Understanding Tax Brackets – Podcast #196

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Podcast #196 Show Notes: Understanding Tax Brackets

Understanding how the tax brackets work will aid your tax planning and make for more informed, reasonable discussions of tax policy. People don’t actually grasp how tax brackets work and they routinely overestimate how much they pay in taxes. We think there are four reasons why tax brackets are hard for people to comprehend. Listen to this episode to find out what they are and to gain a better understanding of tax brackets.

For those with a firm grasp of how they are taxed, we also answer listener questions about choosing stock options or restricted stock units at your next job, what are the major classes of bonds the average DIY investor should understand and consider, which bond classes are least correlated with stocks, what a reasonable overall bond allocation is, bond classes that individuals who live in high COLAs should consider, AOTC tax credits, financial book recommendations for children, and non-governmental 457s.

Sponsor

If you have student loans, SoFi practically invented student loan refinancing in 2011 and right now they have the lowest starting fixed interest rates they’ve had in years, which could help you save thousands of dollars on your student loans. Plus, they just lowered rates for physicians and dentists still in residency. If you refinance your student loans through SoFi, you’ll get a $500 cash welcome bonus just for listeners of this podcast.

Terms and conditions apply. Not all products available in all states. Welcome bonus not available to residents of Ohio and cannot be combined with any other offer, bonus, or discount. SoFi reserves the right to change or terminate the offer at any time with or without notice. Recipient is responsible for any federal, state, or local taxes associated with receiving the bonus offer. See SoFi for more information. Loans originated by SoFi Lending Corp. CFL 6054612 NMLS# 1121636

Quote of the Day

Our quote of the day is very fitting. It comes from Martin Ginsburg. He said,

“As Forbes magazine with rare accuracy suggested a dozen years ago, tax shelter economics were so bad that 19 out of 20 investments could only be sold to groups of doctors. The 20th scheme was awful beyond belief and could be sold only to dentists.”

I think there is a lot of truth to that. So many doctors are terribly worried about taxes so they do all kinds of crazy things that cause them to come out behind even after taxes. You have to be really careful about that, as we will address in this episode.

Conference Registration

Our live, but virtual, conference is next month, March 4th through 6th. You can still sign up for that. Because of the virtual format, we have a ton more content in it and can charge you less for it. You can use your CME funds, as it offers CME, and write it off as a business expense, as well.

Coaching

If you are struggling with burnout or life balance and interested in physician life coaching, The Physician Philosopher’s Alpha Coaching service is opening for enrollment. The service includes an expanded self-coaching course library and a total of 36 coaching sessions with 2 group coaching sessions each week (1 for life/career coaching and 1 for money/business coaching) and once weekly 1:1 sessions. It offers a 14-day no questions asked money back guarantee. Get on the wait list before the 12th of February and buy it during the waitlist sale on the 12th and get $500 off.

 

Understanding Tax Brackets

One of the important financial things to understand in your life is how taxes work, particularly how the tax brackets work. In this episode, we are only talking about federal income tax. We are not discussing state income tax, payroll taxes like social security or medicare, property, gas, or sales taxes.

A Progressive Tax System

There are some things you should understand about federal income tax. The first is that it is a very progressive tax system. The fact is the way it works right now is that a little bit over 40% of people either pay nothing in federal income tax or actually get money back in federal income tax, not a tax refund but actually having negative taxes due to tax credits.

The top 10% of earners pay about 70% of taxes. The top 1% of earners pays 39% of taxes. So, it’s a fairly progressive system. You should understand that. As you make more, not only will you pay more money, but you will pay a higher percentage of your money. That is often described as tax brackets.

A tax bracket really helps you kind of comprehend your marginal tax rate. It’s really important that you understand the difference between marginal tax rates and effective tax rates. Marginal tax rate is the rate at which you pay taxes on the next dollar you earn. So, if you earn another $100 and $43 goes to the tax man, your marginal tax rate is 43%.

For your effective tax rate, you take all the dollars you pay in tax and divide it by the dollars you made. Your effective tax rate due to the progressive nature of the tax code is always less than your marginal tax rate. Your marginal tax rate might be 43% and your effective tax rate is only 19%.

For example, if you look at the 2021 brackets for unmarried people, these are for single people, you will see that the first almost $10,000 is taxed at 10%. You will then see the next $30,000 or so is taxed at 12%. The next $46,000 is taxed at 22%. Then the next $78,000 is taxed at 24%. The next $50,000 is taxed at 32%. Then the next $300,000 is taxed at 35% and everything beyond there is taxed at 37%. Now those brackets are a little bit bigger if you’re married, filing jointly, and actually vary a little bit if you file as a head of household, which usually means a parent and a child.

The standard deductions also go up with your filing status. In 2021, it’s $12,550 if you are a single. It’s $25,100 if you’re married filing jointly, and it’s $18,800 if you’re a filing as head of household. That essentially functions as a 0% tax bracket. As you go along, you fill up the brackets. Just because you get bumped into the next tax bracket, it doesn’t mean that all the money you make is taxed at 35% or 37% or whatever the next tax bracket is. Only the money you earn in that tax bracket is taxed at that rate. That is really important to understand.

Difference Between Taxes Withheld from Paycheck and Taxes Paid

Another thing that’s important to understand is that there is a difference between taxes withheld from your paycheck and taxes that you actually pay. The government has regulations on how much an employer must withhold from your taxes. There are penalties if you do not pay enough tax at the end of the year. You might have to pay penalties or interest if you don’t have enough withheld from your paychecks or that you send in voluntarily as quarterly estimated tax payments.

The federal income tax is a pay as you go system. You’re expected to pay as you earn the money. They enforce this by giving you penalties and interest if you don’t pay enough as you go along. So how much is enough? You have to be in the Safe Harbor. That means you either pay 100% of what you owe for that year within a thousand dollars. Or you can pay, for a higher earner, 110% of what you owed last year.

If you have any more than that withheld, if you have any more than that paid in estimated quarterly tax payments, you don’t get any benefit for that. They don’t pay you interest on it. Basically, you just gave the government a free loan. That is what the tax return is. It’s just the government giving you back the money that you loaned to them without any interest for up to 16 months. It can be even longer if you have a tax extension.

But you just need to understand that there’s a difference between what is actually paid, what you actually owe in taxes, and what is withheld from your paycheck, if you are a W2 employee.

Another factor that confuses a lot of people is that they don’t understand what federal income tax is. They’re assuming all this stuff taken out of their paycheck is all federal income tax. You have social security tax withheld. You have Medicare tax withheld. You might have some other stuff withheld. Those are not federal income taxes.

If you actually run the numbers, you will see that someone who has $100,000 in income will pay about 8.6% of that in federal income taxes, but their actual tax burden will be significantly higher than that. At that level of earnings, and particularly at levels of earnings under $100,000 a year, most of your taxes are actually payroll taxes, social security, and Medicare taxes.

Then, lastly, some people just get confused. If it’s taken out of the paycheck, they think it’s taxes, even if it’s paying for their health insurance or a 401(k) contribution. Just because it’s taken out of your paycheck, it doesn’t mean it is a tax.

Recommended Reading

How Tax Brackets Work

 

Reader and Listener Q&As

Stock Options vs Restricted Stock Units

“I have an option through my compensation for long-term incentives, which means a certain proportion of my salary is provided by the company in the form of either stock options or restricted stock units. There is a three-year vesting period for each. I’m just trying to figure out from my investment and tax perspective, what would be the best one to choose? Assuming all else being equal.”

Not a question we get very often because this doesn’t apply to doctors very often, but I’ve had to dive into it a little bit with my own company when we were deciding how to compensate our own staff. Basically, these two things are similar, but actually function fairly differently.

Restricted stock shares are actual equity that you’re given. You own the company when they give you restricted shares. Why are they called restricted? Because you can’t sell them for a while. A lot of times these are used if a company is already publicly traded.

They are usually vested, meaning that they’re given to you on the condition that you’ll keep working at the company for a while. If you don’t, you don’t necessarily get to keep them. That is not terribly different from stock options, which are often vested as well.

But an option is a promise of future profits. It may or may not pan out. With restricted shares, you’re going to own a piece of the company, no matter what. With stock options, the idea is that in the future you’ll be able to buy shares of the company at a lower price than what they’re then trading at. Of course, the difference is what you earned and what you are paid. You don’t have to keep the stock after that point. Once you exercise the option, you can sell it. But usually, you can’t do that for a certain period of time after the IPO.

But this is used in a lot in startups before they’re traded publicly, with the hope that you’re going to have this massive windfall down the road. That is the way it has worked out a lot in the Bay Area for a lot of these tech workers. They become millionaires when their company goes public and they get to exercise their stock options and make all kinds of money.

So, all else being equal, I guess I’d take the ownership of the company versus potential future profits, but the truth is all else is never equal. You just have to really examine both of those. The better you think the company is going to do in the future, the more likely you are to take the stock options over the restricted shares. Whereas if you don’t necessarily think it’s going to be spectacular in its growth, you may be more happy to actually get something because the stock options might be worthless if the company really doesn’t become valuable. Even if the company doesn’t become valuable, owning shares may still be worth a significant amount of money.

Major Asset Classes of Bonds

What are the major classes of bonds the average “do it yourself” investors should understand and consider? We think there are about six. A bond is a loan. It is a loan to an entity. They pay you interest for it. At the end of the period, when the bond matures, they give you your principal back. That is what happens if you buy an individual bond. If you buy a bond fund, the fund managers essentially are doing that same thing. The major asset classes of bonds are:

  1. Treasury bond. These are loans to the U.S government. They’re considered very high-quality, safe loans because they’re backed by the country’s ability to tax its citizens.
  2. Municipal bond. These are generally loans to states or local government entities. They’re considered slightly riskier than treasuries although the default rates are still very, very low. People worry about them a lot when they see these cities and states that aren’t run very well financially. The truth is, if you look historically, default rates are incredibly low on municipal bonds, but they’re a little more risky. The big reason why people may invest in municipal bonds is because the yields on them are federal income tax free. If it’s a bond issued by your state or municipality, it may also be state tax-free. Because of that, these are attractive for people who are in a high bracket and who are investing in a taxable account.
  3. Corporate bond. These are loans to corporations. You don’t own equity in the company. If the company does really well, you still only get what the bond promised to pay you. Of course, if the company goes bankrupt, you may not get anything.  However, you are more likely than an equity investor or a stock investor to get some money out in that situation because the bond holders get paid first before the stockholders do because they’re not owners, they are a creditor of the company.
  4. Treasury Inflation Protected Security or TIPS. These are inflation index bonds. One of the big risks with a nominal or regular bond is inflation. The idea behind the TIPS is that if unexpected inflation rears its ugly head, there’s actually an adjustment factor that you get paid more. So, it’s a treasury with an inflation indexed component to it.
  5. International bond. Rather than just loaning money inside the US, you can loan money outside the US to companies, to international governments, and get a little bit more diversification there.
  6. Savings bond. These are the EE bonds, which are nominal bonds, and the I bonds, which have an inflation adjustment similar to TIPS. The downside of these is you can’t buy a lot of them. You can basically buy $5,000 a year. Your spouse can buy $5,000 a year. I think if you use your tax return money, you can buy another $10,000 a year, but you are kind of limited. You can’t put a ton of money into these. They’re really designed for the individual investor, not a more wealthy investor or an institution.

Those are the major classes of bonds to consider. And even among all those bonds some of them are better than others. There are companies that are more likely to pay you back than others. So, the ones that are really unlikely to pay back are called junk bonds, and the better ones get higher ratings. But as you take on lower quality bonds where the likelihood of them giving your principal back starts to fall, you can earn higher yields.

Same thing with longer term bonds. As you take on that interest rate risk, the risk that interest rates will go up dramatically and decrease the value of your bond, you generally earn higher yields as well. So longer term bonds tend to pay more than shorter term bonds, which makes sense.

Which Bond Classes are least Correlated to Stocks?

“During times where US and international total stock index funds are performing poorly, which bond classes are least correlated?”

The safest ones. We’re talking about treasury bonds for the most part. If you really want to decrease your risk, you can choose very short-term treasury bonds with the short-term treasury bond index fund. That is a very safe bond. It’s very sheltered from default. It’s very sheltered from interest rate changes, but it’s probably not going to pay you all that much in yield.

However, when stock markets tank, a lot of times the bonds that do the best are not necessarily the short-term bonds. Sometimes they’re the longer-term bonds. Because often when markets are tanking, the economy is tanking, the fed cuts interest rates and dropping interest rates increase the price of long-term bonds more than short-term bonds. And so, in that effect, many times, as long as there is not a big bunch of high inflation that comes with it, a long-term treasury bond actually has the most negative correlation with dropping stock index funds. Not necessarily a reason to carry them, because then you’re taking on all of that interest rate risk, but that is the answer to the question.

Reasonable Bond Allocation

“What a reasonable overall bond allocation as a percent of total portfolio for someone 20 to 30 years out from retirement?”

Reasonable is a pretty wide range, anywhere from 0% to 50%. If you’re in that range at 20 to 30 years out from retirement, you’re in the range of reasonable. We have about 20% bonds in our portfolio and feel pretty comfortable with that. But we have also been through four or five bear markets and know that is enough bonds to stay the course with our plan. If you don’t have any idea how you’re going to react in your next bear market, maybe you want to hold a little bit more bonds. But those are all very reasonable numbers.

Jack Bogle gave a recommendation that you use a hundred minus your age. So, if you’re 25, he’d recommend that you have 25% bonds. If you’re 35, he’d recommend you to have 35% bonds. Some people are more aggressive, they say 120 minus your age. So, if you’re 20 years old, you’d have 0% bonds. At 30, you’d have 10% bonds. At 40 you’d have 20% bonds. At 50, you’d have 30% bonds. That is obviously also well within the reasonable range.

The key, like with all portfolio construction questions, is pick something reasonable that you can stick with for the long-term. Every asset class is going to have its day in the sun, and on that day you’ll be happy you own it. And it’s going to have times when you are not happy that you own it, and that’s the cost of diversification.

Reasonable Approach for Bond Allocation Between the Major Classes

“Within the bond allocation portfolio, what is a reasonable approach for determining the individual bond funds and some allocations such as total US bond versus short-term TIPS?”

There is no right answer to this. No one really knows. Half of our bonds are nominal bonds and half our bonds are inflation indexed bonds.

We figure the biggest risk to our portfolio is probably inflation. We think it is reasonable to have a pretty significant allocation to inflation indexed bonds.

Bond Classes for Individuals Living in High COLAs?

“Are there certain bond classes that individuals who live in high cost of living areas should consider such as municipal bonds? What happens when someone moves out of that state?”

It is not so much that you live in a high cost of living area; the issues are really your tax bracket and how much your state taxes your income.

For example, let’s say you’re in California and you are in the top tax bracket. You’re paying 37% federal and you’re paying 13.3%, I think it is, in state tax. If you’re holding bonds in a taxable account, municipal bonds are probably going to be pretty important to you. It is nice to have California municipal bonds that also don’t pay that 13.3% tax.

If you moved out of California, in that situation, those bonds would still be sheltered from your federal income taxes. But if you moved into Utah, for instance, you’re going to pay 5% on the proceeds of those municipal bonds, because they’re not Utah bonds. So, you still get the federal tax break. You wouldn’t get the state tax break, but hopefully, if you’re moving from California or New York or New Jersey, you’re going to a lower tax state anyway, maybe you’re even going to a no state tax like Nevada or Washington or Florida, but that’s basically what happens with it. So yes, municipal bonds and particularly municipal bonds in your state become much more attractive to you as you make more money.

Should You Diversify to International Bonds?

“In your opinion, should investors diversify to international bonds as they often do for stocks?”

We don’t own international bonds but don’t think it’s an unreasonable thing to do. They were not really accessible when we wrote up our investing plan 16 years ago, and we haven’t felt a huge need to add it to our portfolio. But it isn’t crazy if you put some of your money into international bonds. The key is to pick something reasonable and stick with it in the long run.

AOTC Tax Credits

“I’m a transitional year resident. I was wondering if you could talk a little bit more about the LLC and AOTC tax credits. My specific question is, would I be able to claim that tax credit, even though my medical school tuition in the spring of this year was paid with a scholarship as well as getting a little bit of money above tuition. So, I made $5,000 for school related expenses. I was wondering if I’d be able to claim that and would I need to have that $5,000 of extra scholarship money be counted as taxable income in order to be eligible.”

You want to take a tax deduction for something you never actually paid for? No, that’s not the way the tax code works. You can’t do that. If you go specifically to the IRS site and you read on the American Opportunity Tax Credit page, it says who is an eligible student for AOTC. To be eligible, you have to pursue a degree, enrolled halftime. You can’t have finished the first four years of higher education beginning of the tax year. You can’t have claimed it before. You can’t have a felony drug conviction. You have to get form 1098 T from an eligible educational institution and make sure it’s correct. Perhaps most importantly, you have to actually pay the bill.

Same thing, if you go to the LLC page, it says “to claim the LLC, you must meet all three of the following: 1. you, your dependent or a third-party pay qualified education expenses for higher education.” So basically the first thing is if you don’t pay, you cannot take the credit. That’s just the way it works. You can’t double dip there. You can’t take a scholarship and also get a credit for the scholarship.

Financial Books for Children

What financial books would we recommend for children?

Younger Children

  1. How the Moon Jar was Made
  2. Lemonade in Winter: A Book About Two Kids Counting Money
  3. The Go-Around Dollar
  4. A Chair for My Mother
  5. Ultimate Kids’ Money Book
  6. Pretty Penny Cleans Up

Teenagers

  1. The Richest Man in Babylon
  2. Smart Money, Smart Kids by Rachel Cruze
  3. Dad’s Guidebook: Finance: A Kid’s Guide to Saving and Investing
  4. The Millionaire Next Door

Parents

  1. Make Your Kid a Millionaire
  2. Silver Spoon Kids

Non-Governmental 457

“I had a question about contributing to a non-governmental 457. I was wondering if there were any resources, or should you “Benjamin Graham” it, when you’re thinking about actually contributing to your non-governmental 457? Is there maybe also a resource similar to Benjamin Graham security analysis when it comes to actually evaluating whether you should contribute to a non-governmental 457? Or even if the same principles of security analysis will go into contributing. I know that the 457 non-governmental that’s available has a BBB bond rating investment grade. So, is that enough or are there any other resources that I should look at or any other financials that I should evaluate in the hospital system and the employer to see how secure non-governmental 457 is?”

A 457 is tax-deferred compensation. It is money from your employer that basically they don’t give to you now, they will give to you at some later date. A lot of times they put it into an account that you can actually control the investments on. So, it’s kind of like a 401(k) that way. The contribution amount is exactly the same as your employee contribution to your 401(k), although the catch-up contributions work a little bit differently. Then you can control the investments and decide when you take the money out later.

But there are a couple of things to keep in mind. The first is you want to make sure the investments are good. If they’re just absolutely terrible investments, you may not want to use much of the 457.

The second thing you want to look at, whether it’s a governmental or a non-governmental 457, is what the options are to get the money out. With a governmental one a lot of times you can just roll it into a 401(k) or an IRA. With a non-governmental one that is not an option. So, you really want to look carefully at what the withdrawal options are.

Sometimes they make you take it all out in the year you leave your employer, which is obviously less than ideal. Sometimes you can spread it out over five years. Sometimes you can spread it out as long as you want. Sometimes you can wait 10 years and then you have to take it all out. But understand the options and make sure there is an acceptable one in there for you. That’s really, really important to understand.

The third thing is the one that this whole question is revolving around. With a governmental 457, essentially, it’s backed by the government. With a non-governmental 457, it’s backed by your employer. So, it’s really good for your asset protection. If you get sued, they can’t take your 457 money, but it’s subject to the creditors of your employer. So, if your hospital goes bankrupt, you could lose the 457 if it’s a non-governmental 457. So, this is the big risk. You defer all this compensation, then all of a sudden, they go out of business, and you don’t get that compensation. You want to make sure your employer is very stable before you use a 457 like this, at least in any significant way.

He is talking about trying to evaluate the stability of your employer. That is a pretty hard thing to do, especially if you’re going to be there long term. Because their fortunes today may not be the same as their fortunes in 15 or 20 years. The way most people do this is they just kind of ballpark it. If they’re hearing rumblings about the hospital going out of business, or they know that the hospital is not being run very well, they just avoid the 457 or they just put a little bit of money into it. Maybe you contribute for two or three or four years, but you don’t contribute for 15 years, for instance, because then you’d have a really big 457 in there.

We don’t think there is necessarily a right answer to trying to do a heavy-duty analysis on the value of your employer today, because it may change in 5 or 10 years. Certainly, you could dive into that. If you’re that worried about it, you probably ought to just limit how much you put into your 457.

We wouldn’t necessarily try to get all the financial statements for the hospital and pore through them before deciding whether to keep it or not. You’re not buying the hospital. It really doesn’t depend on their success whether you get your money. All they have to do is stay in business, which is a much lower mark than whether they’re going to be a successful investment on their own, which is really what a Benjamin Graham style security analysis would teach you how to do.

Recommended Reading

What You Need to Know About 457 Plans

Ending

If you need more information on taxes, read How Tax Brackets Work. If you like to have your voice and your question on the WCI podcast, submit it here.

Full Transcription

Intro:
This is the White Coat Investor podcast where we help those who wear the white coat get a fair shake on Wall Street. We’ve been helping doctors and other high-income professionals stop doing dumb things with their money since 2011. Here’s your host, Dr. Jim Dahle.
Dr. Jim Dahle:

This is White Coat Investor podcast number 196 – How tax brackets work.
Dr. Jim Dahle:
Welcome back. We’re recording this on the 21st of January. It’s going to run on February 4th. So, a little bit of a lag there. Hopefully nothing crazy happens in the financial world that makes this seem out of date when it runs. I really think about that after last winter, when we recorded a bunch of podcasts in advance and then of course the entire market went to hell in a hand basket. It was very much seemed out of touch a little bit some of our podcasts there until we caught up with the ones we recorded. So, you never know what’s going to happen. Maybe Bitcoin will drop by 90% or double or who knows what’s going to happen in the next two weeks.
Dr. Jim Dahle:
If you have student loans, SoFi practically invented student loan refinancing in 2011. And right now, they have the lowest starting fixed interest rates they’ve had in years, which could help you save thousands of dollars on your student loans. Plus, they just lowered rates for physicians and dentists still in residency.
Dr. Jim Dahle:
If you refinance your student loans through sofi.com/whitecoatinvestor, you’ll get a $500 cash welcome bonus just for listeners to this podcast. That’s sofi.com/whitecoatinvestor.
Terms and conditions apply. Not all products available in all states. Welcome bonus not available to residents of Ohio and cannot be combined with any other offer, bonus or discount. SoFi reserves the right to change or terminate the offer at any time with or without notice. Recipient is responsible for any federal, state or local taxes associated with receiving the bonus offer. See sofi.com/whitecoatinvestor for more information. Loans originated by SoFi Lending Corp. CFL 6054612 NMLS# 1121636

Dr. Jim Dahle:
All right, we’re going to be talking about taxes today. And our quote of the day is very fitting for this. It comes from Martin Ginsburg. He said, “As Forbes magazine with rare accuracy suggested a dozen years ago, tax shelter economics were so bad that 19 out of 20 investments could only be sold to groups of doctors. The 20th scheme was awful beyond belief, it could be sold only to dentists.”
Dr. Jim Dahle:
And I think there’s a lot of truth to that. So many doctors are just so terribly worried about taxes, that they do all kinds of crazy things that caused them to come out behind even after taxes. So, you got to be really careful about that. And we’ll talk more about that as we get into the podcast.
Dr. Jim Dahle:
Before we do that, I want to tell you about a couple of things that are going on. One, we’ve got the WCI con coming up. This is our conference. It’s live, but virtual this year, thanks to the pandemic, but it will be March 4th through 6th. You can still sign up for that at the website. You can go to whitecoatinvestor.com/conference and you can sign up to get that. It’s going to be really good.
Dr. Jim Dahle:
Because of the virtual format, we’ve got a ton more content in it and we can charge you less for it. And so, it’s just wonderful all the way around. You can use your CME funds for it. It’s got CME, it offers CME. And you can obviously write it off as a business expense as well. So, you can’t beat that, check it out.
Dr. Jim Dahle:
If you were interested in physician life coaching, and if you’re struggling with burnout or you’re struggling with balance, you may very well be. We want you to check out whitecoatinvestor.com/coaching. One of our partner sites, The Philosopher has an alpha coaching service that they open periodically. It includes 12 weekly group coaching sessions, as well as up to 8 one-on-one coaching sessions with an alpha coach, along with books, some video lessons, some tech support and a community of like-minded physicians. It offers a 14-day no questions asked money back guarantee. And if you register, meaning, get on the wait list before the 12th of February and buy it during the waitlist sale on the 12th of February, you get $500 off. Not a bad deal. So, check that out.
Dr. Jim Dahle:
All right, let’s talk about taxes for a minute. We do a lot of difficult things in our work, and I thank you for that, but you still have to understand a few financial things in your life. One of which is how taxes work. Particularly how the tax brackets work. And it’s pretty amazing actually. When you talk to typical Americans, including physicians, how few of them actually understand our tax code?
Dr. Jim Dahle:
Today, we’re talking about federal income taxes. We’re not talking so much about state income taxes. We’re not talking about payroll taxes, like social security and Medicare. We’re not talking about property taxes or gas taxes, or sales taxes. We are talking about federal income taxes.
Dr. Jim Dahle:
There are some things you should understand about federal income tax. One of the first is that it’s a very progressive tax system. Now, depending on where you fall on the political spectrum, you may feel like it’s not progressive enough, or you may feel like it’s overly progressive. But the fact is the way it works right now is a little bit over 40% of people either pay nothing in federal income tax or actually get money back in federal income tax. And I’m not talking about a tax refund. I’m talking about actually having negative taxes due to tax credits.
Dr. Jim Dahle:
The top 10% of earners pay about 70% of taxes. And the top 1% of earners pays 39% of taxes. So, it’s a fairly progressive system. And you should understand that. As you make more, not only will you pay more money, but you will pay a higher percentage of your money. And that is often described as tax brackets.
Dr. Jim Dahle:
What a tax bracket is, it really just helps you kind of comprehend your marginal tax rate. It’s really important that you understand the difference between marginal tax rates and effective tax rates. Marginal tax rate is the rate at which you pay taxes on the next dollar you earn. So, if you earn another $100 and $43 goes to the tax man, your marginal tax rate is 43%.
Dr. Jim Dahle:
The other tax rate is called your effective tax rate. And the way you get this, as you take all the dollars you pay in tax, and you divide it by the dollars you made. Your effective tax rate due to the progressive nature of the tax code is always less than your marginal tax rate. And so, your marginal tax rate might be 43% and you may find your effective tax rate is only 19%. And that’s just because as you go along, you fill the brackets. And that’s really, really important to understand.
Dr. Jim Dahle:
For example, if you look at the 2021 brackets for unmarried people. There are for single people. You will see that the first almost $10,000 is taxed at 10%. You will then see the next $30,000 or so is taxed at 12%. The next $46,000 is taxed at 22%. Then the next $78,000 is taxed at 24%. And the next $50,000 is taxed at 32%. And then the next $300,000 is taxed at 35% and everything beyond there is taxed at 37%. Now those brackets are a little bit bigger if you’re married, filing jointly, and actually vary a little bit if you file as a head of household, which usually means a parent and a child.
Dr. Jim Dahle:
The standard deductions also go up with your status. In 2021, it’s $12,550 if you are a single. It’s $25,100 if you’re married filing jointly, and it’s $18,800, if you’re a filing as head of household. And so, what that means, whether you itemize your tax deductions, basically we’re just talking about the ones that go on Schedule A, which is basically your mortgage interest, $10,000 of your state or property taxes and your charitable deductions are basically the main things that go on Schedule A.
Dr. Jim Dahle:
You either take the sum of all those, or you take the standard deduction, which is $25,100 if you’re married for 2021. And that essentially functions as a 0% tax bracket. Once you get down to your taxable income then all of that is taxed. But there’s essentially money above and beyond that, which is not taxed at all. And that’s covered by the standard deduction or your itemized deductions. And so, keep that in mind that it is entirely possible to have a taxable income of zero, if your income is low enough.
Dr. Jim Dahle:
All right. So, the way those tax brackets work. As you go along, you fill them up. Just because you get bumped into the next tax bracket, it doesn’t mean that all the money you make is taxed at 35% or 37% or whatever the next tax bracket is. Only the money you earn in that tax break, it’s taxed at that rate. And that’s really important to understand.
Dr. Jim Dahle:
Another thing that’s important to understand is that there is a difference between taxes withheld from your paycheck and taxes that you actually pay. Very different numbers, right? The government has regulations on how much an employer must withhold from your taxes. And there are penalties if you do not pay enough tax at the end of the year. Basically, if you have not paid enough tax throughout the year, you get penalized for that. You might have to pay penalties. You might have to pay interest. If you don’t have enough withheld from your paychecks or that you send in voluntarily as quarterly estimated tax payments. If you don’t have enough withheld, you may owe some penalties and interest when it comes time to do your tax return.
Dr. Jim Dahle:
It is a pay as you go system. My state taxes are not like that. In Utah you don’t have to pay the government anything until Tax Day. Until April 15th of the next year you don’t have to send them anything. And there’s no penalties whatsoever. And so, if you’re self-employed, you can just write one big check in April, no big deal. Obviously, if you’re an employee, they’re going to withhold something from you as you go along, but it’s not a pay as you go system.
Dr. Jim Dahle:
The federal income tax is pay as you go. You’re expected to pay as you earn the money. And so how they enforce that is by giving you penalties and interest if you don’t pay enough as you go along. So how much is enough? Well, you have to be in the Safe Harbor. That means you either pay 100% of what you owe for that year within a thousand dollars. You can be a thousand dollars off and still be okay, or you can pay for a higher earner 110% of what you owed last year.
Dr. Jim Dahle:
So, if your income is rising rapidly, you can be in the Safe Harbor even though you weren’t anywhere near in how much you paid as you went along through the year. Those numbers are a little bit lower for lower earners. It’s 90% or 100% instead of 110%. But it’s basically the same game being in that Safe Harbor to avoid taxes and penalties.
Dr. Jim Dahle:
If you have any more than that withheld, if you have any more than that paid in estimated quarterly tax payments, you don’t get any benefit for that. They don’t pay you interest on it. Basically, you just gave the government a free loan. And that is what the tax return is. It’s just the governor giving you back the money that you loaned to them without any interest for up to 16 months. And that’s what a tax refund is. It can be even longer if you got a tax extension.
Dr. Jim Dahle:
But you just need to understand that there’s a difference between what is actually paid, what you actually owe in taxes and what is withheld from your paycheck if you were a W2 employee. You can vary the amount that’s withheld from your paycheck, by messing with your W4. You can have more withheld. You can have less withheld.
Dr. Jim Dahle:
A couple of years ago, as part of The Tax Cut and Jobs Act (TCJA), they actually changed the numbers of how much was supposed to be withheld. And so, people started getting smaller tax refunds because the government wasn’t required to take as much money or the employer wasn’t required to take as much money out of their paychecks. And they were upset about it. They were mad about it because they’re like, “Oh, I get a smaller refund”. Well, you got to keep the money in the first place. It’s just silly to be upset about that, right? So, it’s really important to understand that difference.
Dr. Jim Dahle:
Another factor that confuses a lot of people is that they don’t understand what federal income tax is. They’re assuming all this stuff taken out of their paycheck is all federal income tax. You have social security withheld. You have Medicare withheld. You might have some other stuff withheld. Those are not federal income taxes. Just because you’re paying other taxes, it doesn’t mean you paid them in federal income taxes.
Dr. Jim Dahle:
If you actually run the numbers, you will see that someone who has $100,000 in income will pay about 8.6% of that in federal income taxes. But their actual tax burden will be significantly higher than that. At that level of earnings and particularly at levels of earnings under $100,000 a year, most of your taxes are actually payroll taxes, social security, and Medicare taxes. And so, be prepared for that.
Dr. Jim Dahle:
And then lastly, some people just get confused if it’s taken out of the paycheck, they think it’s taxed. Even if it’s paying for their health insurance or it’s a 401(k) contribution or something. Just because it’s taken out of your paycheck, it doesn’t mean it’s a tax. You have control over those things. If you don’t want to pay for health insurance, I suppose you can do that. I don’t recommend it, but you can do that. Even court ordered child support might be taken out of your paychecks but again, that does not qualify as a tax.
Dr. Jim Dahle:
Okay. Let’s move on to our next subject here. We’ll start with a question off the Speak Pipe. This one comes in from Alex.
Alex:
Hi Jim. I’m a research scientist from California who works for a large pharmaceutical company. I have an option through my compensation for long-term incentives, which means a certain proportion of my salary is provided by the company in forms of either stock options or restricted stock units. There’s a three-year vesting period for each. And I’m just trying to figure out from my investment and tax perspective, what would be the best one to choose? Assuming all else being equal. Thank you.

Dr. Jim Dahle:
All right, Alex. Great question. Not one I get very often because this doesn’t apply to doctors very often. Most doctors do not get restricted shares nor do they get stock options. Some I’ve had to dive into a little bit with my own company, with the White Coat Investor when we were deciding how to compensate our own staff. But basically, these two things are similar, should provide similar motivation to you, but actually function fairly differently.
Dr. Jim Dahle:
Restricted stock shares are actual equity that you’re given. You actually own the company when they give you restricted shares. Why are they called restricted? Because you can’t sell them for a while. That’s why. And a lot of times these are used if a company that’s already publicly traded. Not always, but a lot of times they are given at a company that is already publicly traded.
Dr. Jim Dahle:
They are usually vested, meaning that they’re given to you on the condition that you’ll keep working at the company for a while. If you don’t, you don’t necessarily get to keep them. And that’s not terribly different from stock options, which are often vested as well.
Dr. Jim Dahle:
But what an option is, is it’s a promise of future profits. It may or may not pan out. With restricted shares, you’re going to own a piece of the company, no matter what. With stock options, the idea is that in the future you’ll be able to buy shares of the company at a lower price than what they’re then trading at. And of course, the difference is what you earned and what you are paid. You don’t have to keep the stock after that point. Once you exercise the option, you can sell it. But usually, you can’t do that for a certain period of time after the IPO.
Dr. Jim Dahle:
But this is used in a lot in startups before they’re traded publicly, with the hope that you’re going to have this massive windfall down the road. And that’s the way has worked out a lot in the Bay Area for a lot of these tech workers. They become millionaires when their company goes public and they get to exercise their stock options and make all kinds of money.
Dr. Jim Dahle:
So, all else being equal, I guess I’d take the ownership of the company versus potential future profits, but the truth is all else is never equal, right? And so, you just have to really examine both of those. The better you think the company is going to do in the future, the more likely you are to take the stock options over the restricted shares. Whereas if you don’t necessarily think it’s going to be spectacular in its growth, you may be more happy to actually get something because the stock options might be worthless if the company really doesn’t become valuable. And even if the company doesn’t become valuable, owning shares, it may still be worth a significant amount of money. So, I hope that’s helpful to you.
Dr. Jim Dahle:
All right, our next questions came in via email. As part of a longer email, but I’ll spare you of that. The email said, “I’d greatly appreciate a more in-depth discussion on your podcast or elsewhere on bonds, since you have a great talent for explaining things in practical terms”. And then he lists five or six questions about bonds. So, let’s go through each of these one by one.
Dr. Jim Dahle:
What are the major classes of bonds the average “do it yourself” investors should understand and consider? Well, I think there’s about six. A bond is a loan. It’s a loan to an entity. They pay you interest for it. And at the end of the period, when the bond matures, they give you your principal back. And that’s what happens if you buy an individual bond. If you buy a bond fund, the fund managers, essentially are doing that same thing.
Dr. Jim Dahle:
So, the major asset classes of bonds. Well, perhaps the most important one is treasury bonds. These are loans to the U.S government. They’re considered very high-quality loans because they’re backed by the country’s ability to tax its citizens. And as you’ve learned, they can just issue debt if they want, right? And they basically create money out of thin air and give you your money back. And so, they’re considered very safe.
Dr. Jim Dahle:
Next step down is a municipal bond. These are generally loans to states or local government entities. They’re considered slightly riskier than treasuries although the default rates are still very, very low. People worry about them a lot when they see these cities and states that aren’t run very well financially. But the truth is, if you look historically default rates are incredibly low on municipal bonds but they’re a little more risky.
Dr. Jim Dahle:
The big reason why people may invest in municipal bonds is because they are federal income tax free. At least the yield on them is, the payouts, the coupon from the bond is a federal income tax free. If it’s a bond issued by your state or municipality, it may also be state tax-free. And so, because of that, these are attractive for people who are in a high bracket and who are investing in a taxable account.
Dr. Jim Dahle:
Basically, the municipality or state gets away paying less an interest because that investor after tax comes out ahead with a municipal bond than they would with a regular bond, whether it’s a treasury or a corporate. And so, they’re willing to take and buy those municipal bonds. So, for a lot of us that are in high brackets, when we invest in bonds in a taxable accounts, we use municipal bonds.

Dr. Jim Dahle:
The next step up in risk is a corporate bond. And these are loans to corporations. Maybe you’re loaning money to Apple or Ford or Exxon or whatever. You don’t own equity in the company. So, if the company does really well, you still only get what the bond promise to pay you. If it’s a 5% bond, even if the company doubled in price, you still only get your 5%. And of course, if the company goes bankrupt, you may not get anything. You may lose your money. However, you are more likely than an equity investor or a stock investor to get some money out in that situation because the bond holders get paid first. They get paid before the stockholders do. Because they’re not owners, they are a creditor of the company.
Dr. Jim Dahle:
So, we’ve talked about treasuries, we’ve talked about municipal bonds. We’ve talked about corporate bonds. One type of treasury that is worth understanding is a treasury inflation protected security, or TIPS. And these are inflation index bonds. One of the big risks with a nominal or regular bond is inflation. If inflation goes crazy, yeah, you’ll get your 5%, but inflation will have decreased the value of that bond by the time you’re paid back. And the idea behind the TIPS is that if unexpected inflation rears its ugly head, there’s actually an adjustment factor that you get paid more. So, it’s a treasury with an inflation indexed component to it. It makes it a little bit more complicated and sometimes surprises you how it acts in various different types of markets but the idea behind it is that it gives you more protection than a typical bond from inflation.
Dr. Jim Dahle:
Another asset class that a lot of people think about are international bonds. Rather than just loaning money inside the US, you can loan money outside the US to companies, to international governments and get a little bit more diversification there. Vanguard has started a fund like that a few years ago. They’ve incorporated it into all their target retirement funds and their life strategy funds. And so, that’s another asset class that people more frequently invest in.
Dr. Jim Dahle:
Other types of bonds. Well, there’s treasury or not treasury bonds, but savings bonds. These are the EE bonds, which are nominal bonds and the I bonds, which have an inflation adjustment similar to TIPS. The downside of these, if you want to buy a lot of them, it doesn’t work out very well. You can’t just walk in and buy half a million dollars of these. You can basically buy $5,000 a year. Your spouse can buy $5,000 a year. I think if you use your tax return money, you can buy another $10,000 a year, but you are kind of limited. You can’t put a ton of money into these. They’re really designed for the individual investor, not a more wealthy investor or an institution.

Dr. Jim Dahle:
So, those are the major classes of bonds to consider. And even among all those bonds some of them are better than others. There are companies that are more likely to pay you back than others. So, the ones that are really unlikely to pay back are called junk bonds, and the better ones get higher ratings, whether it’s a AAA or a AA or A or whatever. But as you take on lower quality bonds where the likelihood of them giving your principal back starts to fall, you can earn higher yields.
Dr. Jim Dahle:
Same thing with longer term bonds. As you take on that interest rate risk, the risk that interest rates will go up dramatically and decrease the value of your bond, you generally earn higher yields as well. So longer term bonds tend to pay more than shorter term bonds, which makes sense.
Dr. Jim Dahle:
All right, let’s take his next question. “During times where US and international total stock index funds are performing poorly, which bond classes are least correlated?” Well, the safest ones. We’re talking about treasury bonds for the most part. And if you really want to decrease your risk, you can choose very short-term treasury bonds with the short-term treasury bond index fund, that sort of a thing. And that’s a very safe bond. It’s very sheltered from default. It’s very sheltered from interest rate changes, but it’s probably not going to pay you all that much in yield.
Dr. Jim Dahle:
However, when a stock markets tank, a lot of times the bonds that do the best are not necessarily the short-term bonds. Sometimes they’re the longer-term bonds. Because often when markets are tanking, the economy is tanking, the fed cuts interest rates and dropping interest rates increase the price of long-term bonds more than short-term bonds. And so, in that effect, many times as long as there are not a big bunch of high inflation that comes with it, a long-term treasury bond actually has the most negative correlation with dropping stock index funds. Not necessarily a reason to carry them, because then you’re taking on all of that interest rate risk but that is the answer to the question.
Dr. Jim Dahle:
“What a reasonable overall bond allocation percentage is as a percent of total portfolio for someone 20 to 30 years out from retirement?” Well, reasonable is a pretty wide range. I would say reasonable is anywhere from 0% to 50%. If you’re in that range at 20 to 30 years out from retirement, I think you’re in the range of reasonable.

Dr. Jim Dahle:
Now I have about 20% bonds in my portfolio. I’m 60% stock, 20% real estate and 20% bonds. And I feel pretty comfortable with that. But I’ve also been through four or five bear markets and I know that that’s enough bonds for me to stay the course with my plan. If you don’t have any idea how you’re going to react in your next bear market, maybe you want to hold a little bit more bonds, than otherwise. But those are all very reasonable numbers.
Dr. Jim Dahle:
Jack Bogle gave a recommendation that use a hundred minus your age. So, if you’re 25, he’d recommend that you have 25% bonds. If you’re 35, he’d recommend you to have 35% bonds. Some people are more aggressive, they say 120 minus your age. So, if you’re 20 years old, you’d have 0% bonds. At 30, you’d have 10% bonds. At 40 you’d have 20% bonds. At 50, you’d have 30% bonds. And that’s obviously also well within the reasonable range.
Dr. Jim Dahle:
Nobody really knows the answer here. I think the key, like with all portfolio construction questions is pick something reasonable that you can stick with for the long-term. And every asset class is going to have its day in the sun and that day you’ll be happy, you owned it. And it’s going to have times when you are not happy that you owned it, and that’s the cost of diversification.
Dr. Jim Dahle:
“Within the bond allocation portfolio, what is a reasonable approach for determining the individual bond funds and some allocations such as total US bond versus short-term TIPS?” Well, people are all over the map with this. There is no right answer to this. Nobody really knows. I took that to be, well, maybe I’ll just split it in half. So, half of my bonds are nominal bonds and half my bonds are inflation index bonds.
Dr. Jim Dahle:
I figured the biggest risk to my portfolio is probably inflation. That’s the most common of the deep risks that Bill Bernstein talks about, it’s inflation. It’s much more common than devastation or deflation or confiscation, which are the real risks that investors face. And so, I think I think is reasonable to have a pretty significant allocation to inflation index bonds.
Dr. Jim Dahle:
But I’m probably a little bit out on the spectrum as far as that goes. If you look at something like how Vanguard makes its target retirement funds, they don’t put half of their bonds into a TIPS fund. They have a significantly smaller percentage of that. So, I guess, what, would reasonable be? Well, I would say anywhere from a 0% in TIPS to 50% of your bonds in TIPS, is probably the range of reasonable amounts to have in there.

Dr. Jim Dahle:
Okay. Next question. “Are there certain bond classes that individuals who live in high cost of living areas should consider such as municipal bonds and what happens when someone moves out of that state?” Well, it’s not so much that you live in a high cost of living area. The issues are really your tax bracket and how much your state taxes your income.
Dr. Jim Dahle:
For example, let’s say you’re in California and you are in top tax bracket. You’re paying 37% federal and you’re paying 13.3% I think it is in state tax. Well, shoot, if you’re holding bonds in a taxable account, yeah, municipal bonds are probably going to be pretty important to you. And it was sure to be nice to have California municipal bonds that also don’t pay that 13.3% tax.
Dr. Jim Dahle:
If you moved out of California in that situation, well, those bonds would still be sheltered from your federal income taxes. But if you moved into Utah, for instance, you’re still going to pay 5% on the proceeds of those municipal bonds, because they’re not Utah bonds. So, you still get the federal tax break. You wouldn’t get the state tax break, but hopefully if you’re moving from California or New York or New Jersey, you’re going to a lower tax state anyway, maybe you’re even going to a no state tax like Nevada or Washington or Florida, but that’s basically what happens with it. So yes, municipal bonds and particular municipal bonds in your state become a much more attractive to you as you make more money.
Dr. Jim Dahle:
“In your opinion, should investors diversify to international bonds as they often do for stocks? I know the Vanguard made the international bond a smaller ratio than the comparable international stock”. I think he’s talking about target retirement funds there. I’m agnostic on this. I don’t own international bonds. I don’t think it’s an unreasonable thing to do. They were not really accessible when I wrote up my investing plan 16 years ago. I haven’t felt a huge need to add it to my portfolio. I feel like it’s adding complexity without a lot of benefit to me.
Dr. Jim Dahle:
Do I think it’s crazy if you put some of your money into international bonds? Absolutely not. But it does add one more asset class to keep track of and rebalance. I’ve been pretty happy just owning US bonds for now. There’s no real right answer there. If you want to split your bonds between US and international, that’s not unreasonable. If you want some smaller amount in international, I think that’s reasonable too. I split my stocks two thirds US to one third international. That’s probably a reasonable thing to do as well with your bonds if you would like, but I think investors are all over the place there. And I think the whole range is pretty reasonable. The key is to pick something reasonable, stick with it in the long run.
Dr. Jim Dahle:
All right, let’s take another question off the Speak Pipe. This one is from Danny.

Danny:
Hi, I’m Danny. I’m a transitional year resident. I was wondering if you could talk a little bit more about the LLC and AOTC tax credits. My specific question is for me and it is, would I be able to claim that tax credit, even though my medical school tuition in the spring of this year was paid with a scholarship as well as getting a little bit of money above tuition. So, I made $5,000 for school related expenses. I was wondering if I’d be able to claim that and what I need to have that $5,000 of extra scholarship money be counted as taxable income in order to be eligible.
Dr. Jim Dahle:
All right. So, let me get this straight, Danny. You want to take a tax deduction for something you never actually paid for? No, that’s not the way the tax code works. You can’t do that. If you go specifically to the IRS site and you read on the American Opportunity Tax Credit page, it says who is an eligible student for AOTC. To be eligible you got to pursue a degree. You got to be enrolled halftime. You can’t have finished the first four years of higher education beginning of the tax year. You can’t have claimed it before. You can’t have a felony drug conviction. You have to get form 1098 T from an eligible education institution and make sure it’s correct. And perhaps most importantly, you have to actually pay the bill.
Dr. Jim Dahle:
Same thing if you go to the LLC page. It says to claim the LLC, you must meet all three of the following. One, you, your dependent or a third-party pay qualified education expenses for higher education. And if you don’t pay for it, you can’t claim the credits. So that’s basically the first thing is if you don’t pay, you cannot take the credit. That’s just the way it works. So sorry. No, you can’t basically double dip there. Take a scholarship and get a credit for the scholarship.
Dr. Jim Dahle:
Okay. Next question comes in via email. “What financial books are you recommending for your kids and at what ages?” All right. That’s a great question. It really depends on the kid and the age. If the kids are really young, there are some books out there you might consider that are designed for young kids.
Dr. Jim Dahle:
One is called “How the MoonJar was Made”. It teaches kids how to save and spend and share. “Lemonade in Winter: A Book about Two Kids Counting Money”. You might try that. “The go-around dollar”. This is by Barbara Adams and it shows how dollars move around through the economy. There’s a book called “A Chair for My Mother”, which talks about a daughter and a grandmother saving coins to buy a comfortable chair for the girl’s hardworking mother.
Dr. Jim Dahle:
Neale S. Godfrey’s “Ultimate Kids’ Money Book”. This is a mother, and a grandmother who was an executive at Chase Bank, who basically put a whole bunch of stuff about finance into a kid friendly guide. And the last one for younger kids is “Pretty Penny Cleans Up”. These are all books with illustrations, that kind of thing you would use to try to teach a younger kid about money.
Dr. Jim Dahle:
Once they get into the teenage years, I think you probably need to go a little bit more dense. Maybe you’re looking for a more of a chapter book than you are an illustrated book to read at bedtime. Some like maybe “The Richest Man in Babylon” might be a good choice. Rachel Cruze, Dave Ramsey’s daughter has a book out that’s kind of aimed at teenagers. You might take a look at that one.
Dr. Jim Dahle:
We reviewed one on the blog not long ago called a “Dad’s Guidebook: Finance: A Kid’s Guide to Saving and Investing”. You can find that review on the website. It’s a pretty short book, but talks about a lot of that stuff. That’s a good option for a teenager.
Dr. Jim Dahle:
If they’re getting to be an older teenager and they’re really interested in finance, you might try handing them something like “The Millionaire Next Door”. I’ve got “The Next Millionaire Next Door” right here if you’re watching this on YouTube. We had Sarah Stanley Fallaw on our podcast not long ago. She helped author that book and that’s a great option. It’s really important for kids to understand the main lessons in that book, which is that money is what you don’t spend. What your wealth is, is the money you don’t spend. Not the flashy stuff you see, the cars and the watches and the clothes.
Dr. Jim Dahle:
If you’re looking for books that are more about how you should interact with your kids, I’d recommend these two. This one is from Kevin McKinley. It’s called “Make Your Kid a Millionaire”. And it’s got some awesome stuff that really demonstrates the power of compound interest from starting to save early for your kids. Especially in something like a Roth IRA, but even just in a UTMA account, which is basically a kid’s taxable account, or even some annuity options and what you can do with that. So, lots of great options there for what you can do with your kids. But the book is not written for your kids, it’s written for you.
Dr. Jim Dahle:
And the other one is called “Silver Spoon Kids”, which I reviewed years ago on the blog. This one’s really good subtitled communicating about money in healthy ways, teaching strong values and compassion, preventing a feeling of entitlement, how successful parents raise responsible children. And if you worry about a lot of the issues that I worry about with my kids, that’s the book for you. I hope that’s helpful.
Dr. Jim Dahle:
All right, let’s take one more question off the Speak Pipe here. This one comes in from Ricky.
Ricky:
Hi Jim. I hope the situation in Utah is getting better. I assume it is as this is probably going to air later on. I had a question about contributing to a non-government 457. I was wondering if there were any resources or should you “Benjamin Graham” it when you’re thinking about actually contributing to your non-government 457. Is there maybe also a resource similar to Benjamin Graham security analysis when it comes to actually evaluating whether you should contribute to non-governmental 457? Or even if the same principles of security analysis will go into contributing.
Ricky:
I know that the 457 non-governmental that’s available has a BBB bond rating investment grade. So, is that enough or are there any other resources that I should look at or any other financials that you should evaluate in the hospital system and the employer to see how secure non-governmental 457 is? Thanks so much.

Dr. Jim Dahle:
Some of you might not have any idea what he’s talking about. A 457 is tax deferred compensation. It is money from your employer that basically they don’t give to you now, they will give to you at some later date. A lot of times, however, they put it into an account that you can actually control the investments on. So, it’s kind of like a 401(k) that way, the contribution amount is exactly the same as your employee contribution to your 401(k), although the catch-up contributions work a little bit differently. And then you can control the investments and then you can decide when you take the money out later.

Dr. Jim Dahle:
But there’s a couple of things to keep in mind with it. The first is you want to make sure the investments are good. If they’re just absolutely terrible investments, you may not want to use much of the 457.
Dr. Jim Dahle:
The second thing you want to look at, whether it’s a governmental or a non-governmental 4 57, is what the options are to get the money out. With a governmental one a lot of times you can just roll it into a 401(k) or an IRA. With a non-governmental one that is not an option. So, you really want to look carefully at what the withdrawal options are.
Dr. Jim Dahle:
Sometimes they make it, you take it all out in the year you leave your employer, which is obviously less than ideal. Sometimes you can spread it out over five years. Sometimes you can spread it out as long as you want. Sometimes you can wait 10 years and then you got to take it all out. But understand the options and make sure there’s an acceptable one in there to you. That’s really, really important to understand.
Dr. Jim Dahle:
The third thing is the one that this whole question is revolving around. With a governmental 457, essentially, it’s backed by the government. With a non-governmental 457, it’s backed by your employer. So, it’s really good for your asset protection. If you get sued, they can’t take your 457 money, but it’s subject to the creditors of your employer. So, if your hospital goes bankrupt, you could lose the 457 if it’s a non-governmental 457. So, this is the big risk, right? You defer all this compensation, then all of a sudden, they go out of business and you don’t get that compensation. So that’s obviously a bad thing.
Dr. Jim Dahle:
So, you want to make sure your employer is very stable before you take a 457 like this, for you to use a 457 like this, at least in any significant way. If the hospital seems to be going out of business, maybe you don’t want to use it at all. Maybe you don’t want to run that risk, just invest in a taxable account. It’s not that big of a deal.
Dr. Jim Dahle:
So, what’s Ricky talking about? He’s talking about trying to evaluate the stability of your employer. And that’s a pretty hard thing to do, especially if you’re going to be there long term, right? Because their fortunes today may not be the same as their fortunes in 15 or 20 years. And so, I think the way most people do this is they just kind of ballpark it. If they’re hearing rumblings about the hospital going out of business, or they know that the hospital is not being run very well, they just avoid the 457 or are they just put a little bit of money into it. Maybe you contribute for two or three or four years, but you don’t contribute for 15 years, for instance, because then you’d have a really big 457 in there.
Dr. Jim Dahle:
But I don’t think there’s any necessarily right answer to trying to do a heavy-duty analysis on the value of your employer today, because it may change in 5 or 10 years. Certainly, you could dive into that. I think if you’re that worried about it, you probably ought to just limit how you put into your 457. Maybe instead of putting in $19,500 a year, you put in $5,000 a year and you invest the rest in a taxable account just to hedge against that possibility of them going out of business.
Dr. Jim Dahle:
I don’t know that I would necessarily try to get all the financial statements for the hospital and pour through them before deciding whether to keep it or not. You’re not buying the hospital. It really doesn’t depend on their success whether you get your money. All they have to do is stay in business, which is a much lower mark than whether they’re going to be a successful investment on their own, which is really what a Benjamin Graham style security analysis would teach you how to do. I hope that’s helpful to you.
Dr. Jim Dahle:
As I said earlier on the podcast, right now, SoFi has the lowest starting fixed interest rates they’ve had in years on student loan refinancing, which means you can save thousands on your student loans.
Dr. Jim Dahle:
If you’re a physician or dentist doing your residency, SoFi also has new lower interest rates for you. If you refinance your student loans through sofi.com/whitecoatinvestor, you’ll get a $500 cash send directly to your bank account. That’s sofi.com/whitecoatinvestor.
Dr. Jim Dahle:
Terms and conditions apply. Not all products available in all states. Welcome bonus not available to residents of Ohio and cannot be combined with any other offer, bonus or discount. SoFi reserves the right to change or terminate the offer at any time with or without notice. Recipient is responsible for any federal, state or local taxes associated with receiving the bonus offer. See sofi.com/whitecoatinvestor for more information. Loans originated by SoFi Lending Corp. CFL 6054612 NMLS# 1121636

Dr. Jim Dahle:
All right. Be sure to check out our conference coming up at whitecoatinvestor.com/conference. Be sure to check out Alpha Coaching if you’re interested in a physician life coach service, with no risk to you. Remember, there’s a no questions asked two-week money back guarantee. That’s at whitecoatinvestor.com/coaching. You can get a $500 discount if you’re on that wait list by February 12th.
Dr. Jim Dahle:
Thanks to those of you who are telling your friends about the podcast and that given us a five-star review. Our most recent one comes in from Heather Fork who says, “I love this podcast! I just listened to the one on crushing student debt. It’s information that empowers. I’m sharing it with my physician coaching clients who have this burden of debt. I think the stories of young physicians “living like residents” in order to pay off their debt relatively quickly will inspire others to do the same. Thank you, Dr. Jim Dahle, for all the work and effort you and your team put in to create a very informative and empowering podcast!” Thank you for that, Heather.
Dr. Jim Dahle:
Head up, shoulders back. You’ve got this and we can help. We’ll see you at the White Coat Investor podcast.

Disclaimer:
My dad, your host, Dr. Dahle, is a practicing emergency physician, blogger, author, and podcaster. He’s not a licensed accountant, attorney or financial advisor. So, this podcast is for your entertainment and information only and should not be considered official personalized financial advice.

The post Understanding Tax Brackets – Podcast #196 appeared first on The White Coat Investor – Investing & Personal Finance for Doctors.

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