Robinhood Lives! - Paying School taxes to another State

Just when I thought I could not possibly be asked to pay any more tax, I have been notified by my employer that I owe income tax to the State of Alabama. I live and work in Texas, where there is no state income tax. Instead, we have outrageous property taxes. But that’s another story.

Anyway, it turns out that if you work more than 30 days of the year in Alabama, you will be taxed on all income earned during that time. The 30 days do not need to be consecutive or full work days. As a frequent business traveler, I find it very easy to work 2.5 days per month (30/12= 2.5) in another state.

Who pays?
Fortunately, my employer is very reasonable and since they sent me out of state to work, they will pay the tax to Alabama. And they plan to pay it directly to Alabama. No money will pass through my hands for this transaction. The HR rep explained that the company will pay the tax but does not trust employees to then use that money to pay their own state taxes!

Even More Tax
Of course, the IRS has to get into this and levy an additional tax on the money used to pay the state of Alabama. I am being taxed for money that I have never received. Once again, my employer will also pay that portion of my federal tax to the IRS. All I have to do is file state income tax for the state of Alabama and reference my W-2 withholdings to satisfy the tax collectors.

Who gets the tax dollars?
I tried to identify where my tax dollars will be appropriated in Alabama. But, I didn’t have much luck. After some searching, I found on the state’s website that the money will go to the general fund and the education fund. Hmmm. It seems a little ridiculous to have a Texan paying for schools that are in another state. Especially since just recently, Texas was forced by law to scrap its robinhood style school funding. Robinhood funding takes money from a rich neighborhood and gives it to a poor neighborhood. That was ruled unconstitutional in Texas.

Legal issues aside, it just seems reasonable that the people who benefit from a tax by having schools built to educate their kids and neighbors are also the same people who should pay the tax.

Another big reason why you should have Stock in a 401(k)

For the Tax advantage!

If you thought, like I did, that everything in your 401k from bonds to equities to mutual funds would be exposed to the same awful ordinary income tax rate at withdrawal – check out this seldom discussed or written about 401(k) maneuver that could save a lot in taxes.

Retirees who withdraw their employer's stock, rather than rolling the shares into an Individual Retirement Account will enjoy a tax break.

Upon withdrawal, the retiree will pay taxes on the average cost of the shares when they were bought in the plan.

When shares are sold, the gain (the difference between the current value and cost in the plan) is taxed at long-term capital gains rates.

Given the difference between the top ordinary income tax rate (35 percent) and long-term capital gains rate (15 percent), this tax break can be significant.

For an example, let’s assume you own 1,000 shares in your 401(k) plan that are worth $100 a share, or $100,000, and that these shares were acquired in the plan at an average cost of $20 per share. Roll the shares to an IRA and pay no tax now. Later on, you can take all 1,000 shares out of the IRA, and if you're in the top 35 percent income tax bracket, you'll pay $35,000 in ordinary income taxes on the entire $100,000.

Instead, Do Not Roll the shares into an IRA. Take them out of the plan now and pay ordinary income taxes on the cost of $20,000. In a 35 percent tax bracket, that's $7,000 in taxes now. Later, sell the shares and pay capital gains taxes at 15 percent on $80,000. This works out to be another $12,000 in taxes. Total taxes paid: $19,000 versus $35,000 in taxes if rolling over the shares to an IRA and the shares out later.

One other key point to consider is that If you never sell and left the assets to your heirs, the cost basis on the shares will be stepped up to their value on the date of your death. Your heirs could then sell the shares and never be taxed on any gains!

This gives me one more reason to hang on to my company stock. I had considered selling the stock simply because it has grown to over 10% of my portfolio. I have been struggling with that since its fundamentals are still excellent and its a great stock to hold in recession or bear markets.

Make this Frugal activity part of your Life

Need a New Year's resolution that you can keep? How about walking? Walking is one of the most frugal activities you will ever find. It's free and the benefits to your health are priceless. No special clothes or gear are required. It's convenient and can be done just about anywhere. Best of all walking can be done at your own pace.

I walk everyday. I don’t consider it a work out, just a walk. It feels right. The human body was designed for walking. The natural locomotion puts me at ease, slows down the world and releases stress. Walking is a great time to put your problems at the back of your mind and let it churn on them for awhile, subconsciously. Many times, while walking, I have thought of new ways to tackle a problem.

When walking, you can’t help but become more aware of your surroundings: fresh air, scenery, neighbor interaction, the changing sky, the weather, the wind in the trees. I prefer to walk with my dog and he appreciates these things even more than I. It's rewarding just to see him have the time of his life, raising his nose to catch a scent, investigating a clump of grass and taking note of everything in his path. It’s like a kid in a candy store and really amazing how much energy he generates just walking. It’s his lifeblood.

I usually walk in the evening after work. I use that time to reflect on the day and try to think of a few things that happened during day that were good or that I can be thankful for. It’s easy to take our lives for granted. We are very fortunate compared to most people on this planet and its important to recognize these things on a regular basis. By doing this little exercise, you will quickly realize how many good things that you have in your life.

Some days I am thankful for the nice cup of coffee that I had that morning, or a conversation that I shared with someone, or the enthusiastic greeting that my dog delivered when I arrived home. These are small things that I have learned to appreciate and many times that’s all it takes to make a day better.

Are we UNDER estimating Social Security Benefits?

It seems a lot of us complain about paying into SS. We don’t have much choice and its frustrating to know that we probably can’t count on it. I have always assumed that I would probably pay more into the system than I would ever get out. But, I had never run the numbers and now seems like a great time.

I used the SSA calculator provided on-line to estimate my SS benefits for a couple of different scenarios.
1) I assumed a retirement date of Jan 2010. So as of that date, no more funds would be contributed to my SS total earnings.
2) I assumed a retirement date of now, Jan 2008.
3) I assumed a conventional retirement at age 62. This means I would continue to contribute to my SS total earnings for an additional 15 years.

The difference in the estimated monthly benefit amount, (which would begin at age 62) was 3.5% between retiring today or delaying until Jan 2010. So, working an extra 2 years adds another 3.5%.

In the final comparison, between scenarios 1 and 3, I found that by retiring early in Jan 2010 my SS benefit would be reduced by 14%. That’s not a bad trade off. I am very willing to retire 15 years early and take a 14% benefit cut.

For the next part of this analysis, I referred to the pamphlet that the SSA sends each year to every taxpayer that explains their SS benefit. It details the amounts already paid into the system and projects what your payout will be in the future. My earnings from age 16 to present were provided in the SSA pamphlet.

I added up all of my SS earnings and multiplied by 12.4%. That is the amount that my employer(s) and I have paid into the SS system on my behalf. This number was less than I expected. I then divided that amount by the projected yearly SS benefit, assuming early retirement at Jan 2010, to arrive at the number of years required to collect benefits equal to my pay in. (I estimated my salary for 2008 through 2010 and added it in to the calculation as well)

To my surprise, it appears that with the current system, I could actually get every penny back and more! All I have to do is live 9.5 years beyond my 62nd birthday to collect every penny I ever paid in to SS. It is very likely that I will live to the age of 71 and maybe even several years beyond that.

One last note, for all of these calculations, I used today’s dollars. SS benefits will actually be adjusted for inflation, so the payout will be increased based on the inflation rate. This is a significant adjustment that will improve these numbers even more. By converting to inflated (future) dollars, the time required for me to collect the amount that I paid in to the SS system is reduced to 5.6 years.

Free Portfolio Analysis by Vanguard

Vanguard offers a portfolio evaluation tool called Portfolio Watch, as part of its Voyager select services. The analysis compares your stock and mutual fund investments with overall market weightings in terms of capitalization, style, and industry sector. The concept is that the more your holdings vary from the market bench marks, the greater the probability that your returns will differ, higher or lower, from the market.

The exam included an evaluation of overall market risk, mutual fund costs, tax efficiency and concluded with steps or recommendations to update and fine tune my investment strategy.

Before we get to the analysis, let’s take a look at my portfolio asset allocation. I call it the CoffeeHouse Portfolio with a Double Espresso Shot. The allocations for each holding are shown in the following table. The dollar amount of the asset is divided by the total dollar amount of the portfolio to arrive at the “weighting” for each fund or stock in the portfolio.

The Fixed Income asset type is a money market account. The 40% allocation to Large CAP stocks has been broken down into three subcategories: Health care fund, defense contractor stocks and technology stocks. So, health care is actually 28% (0.7*40) of my holdings, defense is 10% and technology 2%.


















Cautions
Throughout the analysis VG provided advice, tips and made note of a few cautions. VG states that these cautions are areas where my portfolio differs from the broad market target. I have listed each of the four cautions below. I have also summarized my assessment and what my plan of action is concerning these cautions.

Bond allocation is low
I have never been comfortable settling for the significantly lower returns of bonds. In Bogle’s book, Bogle on Mutual Funds, he talks of bonds returning 7% and equities 8%. This was back in the 90’s - I would like to find a quality bond at that rate, today. Bonds are not risk free and have much less upside than stocks.

Certainly as one moves into retirement it is prudent to add more fixed income assets to reduce risk and smooth out the market ride. I have been accumulating cash in a Money Market account as MMs have outperformed bonds in the last few years with minimal additional risk. I plan to direct that cash towards the purchase of TIPS and Municipal bonds in the near-term future.

Hold Less than 5% in company stock
VG recommends not holding over 5% in any one stock. This is sensible advice given the volatility of individual stocks. I have not made this change because the stock that I hold at 10% is a non-cyclical, defensive stock that should do well in volatile markets and recessions. I am well aware of the Enron debacle, but I think every situation needs to be evaluated in it's own light.

Increase Emerging market holdings
Given the capital and liquidity issues that are occurring in the US (see financial mortgage meltdown), I am hesitant to invest in new developing countries that may require extensive amounts of capital for business development. I prefer to invest in developed international markets which have less risk. Additionally, Emerging markets have had a significant run-up in performance lately and are not a good value buy at this time, anyway. This is a sector that I have researched, but never felt compelled to pull the trigger.

Hold Growth and Value stocks in similar proportions
VG recommends a portfolio with equal weight in growth funds and value funds. This is an area that I have been working on to get to at least a 2:1 ratio (Growth equals 2 X Value). I will continue to add new funds to the value side of this as I move into retirement phase. In addition, I am interested in increasing my holdings in Berkshire Hathaway stock – which I consider to be a large cap value stock.

Overall take
The analysis and charts are organized and informative. The advice is straightforward and easy to understand. I especially liked the “xray” ability that VG used to dissect some of my fund holdings. For instance, one fund has a 15/85 split between international and domestic holdings. The tool actually split the fund by the appropriate amount into each of the two sectors, so that my total portfolio allocation reflected this split.

The analysis confirmed my suspicions about some of the shortcomings of my asset allocation strategy. The second opinion was helpful and motivational. After reading through the analysis a couple of times, I have been encouraged to make some changes to my bond and value fund allocations.