My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Winter 2022

What should be the response to a low return environment (i.e. high prices on stocks and bonds)? I have touched on this before (here for example), but it seems like it might be time again.

If returns are lower than they were in the past, but risks are the same (i.e. the return per unit of risk is now lower), there are three perfectly rational responses:

1. Keep your portfolio the same but realize you will not get the returns you once did with that portfolio.
2. Decrease the risk in your portfolio.  Since you are not getting paid as much for taking risk you decide to take less of it.
3. Increase the risk in your portfolio.  Since you desire a certain level of return the only way to get it is to increase risk.

Now, the problem is that although the options above are opposed to each other, they all make sense and are rational.  But we have to pick one.

I don’t have a simple answer though.  I think it depends on your resources compared to your needs.  For example, if someone is wealthy (compared to their needs, not in absolute terms) the correct choice is probably different from someone who is not at all wealthy (again, relative to need).  For example, suppose we have three families, each newly retired, and each need $120,000/year. Social Security/pensions/whatever are expected to provide $40,000.  That means $80,000 must be provided by the portfolio.  One client has an $1,600,000 portfolio; one has $2,000,000 portfolio; and one has a $2,400,000 portfolio.

• The family with the $1,600,000 should probably have a slightly more aggressive portfolio than they would have in a higher return environment.
• The family with the $2,000,000 should probably have the same portfolio they would have in a higher return environment.
• The family with the $2,400,000 should probably have a slightly less aggressive portfolio than they would have in a higher return environment.

I think.  This answer is tentative, provisional, and preliminary!

I have been thinking about wealth taxes that have been proposed and it occurred to me that we already have a few of them (property taxes are one, I’ll get to the other below) but we don’t think of them as wealth taxes. That led me to think about some other illogical tax items. This is just about the items related to capital gains; I may or may not go on to other topics in future posts.

I wrote up some reform ideas a few years ago here and here but this is new.

Here are a few oddities just to illustrate some problems. Let’s assume that inflation is 3% (and always was); long-term capital gains rates are 20%; short-term capital gains/ordinary income rates are 40%; and corporate tax rates are 25%. The numbers aren’t really important, but I want to be able to do some simple examples with nice easy round numbers that are close to what exist though not exact (state taxes, Medicare surcharges, brackets, etc. would all change them for various taxpayers anyway).

• Situation 1: Taxpayer Alpha bought Stock X 20 years ago for $100,000 and it has grown at an average compounded rate of 3%. Since inflation has been 3% the real wealth has not increased. Nonetheless, if sold the taxes would be about $16,000 [($100,000 * 1.03^20 – $100,000) * 20%]. This is a wealth tax basically set at the rate of inflation times the tax rate (so in this case 3%*20%), but only collected upon disposition so there are some compounding differences. Our taxpayer, in purchasing power, is $16,000 poorer. We have had low inflation for so long I don’t think people appreciate the damage that income taxes combined with inflation do.
• Situation 2: Taxpayer Alpha dies and leaves Stock X to Taxpayer Bravo. There are no taxes. (Step-up in basis.)
• Situation 3: Company X pays a special dividend (qualified) of $80,000. Taxes would be $16,000.
• Situation 4: Taxpayer Charlie buys Stock Y one year ago for $100,000 and it is now worth $180,000 (roughly the same as the previous example). Since it has not been a year-and-a-day, sales would result in taxes of $32,000.
• Situation 5: Taxpayer Delta buys Stock Y one-year-and-a-day ago for $100,000 and it is now worth $180,000. Sale would result in taxes of $16,000.

You get the idea, the first three situations are economically identical, yet the taxes are different. Worse, there is no actual (real) gain, yet taxes are assessed. This is why using qualified plans/IRAs, Roths, etc. is so vital. That is the only way to avoid paying taxes on phantom (inflation) gains. (Assuming all qualified plans/IRAs are exclusively funded with pre-tax dollars.) The last two situations are nearly identical, but the taxes are wildly different.

So here is my modest proposal. All of these should be adopted simultaneously, not in isolation, as they work very well together, not nearly as well individually. I’m not trying to minimize (or maximize) taxes, I’m trying to make the economic reality of a situation give rise to appropriate taxes. Anyway:

1. All income tax rates for a given taxpayer should be the same marginal rate, no special long-term capital gain or qualified dividend rates. This eliminates the “gaming” that is sometimes done to turn earned income into a capital gain (carried interest for example). This would raise tax liabilities. (But stay with me, it gets better.) A flat tax would be even better, because the sale of large value items (real estate for example) could kick someone into a higher bracket than they would normally be in.

2. Companies should get a corporate tax deduction for dividends paid. This removes the tax incentive to use debt rather than equity. It also means that the rationale for a special dividend rate to compensate for double taxation is removed. (Under current rules/rates above a company makes $20, pays 25% in taxes leaving $15, pays it out in a dividend taxed at 20%, the taxpayer nets $12. With my change, the company makes $20, pays it out in a dividend and it is taxed at 40% leaving the taxpayer the same $12.) This would lower tax liabilities to the company. (It would also incent management to distribute earnings rather than horde them and empire-build.)

3. Step-up in basis on death should be eliminated. Carry over basis eliminates the economic dislocation from holding property that would otherwise be sold, waiting for the owner to die to avoid tax and leave the heirs more. This would raise tax liabilities. It also, given that we have a progressive tax structure, aligns taxes with the economic situation of the heirs. A “starving artist” heir would pay little or no taxes, a neurosurgeon heir would pay much more. That seems fair.

4. Since we have eliminated the step-up in basis, we can eliminate estate taxes now too. This would also free up many very expensive tax attorneys and CPAs to do something socially useful. This would lower tax revenue.

5. Investment assets held longer than a year have the basis indexed for inflation. So there is no more tax on growth that isn’t real. The stock bought for $100,000 that grew to $180,000 over 20 years at 3% inflation would have no tax due. A 20-year bond bought for $100,000 with 3% interest (remember inflation is 3% too, so this is zero real return) would have taxes on the 3% paid each year (at 40% rate). But upon maturity, the bonds would have a capital loss equivalent (roughly, you have compounding issues again) to the interest paid. So the taxpayer, having received no real return, pays (roughly) no tax. This structure means that the effective tax rate on stocks is still a little lower than bonds given that dividends are usually lower than interest so you are ahead on the time value of money, particularly on growth stocks, but then the company didn’t get a deduction if they had earnings. This would reduce tax revenue.

6. Repeal the $3,000 limit on taking losses against ordinary income. Since all the rates are the same there is no point to this. (And it means the bond buyer in the earlier example, can actually use the real loss upon maturity.) This would reduce tax revenue.

7. Section 121 can be repealed (the home sale exclusion of $500,000/$250,000). Since we are indexing to inflation everyone only pays taxes on real appreciation. The current method penalizes people who 1) buy expensive homes (the “free” appreciation is in dollars, not percentages), and/or 2) don’t move. If I buy homes for $1,000,000 and move every five years I will probably never pay taxes on it. If I buy a home for $500,000 and don’t move for 30 years I probably would. That seems … odd. This would probably raise tax revenue, but it could conceivably go the other way. I don’t have data (and behavior would change).

This is just a guess, but I think doing all of that probably wouldn’t materially alter taxes paid (in aggregate) but it would remove a lot of uneconomic behavior that people engage in for tax reasons.

Of course there is zero chance of this being cleaned up logically…

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Fall 2021

If you have a prudent financial plan, with no legacy desires, you very well might accidentally leave your heirs an estate large enough to have an estate-tax problem anyway! I’ll give the conclusion first (less technical) and then the detail of how it was derived (which is almost certainly more than you want to know).

If you use the 4% rule for spending, with a starting portfolio value of $1,000,000, in 30 years you have (in real, i.e. today’s, dollars):

• A 1/20 (5%) chance of running out of money
• A median (50th percentile) value of $2,000,000
• A 1/20 (5%) chance of $7,500,000 or more

Here’s how that was derived and some elaboration:

Using 1926-2020 data on stocks (CRSP 1-10), bonds (5YR TSY), and inflation (CPI) the real arithmetic mean was 8.8% for stocks with a standard deviation of 18.4% and 2.3% for bonds with a standard deviation of 4.7% (all annualized from monthly data by compounding the monthly return and by multiplying the volatility by the square root of 12). The correlation between stocks and bonds was 8.1%.

If we do projections using a Monte Carlo Simulation (MCS) with those figures using $1,000,000 as the starting value and $40,000 for an annual withdrawal (starting immediately) then this is exactly the 4% rule done with a MCS using historical returns to generate many more scenarios than we actually had historically. (Also, if you use rolling historical data, you over-sample the middle years and under-sample the beginning and ending years). I don’t have to inflation-adjust the withdrawals because I used real returns in the first place. Looking at the results at the 30-year horizon (again to match the Bengen research), the success rates range from 91% for all stock up to 97% for 40/60 (stock/bond) and then back down to 79% for all bond. I’ll focus on the typical 60/40 portfolio here. It has a success rate of 95%. I would say that validates the 4% rule pretty well – though expected real returns might be a little lower than historical realized real returns, this has no international diversification, no factor tilts, etc. but also no fees. Close enough probably to assume all of that roughly cancels out.

While this scenario runs out of money 5% of the time, in the median (middle) case there is just under $2,000,000 (and, to reiterate, all of this is stated in real, i.e. today’s, dollars). The 5% case (the 1-in-20 on good side) had an ending value of about $7,500,000, while the 95% case (the 1-in-20 on the other end) is zero.

Doubling everything so a hypothetical single client had a $2,000,000 portfolio to start with and withdrew $80,000/year (adjusted for inflation) to live on in retirement (and had no other assets), in 30 years there is an equal chance of zero and $15,000,000! The estate tax exemption is scheduled to revert to $6,000,000 (ish) and increase with inflation so we can compare our $15,000,000 to that $6,000,000 since both are real. $15,0000,000 minus $6,000,000 is an estate that would owe taxes on $9,000,000. At the current 40% rate, that is a $3,600,000 estate tax bill! To flog the deceased equine further, to have “only” a 5% chance of running out of money, there’s a 5% chance of pretty significant estate tax issues. (Of course in real life you see how it’s unfolding and adjust spending, gifting, etc. to ameliorate both extremes.)

That math is surprising to most people. We don’t generally realize how wide the range of financial outcomes in retirement can be.