  While it can be hard to know what a stock will do in a short period of time, there are fairly reliable methods to know whether a stock is generally expensive or cheap.  This takes a high level of experience to make these determinations for company stock and we highly encourage you to get professional help in this regard if you aren’t an expert in valuing stocks.  We can help you with those needs.


Should I hire a CPA to do my taxes if I receive stock as part of my compensation?


The tax laws are pretty straightforward on this stuff and if you are a detailed oriented person you can do it yourself.  In general you almost never want to sell your stock options before two years have elapsed since the grant date and one year since the exercise date.  If you break those rules, your taxes are going to get a lot more complicated.


If you are sort of more of a big picture kind of person and not great at details, a CPA can be super helpful.  In general they are extremely detailed oriented and they can help you do these forms right.  Online services like Turbo Tax and H.R. Block are okay if you are detailed oriented, but for big picture type of people sometimes a real CPA is better as they make less mistakes in my experience.  I know some CPA’s in San Diego that I think very highly of and I’m happy to point you in their direction if you want someone to take care of the details and the paperwork for you.




“How are my dividends and interest payments taxed?”

by Daniel Harris, RIA Monday March 7, 2016


 With the tax season in full force, many clients wonder how different investments are taxed especially those that produce income and dividends.  To make this easier, I’ve put together the hierarchy of the least taxed to the most highly taxed popular income investments.


Your State’s Municipal Bonds

Not taxed at all by the Federal or the State Government

Not subject to the net investment income tax

Maximum Marginal Tax Rate: 0%


Another State’s Municipal Bonds

0% tax at the Federal level

Fully exposed to your state tax (In CA you may owe 1-13.3% of the income in taxes)

Maximum Marginal Tax Rate: 13.3%


Alternative Minimum Tax (AMT) Exception Explained

Despite the general rules above, a small subtype of municipal bonds called “private activity bonds” can be subject to the AMT at the Federal and State levels.    The AMT can be as high as 28% in Federal taxes and 7% in California.  This is an exception to the rule, and generally applies to the small set of bonds where a city enters into a public-private partnership and doesn’t own the asset.  So if a city uses some municipal bonds to build a football stadium, but the stadium is owned by a football team and not the city, the municipal bonds used to pay for the stadium can be taxed as much as 35%.  You’ll want to be mindful of these private activity bonds when investing in munis and they can largely be avoided by paying attention to what you buy.


Dividends on U.S. Stocks

Federal Taxes: 15% of the dividend if your income is under $465k or 20% of the dividend for the portion of your household income that exceeds $465k

Subject to a net investment income tax of 3.8% if your household income exceeds $250k

Taxed at your ordinary income rate in California: 1-13.3%

Maximum Marginal Tax Rate: 37.1%


US Treasury or Agency Bonds (Fannie Mae, Freddie Mac, Ginnie Mae ect.)

Taxed at your ordinary income rate at the Federal Level (you may owe 10-39.6% of the income back in Federal taxes)

Subject to the net investment income tax of 3.8% if your household income exceeds $250k

No state income tax on this interest

Maximum Marginal Tax Rate: 43.4%


Corporate Bonds, Real Estate Income, REITS, Savings Accounts and CD’s and Foreign Stocks

Taxed at your ordinary income rate at the Federal level: 10-39.6%

You may also owe a net investment income tax of 3.8% federally if your household income exceeds $250k

Taxed at your ordinary income rate in California: 1-13.3%

Foreign Stock dividends may be taxed by a foreign government but not all governments tax dividends of American owners, and you’ll usually get the tax back in April in the form of a foreign tax credit or foreign tax deduction in taxable account

Maximum Marginal Tax Rate: 56.7%


As always let me throw in the caveat that while I’ve researched these issues thoroughly, this article merely reflects my personal understanding of the tax code.  I believe it is accurate but you should do your own research or consult with your CPA before you make any tax decisions based off this information.


However, as you can see the hierarchy of the lowest taxes to the highest taxed income investments are:

1) Your own state’s municipal bonds [Maximum Tax Rate: 0%]

2)  Another state’s municipal bonds [Maximum Tax Rate in CA: 13.3%]

3)  Dividend payments on U.S. Stocks [Maximum Tax Rate in CA: 37.1%]

4)  Interest Payments on U.S. Treasury and Agency Bonds [Maximum Tax Rate in CA: 43.4%]

5)  Interest from Corporate Bonds, REITS, Savings Accounts and CD’s, Income from real estate, and dividends from foreign stocks [Maximum Tax Rate in CA: 56.7%]


As you can see, there is a huge difference in tax rates amongst the popular income investments.  If you are an income investor in a taxable account, you should really look into municipal bonds first before considering any other income option.  Also you should be aware of how tax inefficient corporate bonds, REITS, savings accounts, CD’s and foreign stock dividends can be in your taxable accounts.  If you want to know more about what type of income streams you could expect from these various asset types, we’d be happy to help.

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