If you’re in the right mood, there’s something a little bit depressing about the subject of investing: how boring it is. An easy way to think about this is that if you make the maximum contribution to a 401(k) and IRA every year, for 20 years, at the end of that 20 years, you’ll be rich. How rich you’ll be depends on a lot of factors, but the fact you’ll be rich doesn’t depend on anything except the steadiness of your contributions and the amount of time they’re allowed to compound.
$24,000 in annual contributions for 20 years turns into a million dollars at 6.6% APY. If you can only manage 6% APY, it takes a year longer, and at 7% APY a few months less. But all anyone has to do to become a millionaire is max out their 401(k) and IRA contributions for around 20 years.
I don’t mean to say that’s easy. You can’t contribute more than 100% of your income to a 401(k) or IRA, so if you make less than $18,500 you can’t maximize that contribution (although you can contribute your first $5,500 in income towards both accounts). I’m just saying it’s boring. Max out your contributions, wait 20 years, and you’ll fall somewhere in the top 10% of households by net worth.
The flip side of that fact is that as long as you make your retirement accounts as boring as possible (my solo 401(k) is invested in a single Vanguard mutual fund), you can do almost anything you like with the rest of your money without posing much if any risk to your chances of ending up rich. I’ve written a lot in separate posts about different kinds of non-retirement investments, so I thought I’d pull those different pieces together in one place.
Taxable brokerage accounts
Pros: no withdrawal penalties, opportunities to manipulate income, cheap or free, $11.2 million estate tax exemption and stepped-up basis
Cons: taxable (at preferential rates), may affect financial aid eligibility, limited control over dividends and capital gains distributions
Taxable brokerage accounts have two huge advantages and a slew of disadvantages.
On the plus side, you can access your money at any time for any reason. It’s true you may owe taxes on any appreciated assets, but as I like to say, if you’re afraid of paying taxes you’re afraid of making money — you only owe capital gains taxes on capital gains, after all. Additionally, simply having a bunch of uncorrelated assets in a taxable account is a tool for managing your tax liability, since you’re able to top up your income with long term capital gains in low-income years (“capital gain harvesting”), and sell losers in high-income years to reduce your taxable income by up to $3,000 in losses per year (“capital loss harvesting”).
The disadvantages are important to consider, however: mutual funds that are forced to pass along capital gains can trigger tax bills even if you don’t sell your own shares. Unpredictable dividends can make it difficult to dial in your income precisely, for example if you intend to qualify for premium subsidies on the Affordable Care Act exchanges. If you or your kids are applying for federal financial aid using the FAFSA, you don’t need to report qualified retirement savings, while assets in taxable brokerage accounts will reduce your assessed financial need (under some circumstances).
One other thing taxable brokerage accounts are perfect for is gambling. If you walk into a Vegas casino and lose $500 playing roulette, you’re out $500. If you buy $500 of Enron stock and it drops to $0, you might be out as little as $250, depending on your federal and state income tax situation.
Variable Annuities
Pros: tax-free internal compounding, asset protection
Cons: gains taxable as ordinary income, inherited assets fully taxable, very expensive, early withdrawal penalty
I wrote relatively recently about variable annuities so I won’t belabor the point here, but one point that reader Justin brought up in the comments to that post is that depending on your precise situation, annuity assets may be protected from creditors in a civil judgment or bankruptcy filing. This is, obviously, not protection afforded to taxable brokerage assets, and I think in certain circumstances an annuity might be worth considering for this reason alone.
However, if your primary goal is asset protection, you should first consider shopping around for an umbrella insurance policy, since the management fees and tax consequences of a variable annuity might be substantially higher than the annual cost of comprehensive liability insurance. However, this would not apply if you’re contemplating bankruptcy in a state that protects annuity assets from creditors.
529 College Savings Plans
Pros: low-cost, state-dependent tax benefits, tax-free internal compounding, flexible beneficiary designation, tax-free qualified withdrawals
Cons: non-qualified withdrawal penalty, contribution limits
Long-time readers know that 529 plans are a crime committed in broad daylight against the American people. But that doesn’t mean they can’t still be useful. It’s useful to think of 529 plans in two ways:
- qualified withdrawals are completely tax-free;
- pro-rated gains on non-qualified withdrawals are taxed as ordinary income with a 10% penalty.
While my main problem with 529 plans is the tax-free transmission of wealth between generations, it’s trivial to conceive of an even simpler hack to achieve both tax-free internal compounding and tax-free withdrawals. Since 529 plan beneficiaries can be changed without any tax consequence to immediate (and not-so-immediate) relatives of the current beneficiary, who does not need to be related to the account owner, all you need to do is find a family with a bunch of kids and designate the oldest (or smartest) as the beneficiary of the account.
Whenever they have any qualified educational expenses (which, thanks to Zodiac Killer and Republican Senator Ted Cruz, now include up to $10,000 in private and religious K-12 expenses per year), you can issue a qualified, tax-free distribution to the school and be reimbursed by whoever would otherwise pay their tuition.
To be clear, this is completely illegal. But if you think that’s stopping our plutocrats from doing it, I’ve got a tax-advantaged infrastructure investment in Brooklyn to sell you.
The other reason to consider 529 plans as an alternative savings vehicle is that the penalty on non-qualified withdrawals just isn’t that harsh. Here’s an example using the 20-year investment horizon I described earlier:
- Contribute $100,000 to the Vanguard Total Stock Market Portfolio in Vanguard’s (Nevada-sponsored) 529 plan;
- Using a 5% APY average return after fees, in 20 years the account’s value will be about $265,000, representing $165,000 in gains, or roughly 62% of the account’s value.
- Assuming a standard deduction of $12,000, you can withdraw $19,354 per year without owing any income tax: 62% of the withdrawal will be taxable as ordinary income and 38% will be a tax- and penalty-free withdrawal of your original contribution. You will, however, owe a 10% penalty on the gains, or $1,200.
In a taxable account, meanwhile, you’d owe taxes annually on every dividend and capital gain distribution as well as taxes on the sale of the asset itself. Under the right circumstances, the 10% “penalty” can be lower than the taxes you’ve avoided on internal compounding, and over even longer time horizons that’s even more likely to be the case.
In other words, over long enough time horizons, 529 college savings plans function like variable annuities with substantially lower management fees and expenses, and the opportunity for completely tax-free withdrawals. In Vanguard’s case, compare the 0.18% all-in fee for their 529 Total Stock Market Portfolio to the 0.42% for the same portfolio in their variable annuity product. The key point is that the higher management fees and expenses are charged on the entire variable annuity portfolio, while the 10% withdrawal penalty is only charged on the gains in the 529 portfolio.
This technique even allows you to replicate the old “horse race” strategy of IRA recharacterizations. Since the gains in each 529 account are calculated separately for the purpose of non-qualified withdrawals, you could open one Vanguard 529 plan invested entirely in the Total Stock Market Portfolio, and one My529 plan invested entirely in the Vanguard Total International Stock Index Fund (and another state’s plan invested in the domestic bond market, and another state’s plan invested in the international bond market, etc.). Since non-qualified distributions are taxed and penalized on an individual account basis, you would always have the option of making non-qualified withdrawals from the account with the most (or least) gains, depending on your tax situation in a given year.
And this, unlike the “sell your 529 plan assets” strategy mentioned earlier, is 100% legal. Hell, it’s practically encouraged.
Non-traded investment scams
Pros: high “expected returns”
Cons: expensive, illiquid, obviously doomed
Today there are a million crowd-funded investment options, from old-school players like Prosper and LendingClub to newfangled bill brokers like Kickfurther. But the investment that most naturally lends itself to crowdfunding is real estate. Real estate is expensive (so you can raise a lot of money), it’s illiquid (so you can lock investors’ money up for years), and it’s opaque (so no one has any idea if you’re getting a “good” or “bad” price on the real estate you acquire or the management fees you charge).
I have a lot of respect for these scams. They charge huge upfront fees and huge management fees for an investment they have no control over the performance of. Fundrise is one of my favorite examples: one thing you could do if you identified a promising piece of real estate is to take out a loan and buy it. Alternately, you could raise money from a group of investors who would then share ownership of it. But Fundrise has an even better idea: collect money from strangers, issue them unsecured claims on a future stream of revenue, charge your expenses against that stream of revenue, then return their money minus your own healthy share of any eventual profit.
If you want to invest in a mutual fund, you ought to invest in a mutual fund. If you want to invest in real estate, you ought to invest in real estate. But if you want to get ripped off by some Silicon Valley dweebs who paid $300 for a graphic artist to design a sleek website, Fundrise is for you.
Rental real estate
Pros: generous tax treatment, stepped-up basis
Cons: expensive, illiquid, volatile
As a leveraged bet on the cost of housing, owning rental real estate doesn’t have any advantages over simply buying a residential REIT on margin. You have all the risks of declining real estate prices, rising vacancy rates, and property damage, and none of the benefits of spreading that risk across hundreds or thousands of properties.
All the advantages come from the special tax treatment real estate receives. While you own a rental property, you’re allowed to deduct the interest on any mortgage you took out to buy it. You’re allowed to deduct the property’s depreciation. And you’re allowed to sell the property and make a “like-kind” exchange for another property (in the US) without triggering taxes on the sale. Finally, like other taxable assets, your heirs will receive the property with a stepped-up basis, meaning they won’t owe taxes on the appreciation of the property during your lifetime.
This is especially valuable in the case of real estate if the original owner was deducting depreciation and reducing their own basis in the property: a property purchased for $200,000 whose owner deducted $100,000 in depreciation, but is worth $400,000 when inherited and sold, avoids capital gains taxes on $300,000 that would have been owed if sold during the original owner’s lifetime.
Collectibles
Pros: interesting conversation pieces
Cons: losing all your money
Some people think the problem with “greater fool” assets, whether it’s bitcoin, Beanie Babies, or Hummel figurines, is that you’ll run out of fools, but I don’t think that’s quite right. If you try hard enough, you’ll likely always be able to find someone, at some price, to take your junk off your hands. The problem isn’t finding a fool, it’s finding a greater fool — someone willing to pay more for your trinkets than you did.
Note that there are strict rules on the tax treatment of hobby losses, so consult a lawyer and/or CPA (again, I am neither) before starting to gamble in any of this stuff.
Start a business
Pros: preposterous tax advantages, higher Social Security benefits, larger 401(k) contributions
Cons: unknown
I’m here to promote entrepreneurs and entrepreneurship, so obviously I’m a bit biased. Nonetheless, the advantages of starting a business are undeniable, whether or not you also work as an employee elsewhere.
First, if you don’t hit the Social Security earnings cap through any other work you do, self-employment allows you to raise your annual contribution and increase the old age and disability payments you’re entitled to. For folks who spent a long time unemployed or in higher education due to the late-2000’s breakdown in global capitalism, the only way to make up for those missing years is higher contributions during the remaining years before retirement.
Second, while your voluntary employee-side 401(k) contributions are capped at $18,500 in 2018 across all your employers and your self-employment, each employer — including yourself — has a separate cap on the amount they’re able to contribute to an employer-side 401(k). That means you can take advantage of any employer matching program at your day job and make additional employer-side contributions into a solo 401(k) subject to a totally separate cap.
Finally, the 2017 Republican tax heist added an additional 20% discount on the taxable income of many small businesses. This is an extremely confusing topic so, again, consult a CPA if you have any questions about whether your small business qualifies, since certain industries and legal structures are excluded under certain circumstances.
the 529s bother me because, as you point out, they are a crime foisted by our beloved congress, and we all know what they give they can take away, or tinker with……..
Never buy a collectible you don’t want to live with. You may not make money, but you will derive pleasure. I think the biggest problem is how your heirs will get rid of the stuff. They know it has value, can’t give to Goodwill, but don’t want the hassle of finding buyers.
The estate tax exemption for 2018 is $11,180,000 per individual. It was laudably raised by Congress in the Tax Cut and Jobs Act of 2017.
Arkansas Traveler,
Thanks for the correction, I thought I had triple-checked but was still using an outdated resource.
—Indy
I think I disagree with some of your math in the 529 section. On one hand, you’re arguing that at withdrawl, you get to exempt $12000 in gains because of the std. deduction. Then you compare that, “In a taxable account, meanwhile, you’d owe taxes annually on every dividend and capital gain distribution”. But, you get that same $12000 exemption every year on annual distributions. And of course, “taxes on the sale of the asset itself” would only apply to (un-distributed) cap gains. Your example here fails to convince me that paying an additional 10% tax 20+ years down the road is a useful strategy.
flyernick,
The point is one of timing: in a taxable account, you don’t have control over the timing of dividends and capital gains distributions, so those distributions would be added to your taxable income and taxable at up to 23.8% federally plus however your state treats them.
In a 529 plan, the dividends and capital gains are tax free when they accrue, and you only owe taxes and penalties on the gains when (if) you make a qualified withdrawal, which means you’re able to time those withdrawals for years where you have little or no taxable income, for example, if you’re taking distributions from a Roth account that don’t appear on your federal income taxes.
So my suggestion is that the right way to think of it is not as an “additional” 10% tax, but rather a 10% tax *in lieu of* the taxes you would have paid over the years, which over long enough time horizons and at high enough incomes will be substantial. The tax-free internal compounding and opportunity to time distributions is doing all the work here: making non-qualified withdrawals in high-income years would cause you to pay ordinary income taxes on the gains plus the 10% penalty, so don’t do that.
It’s obviously not a strategy for everybody, but if you expect to have both high-income and low-income years during your lifetime, then 529 plans are one way to take advantage of the low-income years and avoid capital gains taxes in the high-income years.
—Indy
Hello Matt:
Thank you for an interesting post. Where could I learn more about “If you buy $500 of Enron stock and it drops to $0, you might be out as little as $250, depending on your federal and state income tax situation.”?
Thanks,
Nik
My experience with Fundrise has been overwhelmingly positive. Where else can I get 8% in income with some appreciation thrown in? Is it fully liquid? No, redemption is allowed periodically and yes, I don’t know that I will get the most recent price. Better than an LP, no K-1 and easier liquidity. I could lose some or most of my investment, just the same as my other choices.
Not really concerned about taxes, that’s a rich person’s bogeyman. We currently have the lowest tax rates this country has seen since 1913.
I run two small businesses and am shocked that anybody has the nerve to complain that taxes are high. Schedule C is an exercise in tax liability reduction. If taxpayers had the same deductions available to them, the average rate would be in the single digits!
Dave,
Thanks for sharing your experience with Fundrise. There’s an old story about the chairman of the Ways and Means committee getting so fed up with the hijinks played by real estate developers that he threatened to make real estate totally tax free, since that would ruin all the scams they were running.
—Indy