Top 6 year-end tax tips

Year end is just around the corner. Make sure that you do not forget to check the following before we get into 2017. Some of these items are fairly straight forward and provide huge value for money.

401k contributions

401k contributions are payroll contributions and hence cannot wait till Jan 2017 (for the year 2016). If you have not maxed out your 401k contributions for 2016 and have the funds to do so, then now is the time.

It is a now or never situation. 401k contributions are tax deductible. If you are in the 25% tax bracket, then you save $250 on taxes right away for every $1,000 you contribute to your 401k.

In addition to the tax benefits, 401k plan offers other advantages too – for example, bankruptcy protection. 401k is protected by Bankruptcy laws. Attorneys cannot seize your 401k account to repay creditors.

Tax loss harvesting

You can deduct up to $3,000 capital losses from your other income. Check your stocks and sell the losers.

It is $3,000 in NET capital losses. Here is how the calculation works:

Example-1: Capital gains $2,000, Capital losses $3,000, net capital losses deducted form ordinary income $1,000

Example-2: Capital gains $2,000, Capital losses $5,000, net capital losses deducted form ordinary income $3,000

Example-3: Capital gains $2,000, Capital losses $6,000 -> net capital losses $4,000. Deduct $3,000 from form ordinary income in 2016 taxes and deduct $1,000 from the ordinary income in 2017 (carry forward $1,000 capital losses in excess of the $3,000 allowed limit per year).

Keep in mind the Wash Sale Rule though – you cannot buy the same or ‘substantially identical’ stock within the 30 days before or after the sale. So if you sell the losses on Dec 31st 2016, then you cannot buy a substantially identical stock in all of Dec 2016 and Jan 2017.

FSA account (insurance)

Some employers offer one of the two grace options: “grace period” of up to 2 ½ extra months to use the money in your FSA OR carry over up to $500 to use in the following year.

If your employer does not offer any of these options, then you will lose the money you have in there at year end. So you have to spend it soon.

You can buy things online up to midnight on Dec 31st. Eligible items include contact lens, sunscreens, and even condoms.

IRA/ Roth IRA

In general, sooner you make your IRA contributions the better it is. You can make IRA contributions for 2016 till the tax filing deadline (Apr 15, 2017… or Oct 15, 2017 with extensions).

But here is the catch: the IRA account should have been opened before Dec 31, 2016.

Yes, let me repeat: You can make IRA contributions for 2016 till the tax filing deadline well into 2017 BUT the IRA account should have been opened by Dec 31, 2017.

So make sure that you have an IRA account open – even if you are not able to contribute later, you do not lose anything.

IRA distributions

One of the extremely harsh penalties that exist in the Internal Revenue Code (IRC/ IRS code) is the failure to take Required Minimum Distributions (or RMDs).

You must start making regular minimum distributions from your traditional IRA after the age of 70 ½.

If you do not, then IRS charges you a penalty of 50% based on the amount that should have been withdrawn.

So if applicable to your situation, make that RMD distribution now. I would suggest not to wait till Dec 31st – sometimes the distribution itself might take a few days.

Property taxes

This is applicable to all property taxes but most significant in case of home owners.

In my county, you get a 4% discount on the annual property taxes if you pay them by November (3% if you pay by Dec, 2% by Jan, 1% by Feb, 0% by March, and you are delinquent if the taxes are not paid till April).

I just paid my property taxes last week and received a 4% discount.

In addition, I will be able to itemize these taxes on the Schedule A when I file my taxes.

Time value of money

$1 tomorrow is worth less than $1 today. $1 today = $1 tomorrow + time value of money. This time value of money is represented by interest in savings account and earnings in investment accounts.

Time Value of Money

Time Value of Money

People in general would prefer to consume $1 today than wait till tomorrow. Now, there are two categories of people – those would would postpone their consumption in return of interest/ earnings. And there are those who would prepone their consumption by paying interest.

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How does a well diversified portfolio look?

A simple yet highly scientific explanation of what is diversification, why is it important, and how should you achieve it?

What is diversification?

As the old saying goes “You should not keep all your eggs in the same basket”. Diversification is keeping your eggs in different baskets.

Diversification lowers risk. Risk can be measured by ‘variance’. Therefore, diversification reduces variance.

The below write up about variance looks a little mathematical to begin with, but trust me – it is not complex mathematics. If you read it a few times, you will understand it well. Even if you do not understand the math, continue to read and you will get the gist of this post.

What is Variance?

In most simple terms, variance is nothing but a measure of how far individual values are from the average value.

Look at two portfolios below – both have the same average return (as we will soon confirm) but Portfolio-1 has a higher variance: the returns in individual years are ‘spread’ further from the average (mean) of 5%.

Diversification

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Are you financially smart?

I live with someone who is incredibly smart (ivy-league doctor). Read the 7 examples that lead me to believe that she is not financially smart.

1. If she has money, she will invest. If I see a good investment opportunity, I will think about how to ‘fund’ it. Like other financially smart people I have learned to say How?

2. She does not understand the time value of money – she always lends me money interest-free when we play Monopoly. And then she wonders why I always win – because I will buy every property that I can on the board by taking money from her (or the bank) interest free. Financially smart people are always on the lookout for interest free money.

Keep in mind the following though:

a. High interest debt like credit cards is a suicide but interest free debt is a blessing if invested properly. Read a related post here.

b. Do not over – spend because the seller is offering you an interest free loan. Interest rate should not dictate your purchase size in this case.

3. We own a house that we are in the market for refinancing right now. We got the original mortgage in 2014 (0% down payment). When we talk about refinancing at 100% LTV or pay down 20%, she often talks about ‘But the house might be worth much more in 5 years?’

She seems to think that the house appreciation will benefit us more if we make a down payment. While I know that the house appreciation will benefit us exactly the same amount whether we put nothing down, or 20% down, or even 100% down (pay off the mortgage).

We own the house, irrespective of whether there is mortgage on the house or not. Our equity in the house depends on how much mortgage do we owe to the lender, but our exposure to real estate is the entire value of the house (irrespective of the mortgage amount).

You will see other variations of this problem too – and sometimes even financially smart experts get confused. Here is a good example:

Here a couple would like to plan for an early retirement and the Number 1 personal finance magazine in the country advises them:

The equity in the rental property does not matter (as far as the impact on net worth is concerned). Let us say two examples assuming the rentals are worth $200,000

  1. Equity of $78,000 and debt (mortgage) of $122,000
  2. Equity of $50,000 (and the rest $150,000 is mortgage)

When/ if the real estate market crashes and the value of property falls to say $160,000 – the couple has lost $40,000 from what they own today (irrespective of the debt/ equity ratio).

In case 1, the equity falls to $38,000 and the mortgage is still $122,000 -> so net, they ‘owe’ $84,000. Actually look at it this way -> you owe the bank $121,000 and your property value is $38,000. So now you owe net $84,000.

Earlier you owed $122,000 – $78,000 = $44,000. You have lost $40,000

In case 2, you owe $150,000 to the bank and the equity falls to $10,000 -> so the net you owe is $140,000. Earlier net owed was $150,000 – 50,000 = $100,000. So you lost $40,000.

To summarize this point – the couple owns rental property worth $200,000 -> and they will gain/ lose the entire amount by which the property increases or decreases in value. The amount of equity does not matter.

The other problem with the above expert advise is “sell rentals when you have difficulty finding tenants” – I would say NO, that will be too late. Selling the rental now when it is a turnkey investment might give you a good selling price rather than waiting for the real estate market to go bad before selling it.

4. She was unhappy that she did not get any refund while her colleagues got tends of thousands of dollars back.

She does not explicitly realize the fact that she was getting less taxes withheld during the year so essentially what her colleagues are getting back now, she has been getting all along with every paycheck.

Hopefully she will appreciate taxes due vs tax liability difference some day soon (else I will start to consider myself a failure lol, just kidding).

5. She hated debt and was paying off her student loans as fast as she can – this works great in 2 situations: if you have money then you will end up spending it rather than investing it and if the debt is high interest rate.

She was paying down her loans that had an interest rate of 2% while I take as much loan as possible as I can get at 2%.

The reason – I am confident that I will make much more through my investments. How much more? I am hoping that I will make about 8% over long term.

But debt is risky and since 8% is uncertain, I will not take debt at say more than 4% to speculate. If someone is loaning me money at 2%, then I will surely take it. If someone is giving it to be at 5%, then I will definitely not take it.

For things like 3-4%, I will have to run specific numbers (using my Excel).

6. She was not claiming her mother as a dependent, I made her file amended returns for three years, got back $3,000 in refund each year. This money is not all that much given what she earns today but this was a hell lot of money when she was doing her residency and earning $50,000 a year.Exemption section on 1040 Tax Form

Her CPA never asked her and she never mentioned it. I wish she would have met me sooner. One of the main reasons I urge people to understand taxes is for situations like these: a CPA will only know what you are telling them, sometimes they will not ask you the right things because they do not know your situations.

7. She was about to buy a car for $42,000.  I asked her ‘Will you wait 10 days if I get it for $5,000 less’? She said – yes. 10 days later, we bought the exact same car for $36,000. We saved $6,000.

financially smart

More on car buying negotiation techniques some other time, but essentially I negotiated the price of the car down to $36,000 from $42,000. I was able to do so because I was not in a hurry – I got multiple quotes from multiple dealers and essentially made them bid against each other.

How I saved $6,000 on a car purchase?

My girlfriend selected a car that she wanted to buy for $42,000. I asked her if she can wait for a few days, 1 week later I bought the same car at $36,000.

All I did was follow a few simple steps of negotiation. Listed below are the steps you can also follow to save huge amounts of money when you buy a car (I saved $6,000 on a car purchase using these simple steps).

Step 1: Document your requirements exactly 

I documented exactly what I needed – Make, model, color, accessories. I listed everything so that there is no discussion required with any car dealer.

This is very important. Time is of essence – visiting any dealership will take a couple of hours, and however determined you are you will not be able to do more than 2-3 in an entire day.

While on the internet you can easily reach out to 15 – 20 within an hour.

Step 2: Find all the dealers in your area

Again, internet is your friend here. Go online and search all dealers in your neighborhood.

I suggest to think of neighborhood as something really broad – would you not drive 300 miles if you can save $2,000? If yes, then search for dealers in your city and neighboring cities.

Caste your net wide – you do not have to drive 300 miles later but it does not harm to know what the price difference is. May be the price difference will be enough to warrant a drive.

The only thing to keep in mind is: stay within your state. Handling out of state registrations might be something you would like to avoid.

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Should you afford what you can afford?

I live (and want to live) a comfortable life but I do not want to maximize my consumption just because I have money to do it.

In 2014, I was in the looking for a house to buy (primary residence). Like most rational people, I wanted to start with a budget. I wanted to find out answer the following question:

“Given my income, what is the least amount I should spend on housing?” I searched for days and weeks, but did not find an answer.

Let me first elaborate on my question. I have good income. I tend to be frugal (simple living). But I did not want to be frugal to the extreme, I did not want to end up below the ‘suggested bottom’. I had often heard people talk about “You should not spend more than x% of your salary on housing”. I wanted to hear something like “You should spend at least y% of your salary on housing”.

I did not find my answer, here is what I found – I found hundreds and hundreds of websites and blogs telling me ‘the upper limit of how much should I spend’. Here are some examples:
1. Your monthly total debt should not be more than 43% of your take home pay
2. Your house should not cost more than 2.5 times your gross annual base pay

This related to my car buying experience too – the salesman always kept on coming back to monthly payments saying “It is only $391 a month, you can afford that”. And I was thinking in my mind “Should I afford it just because I can?”.

Coming back to my housing question – I do not have an answer today on how much is the minimum you should spend. Frankly, I did not start to write the post looking for an answer.

Affordability calculator

Affordability calculator

All I would like to discuss today is – should you afford what you can? Since no website was able to tell me the ‘suggested minimum’, I believe most people are not thinking along those lines.

Per the affordability calculator present on www.zillow.com, someone earning $100,000 a year without any other debt can afford a house worth $489,216. They make the calculations using some assumptions and those assumptions are not our focus today.

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Rent vs Buy a house

12 factors that go in the decision Rent vs Buy a house – you can also download the Excel with a real example, change the numbers per your situation.

36 million people move every year, assuming these 36 million people represent 20 million households, 20 million households face the following question every year: Rent or Buy?

In most cases, people say ‘Let us start by renting and then see if we like the place enough to buy’. Although that is a very valid way to think about things, read on to find a holistic scientific method of determining what makes more sense financially?

12 Facts to consider

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Importance of Asset Allocation

What is an Asset Class? What is Asset Allocation? How should you determine your Target Asset Allocation?

If you read my blog often enough, and have started to think I qualify everything I write about as ‘most important’ – then you are mistaken (and partly it is my fault). I might be saying those things in a different context.

For example, when I say compounding is your biggest friend, I mean it, but keep in mind that compounding happens over a period of time. When I say Asset Allocation is the most important factor in determining long term returns, I do not mean to say asset allocation is more important than compounding.

Things apart from Asset Allocation are important too, specially how much you save and how soon you start to save, how much expenses do you have etc; but once you have started to save/ invest, Asset Allocation is what will be a primary driver of your long-term returns.

What is Asset Allocation?

Asset Allocation is simply how your portfolio (money) is divided into various Asset Classes.

If you do not understand big jargon like Asset Allocation and Asset Class (and some others) we are talking about today, please do not be discouraged, read till the end. I am introducing these terms so that you can interpret and understand host of information that is available on the internet on this topic.

I could have explained the basics even without using any jargon but I want you to be able to read that Wall Street Journal article with confidence the next time you see it, so getting familiar with the jargon is essential.

What is an Asset Class?

An asset class is a group of ‘investments’ that share riskiness and return. Three main asset classes in stock market are stocks, bonds, and cash. Let us focus on stocks and bonds for now. Stocks are more risky but provide higher returns long term.

By risky, I mean the returns on stocks are more volatile – they might return 25% in a single year but might lose 25% of the value also in a given year. But over a long period of time, their annualized returns are most likely going to be higher than bonds.
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Bobby’s theory of Relativity

Time can be converted to Dime and Dime can be converted to Time. Read on to how what should you do (Time-> $ OR $ -> Time) and how should you go about doing it?

Albert Einstein proposed theory of relativity in the year 1905, whereby he established that matter can be converted to energy and energy can be converted to matter.

Today, I am proposing Bobby’s theory of relativity – it states “Time can be converted to money AND money can be converted to time”.

Time can be converted to money

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Shark Tank Audition

Read on to find out how my Shark Tank audition went and how I was sitting there documenting my thoughts so that I can share them with you.

This was the most beautiful face at the audition, so beautiful that I had to remove my face:

Winner of the ‘Most Beautiful Face at Shark Tank Audition, Miami, 3/3/2016’ (Awarded by One More Dime)

I had my Shark Tank audition on 3/3/2016 but I will still write the post as if this was today.

Here is how the day went:

I planned to leave at 6.30am – I was in my car at 6.35am. Continue reading