investment Archives - Evergreen Small Business

Trump Savings Accounts – Free Money from the Government

Christian Block CPA — Wed, 01 Oct 2025 17:59:58 +0000

Child focused tax benefits have taken on many forms over the years. We’ve had child tax credits, dependent care credits, education credits, 529 accounts, UTMA & UGMA accounts, and more. But, the recently passed One Big Beautiful Bill (OBBB) introduced something completely new: a federally seeded, tax deferred savings product for children known as Trump Savings Accounts.

This is a big deal that parents, grand parents, legal guardians, and even employers should pay attention to. The federal government is giving $1,000 to eligible new born babies. This isn’t a tax credit, a tax deduction, or anything else. It is actual cash the government deposits into a bank account. And that is just the beginning.

We’ll unpack what these new Trump Savings Accounts are, who qualifies, how to maximize contributions, and what they can be used for. We’ll also compare these to other accounts designed for children and see how they differ from what is already available.

What is a Trump Savings Account?

A Trump Savings Accounts is a tax-deferred custodial account that is structured like a Roth IRA. Qualifying children will receive a seed deposit of $1,000 from the federal government, beginning 1/1/2026.

To be absolutely clear, this is FREE money from the government! To qualify, a child only needs to:

Be a United States Citizen
Be born between 1/1/2025 and 12/31/2028
Have a Social Security number

No income limits for the parents or guardians exist. Every single qualifying child receives the seed deposit. However, parents and guardians can make additional deposits into the account as well. Lets dig into the details.

Contribution Rules and Limits

In addition to the government seed money, parents, relatives, friends, and even employers can make contributions into the savings account until the child reaches age 18.

The annual contribution limit is $5,000/child, indexed for inflation in future years. Employer’s can also contribute up to $2,500 per child, which counts towards the $5,000 contribution cap. Ignoring the inflation adjustments, it’s possible for a child to have $90,000 deposited into their account by the time they reach 18! That is serious money.

Contributions aren’t tax-deductible for the donor and aren’t treated as income to the child. The money grows tax deferred, however, until the child starts withdrawing the funds.

The IRS determines the tax rate on a distribution based on how the recipient uses the funds. The tax rate is the same as long term capital gains tax rates on qualified withdrawals. A qualified withdrawal includes the following:

Education, including tuition, supplies, & room and board.
Expanded definition of education to include certified trade and vocational programs
First time home purchase
Starting a business

If the recipient uses the money for anything else before turning 59½, they must pay ordinary income taxes and a 10% penalty on the amount withdrawn. These are the same consequences as taking a nonqualified distribution from a retirement account.

Account Investment Vehicles

The money must be invested within specific eligible investments as detailed in the OBBB. Eligible investment means any mutual fund or exchange traded fund which:

Tracks the returns of a qualified index
Does not use leverage
Does not have annual fees and expenses of more than 0.1% of the balance of the investment fund

The term “qualified index” means:

The S&P 500 market index, or
Any other index which is
- comprised of equity investments in primarily United States companies, and
- for which regulated futures contracts are traded on a qualified board or exchange

So how do you open an account?

Opening a Trump Savings Account

First, as previously discussed, you must have a qualifying child born between 1/1/2025 – 12/31/2028 to open an account. If qualified, there are two ways to establish an account:

Eligible custodians can manually open accounts after 12/31/2025 with an authorized financial institution.
If no eligible custodian establishes an account on behalf of a qualified child within 12 months of the child’s date of birth, the Secretary of Treasury shall cause an account to be opened in the name of such child and held by a designated institutional custodian.

The treasury hasn’t issued guidance or an approved list of authorized financial institutions at the time of this writing. But most likely, a majority of the major financial institutions (Fidelity, Vanguard, Ascensus, JP Morgan Chase etc.) will support the accounts.

Trump Savings Account Alternatives

Now let’s see how Trump Savings Accounts stack up against more familiar options like 529 plans and custodial accounts, and explore which might be the best fit for your financial goals.

As compared to Trump Savings accounts, Section 529 plans

Are designed to help families save for education-related expenses
Contributions are not federally deductible but are deductible in some states
No contribution limits and considered as gifts to minor
Can change beneficiary
Funds grow inside of the account tax free
Qualified withdrawals are not taxed, if used to pay for
- College tuition and fees
- K-12 tuition
- Room and board
- Books, supplies, and required technology
Non-qualified distributions are taxed at ordinary rates and subject to a 10% penalty

A Section 529 plan has the advantage over a Trump Savings Account IF the funds are used for college expenses. If flexibility is a priority, the advantage goes to the Trump Savings Account.

As compared to Trump Savings accounts, custodial Accounts (UTMA, UGMA)

Are designed to allow an adult custodian to manage assets of a minor child
Contributions are not federally or state deductible
No contribution limits and considered as gifts to minor
Cannot change beneficiary
Funds can be used for anything that benefits the child
No tax shelter treatment, income is subject to kiddie tax annually

A custodial account has the advantage over a Trump Savings Account when spending flexibility is the priority. However, there is little to no tax advantage like a Trump Savings Account provides. Verdict? Max out Trump Savings Account contributions first, fund a custodian account second.

Are Trump Savings Accounts a Good Deal?

For eligible families (those with children born between 2025 and 2028) they present a rare opportunity: a $1,000 head start, tax-deferred investment growth, and potential employer contributions.

While they don’t replace the role of Section 529s for education savings or offer the flexibility of UGMA/UTMA custodial accounts, they fill a new niche by helping families build long-term wealth for their children with minimal upfront cost. Like any financial tool, the value depends on your goals, but for many, opening one is a low-risk, high-upside way to diversify a child’s financial future.

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Super Safe Withdrawal Rate Calculator

Stephen Nelson CPA — Fri, 13 Dec 2024 18:15:48 +0000

The ‘super safe withdrawal rate” calculator below estimates certainty-equivalent returns and the Merton share.

You can use these certainty-equivalent returns as ultraconservative safe withdrawal rates. And the Merton share as the optimal allocation to stocks in your portfolio.

Click Calculate to see example calculations using historical averages. Or follow the instructions below the calculator to make your own personalized calculations.

Note: The initial default inputs use U.S. historical real average returns and volatility with one simplification: While the historical volatility of intermediate US treasury bonds equals 5 percent. I set this input to 0 (zero) to match the typical textbook treatment.

Equity Geometric Return (%):

Risk-free Geometric Return (%):

Equity Standard Deviation (%):

Risk-free Return Standard Deviation (%):

Equity Arithmetic Mean (%):

Riskfree Arithmetic Mean (%):

Equity Premium (%):

How Calculator Works

The super safe withdrawal rate calculator steps through three calculations.

First, it takes the average geometric returns expected from equities and risk-free assets and adjusts these percentages so they approximate arithmetic mean returns. (Mechanically, the formulas add one-half the squared volatility.)

Second, the calculator estimates the equity premium. (If equities return 7 percent and risk-free bonds return 2 percent, the equity premium equals 5 percent.)

Third, finally, the super safe withdrawal rate calculator estimates the certainty-equivalent returns (CERs) as well as the resulting Merton “equity allocation” shares suggested for the standard set of risk tolerances.

Personalized Super Safe Withdrawal Rate

To calculate a personal super safe withdrawal rate, replace the default annual average “geometric mean” returns for equities and risk-free bonds with your forecasted returns. And then also estimate the volatilty, or standard deviation, for both asset classes.

You may aleady have estimates for these inputs. But if you don’t? No problem. The large investment services also provide this information regularly. (See here, for example, for the December 2024 Market Outlook from Vanguard.)

Certainty-equivalent Returns and Merton Shares in a Picture

A simple line chart accurately shows how Merton shares and certainty-equivalent returns work (see below).

The blue line shows the average expected arithmetic returns for portfolios using a variety of stock allocations: 0%, 10%, 20%, 30% and so on. If the portfolio holds only risk-free assets, for example, the expected return equals the risk-free return. If the portfolio holds only equities, the expected return equals the equity return. In between those equity percentages, the expected return reflects a weighted average.

The line chart hints at the portfolio risks using those two dashed grey lines. They show the 25th and the 75th percentile returns. (All of these calculations reflect the historical real returns of US stocks and risk-free assets and their volatility. Also, in this chart to make it make sense, I did set the standard deviation of the risk-free assets to 5%.)

That green line shows the certainty-equivalent returns, or CERs, and graphically shows the utility the investor enjoys at various stock allocations. The green line flattens as the investor increases the allocation to stocks. That visually signals the diminished marginal utility. In effect, the formulas assume there’s a risk penalty diminishing the expected value.

By the way, the green line reflects a good guess as to the utility. The Python script that draws the line chart uses the standard utility function, or formula, economists think does a pretty good job. But the main takeaway here for non-economists? Sure, you and I get larger returns by allocating ever larger percentages to stocks (see the blue line). But risks explode as we do this (see the two grey dashed lines.) The utility we enjoy (see the green line) essentially tops out at the Merton share.

Historical Context Helps

Using the historical default numbers, which is what the line chart does, the Merton share formula suggests a 62.5% allocation to stocks based on a constant relative risk aversion equal to 2. (More on this constant in a minute.) So very close to the orthodox 60-percent stocks and 40-percent bonds asset allocation. Furthermore, the certainty-equivalent return per the formula equals about 3.56%. Which is interestingly close to the cannonical four percent safe withdrawal rate.

Personalizing Your Relative Risk Aversion

For practical purposes, the super safe withdrawal calculator above assumes your personal relative risk aversion equals 1, 2, 3, 4 or 5. The way the Merton share and CER formulas work, those values are sort of the standard “shoe sizes.”

Most people, according to the research, feel a constant relative risk aversion equal to 2 or 3.

A constant relative risk aversion equal to 1 might signal someone comfortable with a leveraged portfolio in many economic scenarios. (In late December 2024, a constant relative risk aversion equal to 1 would mean an investor focusing on only US stocks might invest between 60 and 65 percent of their portfolio in US equities.)

A constant relative risk aversion equal to 4 or 5 would suggest in the current market an allocation to US equities of maybe 10 percent to 15 percent.

Use CER as a Super Safe Withdrawal Rate?

The $64 question: Can you or I really use certainty-equivalent returns as a “safer” safe withdrawal rate? Good question. And one worth chewing over a bit.

Certainty-equivalent returns can provide a good safe withdrawal rate number. As noted, if you make the calculations using historical averages? The resulting Merton shares and CERs mesh with the almost canonical 4 percent rule and popular 60-percent stocks and 40-percent bonds asset allocation. But you need to be careful here.

True, using CERs as a super safe withdrawal rate delivers some unique benefits. The approach considers the risks of a particular portfolio. It explicitly addresses periods where expected returns going forward will probably be lower. (If you don’t like the idea of forecasting lower expected equity returns, you can surely see it makes sense to forecast lower expected bond returns if interest rates have dropped.) Further for investors with long retirements and who want to preserve their wealth? The ultraconservative nature of CERs mean they’re almost guaranteed not to fail. (If this sounds implausible, consider the CER percentages start lower. And then if portfolios shrink in value, that CER percentage probably increases but it also gets multiplied by the new year’s lower portfolio value.)

However, using the CER as a super safe withdrawal rate may not make sense in many situations. Currently, the formula returns a very low withdrawal rate for investors who limit their equity investments to US stocks. (The certainty-equivalent return in late 2024 might suggest a super safe withdrawal rate of less than 2 percent for an all US stocks investor.) The CER formula would also often result in investors simply not spending much of their retirement nest egg. (That doesn’t really make sure.) And the formula would tend to restrict a retiree’s spending. (That doesn’t sound great.)

Two Final Thoughts

A couple of other thoughts before I end.

First, if you’ve been using the four percent safe withdrawal rate, one way to maybe benefit from the super safe withdrawal rate calculator is to make the calculations for your portfolio. And then think about an average of the CER percentage and that four percent figure. That hybrid approach hedges your bets a bit.

A second idea: Calculating CERs and Merton shares may help you think about diversifying away from US stocks. (Adding more international stocks will make the numbers work better.) And doing the arithmetic may also help you more unemotionally calibrate your portfolio risks. (The CERs and Merton share math help you quantatively adjust your portfolio risk.) Those effects? Arguably pretty good.

Related Resources

This companion calculator and discussion may be interesting as you’re learning about this stuff: Merton Share Estimator.

This related discusion of the variability of portfolio returns may provide nice context: Retirement Plan B: Why You Need One.

I like the insights the Merton share and certainty-equivalent returns provide when thinking about retirement. But personally? I think it makes more sense to do Monte Carlo simulations to think about the risks. That topic is discussed in more detail here: Monte Carlo Safe Withdrawal Rates for Low Expected Returns.

Finally, if you’re struggling with the math and logic of certainty-equivalent returns and how lower-returning bonds can possibly help? Check this blog post: Monte Carlo Simulations Show How Bonds Dampen Retirement Risk. It provides a visual approach to exploring how risk-free assets can mostly dial down your risks during retirement.

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Merton Share Estimator

Stephen Nelson CPA — Fri, 13 Dec 2024 18:00:04 +0000

You can use rules of thumb to determine what percentage to allocate to stocks versus bonds. Like “60 percent to stocks and 40 percent to bonds.”

But Nobel Laureate Robert Merton developed a formula you can use to calculate a “Merton share” or optimal allocation to equities. The Merton share estimator below makes this calculation for you.

Note: Instructions and additional information appear beneath the calculator.

Merton Share Estimator

Geometric Equity Return:

Equity Standard Deviation:

Geometric Risk-free Return:

Risk-free Standard Deviation:

Constant Relative Risk Aversion:

Merton Share:

Merton Share Estimator Instructions

The Merton Share Estimator requires five inputs in order to calculate how much you or I should allocate to equities: equity return, equity standard deviation, risk-free return, risk-free standard deviation, and the constant relative risk aversion.

You should be able to get needed estimates of rates of return from the financial services company that holds your 401(k) or Individual Retirement Account. These firms also usually provide a volatility measure, too, which is the standard deviation.

Three tips here. First, if you’ve invested in several different equity classes with different expected returns? For example, if your equities allocation invests 50 percent in U.S. stocks expected to earn three percent and 50% in Non-US stocks expected to earn five percent? You calculate a weighted average return equal to four percent for the blended equities. For example:

50% * 3% + 50% * 5% = 4% weighted average return

A second tip: Adjust for inflation and work with real returns. That approach lets you use Treasury Inflation Protected Securities (TIPS) rates as the risk-free return. To adjust nominal equity returns for inflation, just subtract the inflation rate. For example, a six percent nominal equity return equates to a four percent real return if inflation equals two percent. For example:

6% nominal return – 2% inflation = 4% real return

A third tip: You can probably use historical standard deviations for your calculations. At least to start. Sometimes people say the standard deviation equals 15% roughly. Sometimes 20%. But an online tool like Portfolio Visualizer lets you calculate the actual standard deviation of blended portfolios of equities. Also, the CBOE VIX index shows the expected standard deviation on US stocks expected over the next month. (You can Google to get the most recent VIX value.)

Understanding Merton Share Estimator Calculations

A single formula calculates the Merton share. And that formula basically divides the equity premium by the squared standard deviation, or variance, of equities. So like this:

Equity Premium / Standard Deviation^2 = Equity allocation

For example, in a simple case where equities return two percent more than riskless investments and the standard deviation equals twenty percent? The formula might make this calculation and return .5, or 50%, thus signaling a 50 percent allocation to equities. Here’s the formula:

2% equity premium / (20% standard deviation ^2) = 50% equity allocation

But in practice, it’s a little more complicated. So let me drop down the rabbit hole for just a few sentences.

Nitty Gritty Details of Merton Share Estimator

To calculate the equity premium, the calculator assumes you’ve entered the expected, real, geometric mean return of equities and the expected, real, geometric mean return of risk-free bonds (like Treasury Inflation Protected Securities) along with the expected standard deviations of these two investment choices. (When a financial services company like Vanguard, Blackrock or Fidelity estimates the return you or I might earn from stocks or bonds over a decade? That’s a geometric mean, or average. It may also be nominal so including inflation. Or real, so adjusted for inflation.)

The calculator then estimates the real, arithmetic, mean return on equities and on risk-free bonds, and the difference between the two–which is the equity premium. (To make this estimate, the calculator uses a common but imprecise tweak: It adds half the variance, or the standard deviation squared divided by two, to the geometric return.)

To determine the appropriate allocation to equities, the calculator then does that simple division operation. But with another tweak, this one from Professor Merton. The formula actually divides by equity premium by the standard deviation squared, or the variance, times the constant relative risk aversion input. Thus the actual formula looks like this:

Equity Premium / (Standard Deviation^2*Constant Relative Risk Aversion)

The “constant” lets people assume different risk aversions. Research suggests many people have constant relative risk aversion equal to 2, a level which suggests some risk aversion. And the common range of constants runs from 1 (low risk aversion) to 5 (high risk aversion). For what it’s worth? I think my personal constant relative risk aversion equals 1 or 2. Most people’s relative risk aversion constant equals 2 or 3.

Note: Someone who is risk neutral or nearly so? Their relative risk aversion constant maybe equals 0. And in this case, they ignore risk and focus solely on the expected return.

Observations about Making Merton Share Estimator Calculations

Some quick observations about making Merton share calculations. And about using the calculation results to make better decisions.

First, the calculations suggest that we ought to often bear more risk than we do. Not always, no. And maybe not at the time I’m writing this in December of 2024, but usually individuals should bear more risk to earn higher expected returns.

A second point: The Merton Share Estimator’s calculations suggest that currently (late 2024) a smart way to dial down US investors’ risk is to invest more broadly than just in US stocks. If I model investing half in US stocks and half in international stocks, for example, the calculator suggests maybe a 70 percent allocation to equities for an average-ish risk aversion investor. If I model just investing in US stocks? It suggests less than a 40 allocation to equities for a low risk aversion investor and a 20 allocation to equities for an average-ish risk aversion investor.

Third, and this is personal and anecdotal… but I suspect the more you or I experiment with Merton share calculations? And the more you or I root around to get updated expected returns and standard deviations for stocks and bonds? Yeah. Okay. I think that may jack your or my constant relative risk aversion input. Thus, be careful.

Other Resources

The Super Safe Withdrawal Rate blog post provides a companion discussion and another calculator: Super Safe Withdrawal Rate Calculator.

Professor Merton’s research paper appears here: Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case

The authors of the book, “The Missing Billionaries,” use Merton’s share in their wealth advisory business. Lots of interesting insights appear at their website, including this one: Man Doth Not Invest by Earnings Alone. BTW, “The Missing Billionaires” is dense but a very interesting read.

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Estimating Investment Portfolio Returns and Values

Stephen Nelson CPA — Fri, 01 Mar 2024 17:44:09 +0000

Over the last few months, I’ve encountered investors, advisors and even some financial writers struggling to make or suggest good estimates of future investment portfolio returns.

No easy answer exists. But these inputs matter for planning.

And so maybe predictably, people fall into the habit of just extrapolating the past. Maybe assuming they, their clients or readers will enjoy the historical average return on stocks or on a balanced portfolio.

Starting with the historical average? That’s probably an okay place to begin. But I’m going to argue you and I want to make several adjustments to average returns to improve the usefulness of our forecasts. So let me share some thoughts and tips.

First Tip: Understand Whether Returns Adjusted for Inflation

A first quick tip: Understand whether you’re looking at real, adjusted for inflation, returns or not. Ideally you’ll work with real rates of return. (That’s best.) But if you must work with nominal, or unadjusted-for-inflation returns, be sure you know that. Because when you work with rates of returns without knowing whether the rates are real or nominal? It scrambles our ability to understand what’s going on.

A quick example to show you what I mean: Blogger Ben Carlson posted a few years ago that the worst-case all stocks return equals nearly 8%. He was talking about why you don’t need to worry about going all-in on stocks. Here’s the actual language:

The worst 30 year return — using rolling monthly performance — occurred at the height of the market just before the Great Depression and stocks still returned almost 8% per year over the ensuing three decades.

A little later in his post, Mr. Carlson acknowledged that his number ignored inflation. But that seems to me like a pretty important omission. Why? Because the adjusted for inflation return equals about 2.5%. That’s a huge difference.

If you earn an 8% return, you double your money every 9 years. If you earn a 2.5% return? You double your every 29 years.

By the way, you can tell Portfolio Visualizer, one popular tool, to adjust dollar amounts for inflation. You check a box. FireCalc and cFireSim both work in adjusted-for-inflation numbers.

But the big point here: Before you do anything else, nail down whether the numbers you’re looking are real or nominal, adjusted for inflation or not adjusted.

Second Tip: Recognize Variability in Investment Portfolio Returns

Another tip for thinking about returns and portfolio ending values. You and I aren’t guaranteed a predictable return if we invest in the stock market. Not even if we invest for a long time.

An example: If you invested $1,000,000 into your retirement account, paid a low .08% expense ratio for three decades, and invested 100% in US stocks, cFireSim says historically your results look like what show in the following table:

cFireSim Result	End. Bal.	Avg Return
Average	$7,153,315	6.78%
Median	$6,729,092	6.56%
St. Dev.	$3,152,110	N.A.
Highest	$16,396,431	9.77%
Lowest	$2,141,078	2.57%
Lowest 10%	$3,561,032	4.32%
Lowest 5%	$3,210,669	3.96%

Just to be clear, the median adjusted for inflation return equals roughly 6.56%. That’s good. You or I can easily prepare for retirement with that real annual return.

But the worst-case result equals 2.57%. Five percent of investors earned 3.96% or less. And ten percent of investors earned 4.32% or less. Those numbers are not as good.

And the main point: Earning 3% or 4% over three decades as opposed to the median 6.56% annual return? You’re talking probably about hundreds of thousands or even millions of dollars of difference, as the table above shows.

Thus we want to plan for this variability. Not ignore it.

A quick sidebar here: If you’ve read something that suggests differently? Let me make this observation. I will guess what you’ve heard goes like this: Sure, in short term? You absolutely might be up and down, gosh, 50% in any given year? But over time the zigs and the zags even out. That’s sort of true. But not true to a degree you want to rely on. As at least a couple of Nobel Prize winners, Paul Samuelson and Robert Merton, have pointed out. (Economist Zvi Bodie has a great free discussion of this topic here: Wishful Thinking About the Risk of Stocks.)

Third Tip: Model the Right Saving Amounts and Timing

A mechanical point next. Sometimes when you estimate returns and portfolio values, you’re calculating the future vale of a single initial lump-sum investment made up front. For example, you might make calculations similar to those reflected in the preceding table. There, I calculated historical returns and values for a single $1,000,000 investment made at the very start of a 30-year time span.

The numbers look differently however if you save annually. For example, if you save $10,000 at the end of every year. Or if you start with a $25,000 lump sum investment and then save an additional $5,000 each year.

Thus, you want to work with calculators that show the same pattern of investments you plan to make. The popular FireCalc website doesn’t let you do this very easily. Neither does the Portfolio Visualizer website or the PortfolioCharts webside. The cFireSim web site does let you do this easily.

Fourth Tip: Factor in Fees and Expenses

A drum lots of people bang on. But one worth hitting at least one more time. I’m using a low .08% expense ratio for the calculations here. That’s a “Vanguard-low” level of fees on the hodge-podge of mutual funds I actually hold. And you can almost ignore fees at that level. A fee set at .08% equals $800 annually on a $1,000,000.

But many folks are paying more than that for an investment advisor. And if someone pays a larger fee like 1%? One would want to subtract that fee from all of the percentage returns shown in the tables above.

An average real return of 6.56%, for example, shrinks to 5.56% if you’re paying 1% in fees.

A tenth percentile real return of 4.32% shrinks to 3.32%.

If you have to pay 1% for an investment advisor? Okay. I get it. But make sure you account for that.

And make sure you understand that in a worst-case scenario? Your investment advisor may be capturing nearly half of the historical real return.

Fifth Tip: Consider Current Market Conditions

Let me end with something more, er, controversial.

I think we want to consider adjusting return estimates for higher stock market values in the U.S. at least. And also for the long-term trend in ever-lower interest rates.

Some investors appear to still confidently predict the future will mirror the past. That appears overly optimistic to me. Good data exists which suggest interest rates have been trending down over centuries. (See here.) That surely means it’s reasonable to think about earning less on bonds if you’re including those in your portfolio.

Low dividend rates and high valuations suggest future equity returns should be lower than over the last century.

Personally? I’m using Vanguard’s market outlook as my long-term forecast. (An example appears here.) Vanguard supplies a range of nominal (so not adjusted for inflation) returns by asset classes, which is good.

Two Final Comments So I Don’t Leave You Bummed Out

Before I end, a couple of remarks.

First, the stuff in the preceding paragraphs? Just to be clear: I don’t think it means you or I go off and do something unorthodox.

We will want to follow the prescriptions given by like David Swensen, John Bogle, Burton Malkiel, Bill Bernstein, the Bogleheads forum, and anyone else promoting low-cost passive investing that emphasizes traditional assets classes. Especially equities.

Second, if outcomes look a little less rosy once you adjust for the things mentioned above? The practical way to address them for most folks is probably to save more or work a longer.

Some Other Resources Related to Investment Portfolio Returns

A discussion of why high valuations suggest longer-run returns: CAPE Fatigue.

The first post in a series about having a backup “plan b” for retirement: Retirement Plan B: Why You Need One.

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Monte Carlo Simulations Show How Bonds Dampen Investment Risk

Stephen Nelson CPA — Wed, 13 Dec 2023 12:12:20 +0000

Figuring out how much bonds dampen investment risk? Sometimes tricky.

You hear people offer bromides. Like “bonds provide ballast.” Or “bonds smooth returns.” But those truisms don’t really help you or me think objectively.

So this idea: Try plotting investment outcomes in a line chart that compares a portfolio that holds 100% stocks… to a portfolio that holds a balance of stocks and bonds. Say 70% stocks and 30% bonds. You can then visually see if and how much difference bonds make.

If you’re interested, I’ve got a free, downloadable Microsoft Excel spreadsheet that lets you this. But let me describe the approach I think works. And then I’ll walk you through the steps for using the spreadsheet for your own specific situation.

Plotting Monte Carlo Simulation Results

A problem to mention first, however. We don’t really have enough data to plot hundreds or thousands of investment outcomes comparing a 100% stocks portfolio to a 70% stocks and 30% bonds portfolio. If you want to look at 40-year accumulations or 40-year withdrawals? Well, the earliest usable stock and bond return histories for US investors start in 1871. That gives you or me less than four unique 40-year histories.

Thus, this idea: One can use average stock market returns and volatility to run a Monte Carlo simulation that plots likely scenarios. A bunch of likely scenarios. And then we can compare those. For example, you can run a 100 100% stock simulations. And 100 70% stock and 30% bonds simulations. Compare them using a line chart. And see how bonds affect the outcomes.

Charting How Bonds Dampen Investment Risk

The chart below does exactly this, plotting two simulations, one I’m calling the Red Portfolio and the other the Black Portfolio. The Red Portfolio results show as red lines and depict one hundred simulated “100% stocks” portfolios over 40 years. The Black Portfolio results aren’t fully plotted. To keep the chart legible, it plots two dashed black lines. The lines show the best-case and worst-case investment scenarios of a balanced portfolio that combines 70% stocks and 30% bonds. (You can click the chart to see a larger image.)

You may not even need me to explain this. But the dashed black lines show the benefit of adding bonds. You probably avoid those investment returns that show up as red lines that fall beneath the bottom black dashed line. All of those 100% stocks outcomes? Worse than the worst balanced portfolio outcome. But the other thing to note of course? You also probably lose upside when you add bonds. All those red lines that float off above the top black dashed line? All of those 100% stocks outcomes beat the very best balanced portfolio outcome. And that’s the way to visualize the trade-off bonds offer you and me. We probably dodge some downside. And probably give up some upside.

By the way, to keep the chart legible? It logarithmically scales the value axis for legibility. Thus, pay close attention to the scaling so the chart doesn’t mislead you. For example, while the upside risk and downside risk of using a 100% stocks portfolio visually look similar? Sort of a finger’s width? The logarithmic scaling means a 100% stocks portfolio might deliver way, way more upside risk than downside risk. (We’ll look at the actual numbers next section.)

A tangential comment? Note another reality suggested by the line chart. Over time, the range of returns for both the Red Portfolio and the Black Portfolio widen. That widening visually shows the passage of time does not remove risk. It increases the risk. (If time removed risk, the best and worst case scenarios would get closer and closer together… finally converging at some point in the future.) That’s interesting and something hard to understand until you actually “see” it.

The Good and Bad by Numbers

Take a peek at the green, red and charcoal spreadsheet fragments shown below. The green cells shown the input values: Starting balance, annual addition, growth in additions and then the two portfolio’s returns and standard deviations. The red and charcoal cells summarize the Red and Black Portfolio simulation results plotted in the chart just shown.

As you might expect, on average the higher risk Red Portfolio delivers a significantly higher average return (cells H5 and K5). Nearly one percent a year. That’s huge. And with that average annual return, an investor on average ends up with about $500,000 more money at the end of the four decades (cells G5 and J5). The higher average return of equities like stocks? The reason we all want to invest as much as we can bear the risk for.

Another tangential point: Online retirement planning tools like FireCalc and cFireSim don’t make it easy to see the downsize risk investors avoid by adding bonds. Or the upside reward bond investors lose. But as we’ve discussed in other blog posts ( Why Bonds Matter for Your Portfolio and Myth of the Long run Stock Market Return Chart), their historical data and calculations paint a similar picture.

Monte Carlo Simulations for Accumulations

If you’re ready to experiment with the free Monte Carlo simulations spreadsheet, download the spreadsheet (available here: RedPortfolioBlackPortfolio), and then follow these steps:

Enter the starting balance into cell B4.
Specify any additional annual amounts saved using cell B5.
If you plan to increase the annual saving amount, enter your annual percentage adjustment into cell B6.
Provide standard deviations for both Red and Black Portfolios into cells B8 and D8.
Estimate the average return by entering percentages into cells B9 and D9 for both Red and Black Portfolios.

The workbook automatically recalculates as you enter the data. But you can and should press F9 several times in a row once you enter all the inputs to see additional simulations.

Some quick notes too. First, the logarithmic line chart can’t display negative values. Thus, if a particular simulation results in negative value (signaling a loss), Excel ends the line. (I try to protect against this outcome in most cases.)

Second, Excel may not be able to calculate rates of return for all simulations in which case the outputs will show the #NUM error. (The error occurs typically when the simulation produces wildly extreme results.)

Third, on some computers and with some display property settings? Excel doesn’t always finish updating the chart for every simulation. (If you encounter this, save the workbook to force Excel to redraw the line chart. Or display another window and then redisplay the Excel program window.)

Monte Carlo Simulations for Withdrawals

That line chart show in the beginning? It tries to help you visualize accumulation scenarios with differently-risked portfolios. But you can also use the Red Portfolio Black Portfolio spreadsheet to simulate withdrawal situations, too. To try this, follow these steps:

Enter the savings at the start of retirement into cell B4.
Specify the annual withdrawal as a negative value using cell B5.
If you plan to increase the annual withdrawal—such as for inflation—enter your annual percentage adjustment into cell B6.
Provide standard deviations for both Red and Black Portfolios into cells B8 and D8.
Estimate the average return into cells B9 and D9 for both Red and Black Portfolios.

The spreadsheet fragment below shows how the inputs look for someone starting retirement with $1,000,000, planning to initially draw $40,000 but bumping this amount by 3% annually. The standard deviation and arithmetic mean inputs reflect a Red Portfolio invested 100% in stocks and a Black Portfolio invested 70% in stocks and 30% in bonds.

The line chart below shows a “withdrawals” Monte Carlo simulation. (Again, click the chart to see a larger image.) When a red or black line drops to zero or close to zero, that reflects a portfolio failure.

Note that nine or ten Red Portfolio lines drop to zero or nearly zero and so represent failures. That single black line doesn’t mean the Black Portfolio fails only once. That’s just the worst case Black Portfolio outcome. (The significant thing to notice here? The Black Portfolio maybe fails for the first time farther into the future. But you’d want to run several simulations.) Also note that three or four of the Red Portfolio failures occur nearly forty years into the accumulation. (That may not matter much.) The thirty year failure rate show above is 6% (6 out of 100 failures). Which roughly matches the conventional wisdom.

Three Final Notes

First of all, if you need help with the Red Portfolio Black Portfolio spreadsheet? Refer to the FAQ I created: Red Portfolio Black Portfolio Frequently Asked Questions. That resource answers a handful of questions and addresses some common issues (including how you come up with inputs to use for your modeling.)

Second, and related to the first point, if you get into this Monte Carlo stuff, know that you can get a good starter set of arithmetic means and standard deviations from Wade Pfau’s excellent resource: Historical Market Returns.

Third, we get so much content plagiarized at our blog, I put a password on the spreadsheet to make the theft a little harder. But if you’re interested in seeing the Microsoft Excel formula that calculates the returns? Just take a peek at this earlier blog post: Stock Market Monte Carlo simulation spreadsheet.

The post Monte Carlo Simulations Show How Bonds Dampen Investment Risk appeared first on Evergreen Small Business.

Why Bonds Matter for Your Portfolio

Stephen Nelson CPA — Mon, 21 Aug 2023 21:00:56 +0000

A couple of times recently, I’ve encountered people who argue you or I should not invest any part of a portfolio in bonds. Or who argue only a small percentage of a portfolio should go into bonds. Except if we’re retired. Or close to retirement.

But can I challenge that idea? Argue (politely) bonds matter in some cases? And then because it’s pretty obvious to me a number of vocal investors and even investment advisors don’t understand the math? Would it make sense to quantitatively show both how bonds help and hurt? I think so. So let me keep going…

The Big Bond Misunderstanding

I’m not absolutely sure about this. But in discussing with many investors why bonds don’t belong in an investment portfolio, two facts seem to be what “bond haters” focus on.

First fact? That over time, the average return on equities adjusted for inflation equals roughly 7% while the average return on bonds adjusted for inflation equals about 2%.

Note: I calculated these returns using cFireSim.com and Microsoft Excel on August 21, 2023. At that time, the actual average real return of an all-stocks portfolio equaled 6.64%. The actual average real return of an all bonds portfolio equaled 2.14%.

Second fact, that while stock prices and returns swing wildly from year to year, the variability dampens down over time. (This is true.) And this fact is often followed by a half-fact. If you can just hold stocks long enough, you win. (This is often the case but not necessarily true.)

Often if some writer is talking about this “all stocks” strategy, she or he includes a chart that shows how as time passes the annual return on stocks “reverts to the mean.” Or “averages out.” Here’s a crude version of one these charts I whipped up for another blog post, Unreliability of Long-run Stock Market Returns.

Figure 1

But chart above fosters a misunderstanding: We aren’t guaranteed to earn that better average return on stocks if we just hold on long enough. Yes, you or I will probably get a better result from an all-stocks portfolio. But we won’t for sure “guaranteed” get that. A significant chance also exists we’ll lose money with an all-stocks portfolio as compared to a balanced portfolio that includes stocks and bonds. Or that we’ll more likely run out of money in retirement if we use an all-stocks portfolio.

Because of this reality, some people probably want to include bonds in their portfolios. Who? People willing to trade away the higher upside from stocks and the likely higher average return for dodging some worst-case scenarios.

But Stocks Always Beat Bonds Right?

I’m going to get pretty gritty about the details in a few paragraphs. But before I do that? Let me first show graphically a very recent example where an all stocks portfolio loses compared to a balanced portfolio which holds 70 percent in stocks and 30 percent in U.S. Treasury bonds. Figure 2 below shows a line chart the Portfolio Visualizer Backtest Portfolio tool draws for three example portfolios. The blue line shows a 100 percent allocation to US stocks. The red line shows a 70 percent allocation to US stocks and a 30 allocation to US long treasuries. And the yellow line shows a 100 percent allocation to US long treasuries.

Figure 2

Two observations. First, if you started in 2020, over the next two decades, an all-stocks portfolio (the blue line above) performed more poorly than an all bond portfolio (the yellow line above). The all stocks portfolio only catches up in year 21. (This shows in the chart when the yellow line crosses the blue line.)

Second, even after more than 22 years? A balanced portfolio (the red line) beats the all stocks portfolio (again the blue line). No, you’re right. The all stocks portfolio may be ahead at year 25. Or year 30. (I hope it will be. I’m personally allocating 30 percent to US stocks.) But the line chart shown above doesn’t prove that if you or I just hold stocks long enough, we always win. In fact, it hints the opposite.

Note: If you use US intermediate treasury bonds rather than US long treasury bonds, the all-stocks portfolio looks better. But not much. And the intermediate treasuries still do reduce your downside risk over a couple of decades.

Calculating Downside Protection from Bonds

You can use another Portfolio Visualizer too, its Monte Carlo simulator, to assess example effects of adding bonds to your portfolio. Specifically, you can use that tool to get an idea as to how much upside risk you give away by adding bonds, how the average return probably shrinks by adding bonds, and then how the downsize risk probably lessens by adding bonds.

Just follow these steps, for example, to assess the downside risk avoided by adding bonds:

Enter https://www.portfoliovisualizer.com/monte-carlo-simulation into your web browser’s address box.
Set the Cashflows drop-down list box to “No Contributions or Withdrawals.”
Verify the Simulation Model drop-down list box shows “Historical Returns.”
Open the Intervals drop-down list box, and select Custom. Portfolio Visualizer adds two new text boxes: Percentile Intervals and Return Intervals.
Edit the Percentile Intervals values to show 1, 5, 10, 20, 30.
Set the Asset 1 drop-down list box to “US Stock Market.”
Enter 100 into the Asset 1 Allocation text box.
Click Run Simulation.
Check the Inflation Adjusted box.

Figure 3 below shows the line chart with the first, fifth, tenth, twentieth and thirtieth percentile outcomes for an all-stocks portfolio based on historical returns. (Click the image to see a larger version of the chart.)

Figure 3

To see what a 70-percent stocks and 30-percent US intermediate treasuries allocation looks like, follow these steps:

Enter 70 into the Asset 1 Allocation text box.
Set the Asset 2 drop-down list box to “Intermediate Term Treasury”.
Enter 30 into the Asset 2 Allocation text box.
Click Run Simulation.
Check the Inflation Adjusted box.

Figure 4 below shows the line chart with first, fifth, tenth, twentieth and thirtieth percentile outcomes based with an balanced portfolio generating historical returns

Figure 4

The big thing to note: The all-stocks portfolio’s worst-case scenarios? They’re worse, much worse, that the those that occur for a balanced portfolio.

The “Do Bonds Matter” Simulation Summarized in a Table

The line charts in Figures 3 and 4 make it hard to see precise numbers. But the table below shows the ending values from the two simulations to make comparisons easier.

Percentile	100 % Stocks Ending Value	70 % Stocks 30 % Bonds Ending Value
1st	$501,466	$844,396
5th	$1,101,634	$1,438,592
10th	$1,612,193	$1,881,653
20th	$2,496,579	$2,598,086
30th	$3,500,988	$3,310,787

Let me specifically call out four observations.

First observation, the calculations above don’t show actual three-decade long returns for the two portfolios. Not enough unique thirty-year historical outcomes “exist”. Thus, the simulation uses historical returns as the inputs to 10,000 different simulations. (The first percentile shows the average of the worst 100 simulations.) Also, note that if you run your own simulations using a starting value of $1,000,000, you’ll get slightly different ending values. That’s the nature of the simulation.

Second, the risk minimization you get with bonds? You see that by comparing the first percentile, fifth percentile, and tenth percentile ending values. In all those cases, the worst-case balanced portfolio investor ends up with—per the simulation—a few hundred thousand dollars ahead of the worst-case all-stocks investor. That’s the example benefit of adding bonds. Again, note that the investor in this simulation started with $1,000,000.

Third, somewhere between the 20^th and 30^th percentiles, the all-stocks portfolio beats the balanced portfolio. That makes sense. Most of the time, an all-stocks portfolio gives you a better return. That’s why you and I want to hold as large a percentage in stocks as we can. Especially early on in our saving.

Fourth, you probably ought to go back and redo your simulations so you can see how well the 50^th percentile, the 75^th percentile and 90^th percentile investors do too. Those investors make out like bandits by loading up on equities.

Just So There’s Not a Misunderstanding

To close, four tangential remarks about this “bonds matter” argument.

First, I’m not arguing everyone should load up on bonds. Rather, I’m trying to show quantitatively how bonds can reduce your downside risk.

Second, for what it’s worth, I’m thinking a modest allocation to bonds. Something like 30 percent. (That’s my actual allocation.) Or 20 percent. Or maybe 40 percent.

Third, I think we follow the suggestion of former Yale endowment fund Chief Investment Officer David Swensen and use U.S. Treasury Bonds and Inflation Protected Securities. (This suggestion from Swensen’s classic book, “Unconventional Success.“)

Fourth, let me reference a couple of related blog posts. You might want to peek at our Unreliability of Long Run Stock Market Returns blog post because it includes a full discussion of that “just be patient everything evens out” line chart that people commonly misinterpret. And you might also want to look at another article here: Rate of Return of Everything Line Charts. That blog post may be worth skimming too to get a good visual sense of the variability of stock market returns in different countries and over the last 150 years.

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Rethinking Retirement for Lower Real Rates of Return

Stephen Nelson CPA — Tue, 01 Nov 2022 12:35:49 +0000

The recent research paper, “Long-run Trends in Long-maturity Real Rates 1311-2021,” from economists Kenneth S. Rogoff, Barbara Rossi and Paul Schmelzing shares a fascinating observation: Over the last seven centuries, long-term interest rates have trended down at a slow, steady, pace.

The research provides economists and policy makers with new perspectives and insights. But it should also cause some individual investors and small business owners to rethink their retirement plans.

So I want to summarize the research, point out a couple of connections to retirement planning, and make three suggestions.

But let’s start with a quick review of the research.

Long-run Trends in Long-term Real Interest Rates

The research from Rogoff, Rossi and Schmelzing says that over the really long haul, long-term, real interest rates trend down at a steady .00016 percent each year.

Basically, a 1.6 percent reduction every century.

Four or five decades into the future, if the trend continues, long-term interest rates reach zero. Maybe even go into negative territory. At least per the trend line.

Only two shocks even break the 700-year trend. First, the bubonic plague pandemic in the 14^th century in which maybe a quarter to a half of the people in Europe died. So, to put that into context, a situation roughly one hundred to two hundred times worse than the COVID-19 pandemic.

And then the second shock? The big sovereign borrower defaults in the late 16^th century when three of the world’s largest governments (France, Spain and the States General of the Netherlands) defaulted on their loans.

The economists don’t explain why the long-run trend occurs. Or why it appears so steady. They do say the data doesn’t support the obvious or conventional explanations. Neither population nor output growth explain it, for example.

But despite the unanswered questions related to this new information? I think I see at least two connections to our retirement planning.

Past Returns Poor Predicter

A first obvious connection: The past may not be a great predicter of the future.

If long-term interest rates on the safest “sovereign borrower” loans, which the paper mostly looks at, steadily grind down? Gosh, that strongly suggests that the bonds many of us include in our portfolios will pay lower and lower interest rates over the coming decades.

Further, the steadily decreasing long-term interest rates paid by sovereign borrowers suggests that stock market and equity investment returns may steadily grind down, too.

The theory says that investment returns reflect the risk-free interest rate. Textbook formulas say the return on an investment should equal the risk-free rate plus a premium for bearing risk.

Thus, the unfortunate situation investors face: Not only are returns today probably lower than in the past. Going forward? They’re probably continuing to steadily decline.

A tangential comment: The popular financial planning tools FireCalc and cFIREsim look at 150-year-ish histories of stock and bond returns. That sounds pretty good as a sample size. But that may also mean they describe an investing environment where returns were maybe one to two percent above what you or I should expect in coming decades.

Note: It looks to me, as I write this in the fall of 2022, that the ten-year US Treasury bond rate is right on the long-term trend line.

Half-Century and Century Datasets Too Short

A second less-obvious connection: The steady 1.6 percent decline in long-term rates every century shows up only because Paul Schmelzing assembled a very large dataset. The researchers point out that looking at 75 years or 150 years? Not enough to spot the trend that appears once you look at the big data.

And so this notion: Working with financial planning tools (like FireCalc or cFIREsim) that predict on the basis of a 150 years or data? Or, worse probably, working with financial tools (like PortfolioCharts or Portfolio Visualizer) that predict on the 50 years of data? That seems like a bad idea to me if we’re trying to assess safe withdrawal rates.

Don’t get me wrong. I love those financial planning tools. They provide great insights.

But the small datasets they use? Yeah, probably those datasets aren’t large enough to let us see all the extraordinary economic shocks, so called tail events or black swans, that impact a safe withdrawal rate plan.

Another tangential comment: The Portfolio Visualizer also includes a Monte Carlo simulation. And that tool does provide a way to fold tail events and black swans into our planning.

Actionable Insight #1: Workers Need to Save More

Okay, so three quick suggestions as to what actionable insights investors can maybe draw from this new information.

First an insight for people still working and saving: If you’ve implicitly or explicitly based your financial plans on past returns? Probably you’re not saving enough. Or you’re planning to retire too early. Sorry.

You therefore probably need to save more, work longer, or a little bit of both.

Two ideas to throw out at you for saving more? First idea: You want to get as much remuneration as possible for your worktime. Anything you or I can do to bump our earnings a bit—like acquire a new skill—makes a huge difference. Maybe all the difference needed in fact. We want to focus then not just on the financial capital in our investment portfolios. We want to actively manage our human capital, too. (A longer discussion of this subject here: Human Capitalists in the Twenty-first Century.)

A second idea for saving more: If we’re going to work a bit longer—and two or three years should be enough to get back to plan—we want to do something enjoyable. Or mostly enjoyable. A role with interesting challenges. Something that keeps us socially engaged. Physically active.

Actionable Insight #2: Retirees Should Stay Alert

A second insight for retirees: You should not overreact to a long-run downward trend in interest rates and stock market returns. Lower real returns in the future does not mean your retirement plan fails. Rather, I think it means the chance of failure is a little higher than the popular financial planning tools show. Which you already know.

So a little extra frugality if you’re planning on a really long retirement? Maybe spending less when the stock market goes through a rough patch? That sort of thinking, to me, makes a ton of sense. Which again you already know.

Actionable Insight #3: Small Business Owners Reconsider Timing

A final thought for small business owners: If you own and operate a small business that gives you a good income? Especially a small business that keeps you intellectually stimulated and constructively engaged with life?

I’m just going to say it. You may want to delay your exit from the business. Your small business may not only provide you with a good income. The equity in your small business may significantly juice your investment portfolio returns.

Example: You’ve got a small business that makes, say, $250,000 a year. You could maybe sell the business for $1,000,000. After taxes you’ll net maybe $800,000. And that sounds pretty good. But what will you earn on the $800,000? Five percent? So $40,000 a year?

You got to think about whether you should delay the drop from $250,000 a year to $40,000 a year.

Related Resources

Here’s a link to the “Long-run Trends in Long-maturity Real Rates 1311-2021” research paper: click here to grab a copy you can read and ponder.

We’ve talked before about having a plan “B” for your retirement. This blog post might be helpful if you’re now a little bit perplexed: Retirement Plan B: Why You Need One.

Finally, if you’re interested in learning more about Monte Carlo simulations by building your own simple simulation spreadsheet, peek at these two blog posts: Stock Market Monte Carlo Simulation and Small Business Monte Carlo Simulation.

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Inflation Reduction Act: What Every Real Estate Investor Should Know

Beth Nelson CPA — Wed, 10 Aug 2022 15:00:40 +0000

On Sunday morning, the U.S. Senate passed the Inflation Reduction Act (H.R. 5376). Assuming the House passes an identical bill this Friday (and Nancy Pelosi says they will), taxpayers have a few new tax increases and scores of green tax incentives to sort through.

Tax increases in the bill

Here’s some good news: if you’re a small business owner or real estate investor, the Inflation Reduction Act probably doesn’t raise your taxes.

The major revenue raisers in this bill are:

A new book minimum tax for large ($1 billion+ average book income) C corporations
A new excise tax on stock buybacks (only applies to publicly-traded corporations)
Extension of excess business loss limitation rules from 2026 to 2028
Increased money for IRS enforcement

The extension of the excess business loss limitation rules will hit some real estate investors. But for most folks in this category, we think the increased money for the IRS will be the most visible and meaningful change to our tax system due to this law. As we’ve frequently noted on this blog, keeping good records and staying on top of your bookkeeping are the two most important ways to protect yourself in an audit.

Tax increases not in the bill

Back in the autumn of 2021, Democrats had proposed significant changes to the federal income tax code. In response to these proposals we wrote a blog post last September on the slow death of the S corporation, had the ideas become law.

Well, it turns out reports of the S corporation’s death were greatly exaggerated; the Inflation Reduction Act contains no changes to the net investment income tax, or NIIT. It also contains no changes to the basis step-up rules for inherited assets, no change to the unified gift/estate tax credit, and no changes to IRA contribution or distribution rules. In fact, we could write a whole laundry list of proposed changes that never found their way into the Inflation Reduction Act—and we have:

No change to top marginal rate for individuals
No changes to capital gains tax rates
No “billionaire tax”
No changes to SALT
No changes to 199A
No change to carried interest loophole
No change to 21% C corporation rate
No new limits on deductibility of interest expense for C corporations
No changes to limit 1202 exclusions
No changes to expand wash sale rules
No changes to foreign tax credit
No changes to GILTI, FDII, or BEAT

So, what else is in this bill? Well, a lot of climate change-related stuff.

Green tax incentives for real estate investors

Real estate investors may be interested in the bill’s tax incentives for green retrofits—especially if your building is in Washington State and subject to the Clean Buildings law.

For multifamily and commercial buildings: a 179D revamp

Section 13303 of the Inflation Reduction Act dusts the cobwebs off Section 179D of the tax code. The 179D deduction is, in essence, a depreciation acceleration trick similar to the Section 179 deduction small business owners are familiar with. The basic idea is if a real estate investor either (1) purchases a new energy efficient building or (2) makes a deep energy retrofit to an existing building, the investor can deduct a large chunk of the cost of that asset in the first year instead of waiting several years to deduct the cost as “depreciation expense.”

The amount a taxpayer can deduct up front is the lesser of either (1) the cost of the retrofit or (2) the result of a complex formula built around an efficiency engineering standard, ASHRAE Standard 90.1. Predictably, then, one of the rules for claiming a 179D deduction is that an independent licensed engineer (or in some cases, an architect) must certify the energy savings targets before the taxpayer can claim the deduction.

We’re not going to go into the nuts and bolts of the formula here, because really the way to claim this deduction is to hire a consulting firm staffed with tax professionals and engineers to design the retrofit to maximize the deduction for you. They’ll calculate your deduction and prepare a report for your regular tax accountant as part of that process. But here are a few key things to understand about Section 179D if you’re interested in this tax savings opportunity.

First, know that this deduction is for larger buildings: think commercial buildings, 4+ story apartment buildings, schools, hospitals, etc.

Second, know that a 179D deduction isn’t something to start thinking about when it’s time to prepare your tax return for the year. You need to decide whether you’ll claim this deduction before you begin the project. That’s because you’ll want to choose a design firm that really knows Section 179D and the ASHRAE standard it rests on, to make sure their design meets the tax law’s requirements. And if you want to claim the full deduction, not just part of it, you’ll need to be sure the building contractor you select for the construction work understands and complies with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules.

Third, for the sake of my own conscience, I feel I ought to point out that the consulting fees for calculating 179D deductions can be very expensive. And some big players have gotten into hot water after being fairly aggressive with this stuff.

Finally, this may be an odd thing for a tax accountant to admit, but there are options for funding deep energy retrofits that go beyond tax deductions and credits. For example, some sophisticated real estate investors in Seattle are experimenting with a novel transaction structure called the “metered energy efficiency transaction structure,” or “MEETS” for short. And King County recently launched a PACE loan program. Of course, we can’t endorse any particular financing idea for you if we don’t know your situation. But we want to acknowledge that there are many options to consider.

For buildings with a sunny roof: the commercial solar panel credit

Section 13102 of the Inflation Reduction Act extends the commercial tax credit for solar panels (in Section 48 of the IRC) to 2034, with a phase-out beginning in 2032. Starting January 1, 2022, your maximum tax savings will be 30% of whatever the panels cost your business or real estate activity.

Example: You install a $20,000 solar panel system on a duplex you own and lease to tenants. If you qualify for the credit and meet the wage and apprenticeship rules, the IRS will pay for 30% of the cost of the system—so, $6,000.

That probably already sounds pretty good. But here’s where the numbers get silly. In addition to getting a (usually 30%) tax credit, Section 48 “energy property” also gets a 5-year asset life under MACRS. What’s more, the section 48 credit reduces the basis for depreciation by only half the credit amount. And while you can’t use the Section 179 deduction on any property you’ve claimed the Section 48 energy credit on, for the next few years you can likely use bonus depreciation to achieve a similar result.

So, just to put this all together: if a landlord installs a solar energy system on a building it owns and rents to tenants, or a small business installs a solar energy system on a building it owns and uses for business, not only will the IRS pay for up to 30% of the cost of the solar panels, but the panels get depreciated over just 5 years (even though in reality the panels will likely last for 25-30 years). What’s more, even though you might think the depreciable basis would be the 70% of the cost of the panel the landlord or business owner paid themselves, really the basis for depreciation is 85% of the total cost of the panels (because only ½ of the credit is subtracted from the depreciable basis). And remember, just like any other 5-year property, the depreciable basis can be (at least partially) expensed using the bonus depreciation rules, depending on what year you install and start using the property.

Now, of course Congress has attached some strings to all of this free money. The panel system must be new, not used, and it needs to be located in the United States. You’ll also need to comply with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules, or the credit is only 6%. And you must hold the property at least 5 years or the IRS will recapture the credit.

One final comment: the Inflation Reduction Act adds 10% to your solar panel credit if you install the panels in a low-income community, and 20% if you install the panels on a qualified low-income residential building project. There are also bonus credits for using domestic content and for installing panels in an “energy community” (think West Virginia coal country).

For parking lots in low income or rural areas: the EV charger credit

Section 13404 of the Inflation Reduction Act extends and modifies the Alternative Fuel Refueling Property Credit. “Alternative refueling property” includes electric vehicle charging stations, so this credit is relevant for any building owner who would like to install EV chargers in their parking garage or parking lot.

The new EV charger credit rules apply to property placed in service after December 31, 2022, and the credit expires December 31, 2032. One notable difference between the Senate Finance Committee proposal and what passed the Senate last Sunday: this credit is now only available to EV chargers installed in low income communities and rural areas. It’s also worth noting that the Inflation Reduction Act modifies section 30C to make bidirectional charging equipment and charging equipment for 2- and 3-wheelers eligible for the credit.

Example: You own a small office building in a low-income community and install 10 level 2 EV chargers in the building’s parking lot for $3,500 each (including parts and labor). If you qualify for the credit and meet the wage and apprenticeship rules, the IRS will pay for 30% of the cost of the chargers—so, $10,500.

Predictably, there are some strings attached. The charger must be new, not used, and it needs to be located in the United States. To get the full 30% credit, you’ll need to comply with the Inflation Reduction Act’s new prevailing wage and apprenticeship rules; otherwise, the credit is only 6%. And the credit is limited to $100,000 per item of property (that limit used to be $30,000 and it used to apply per location, not per item).

The Inflation Reduction Act keeps language in the old statute which says recapture rules “similar to” the rules of 179A apply to the credit. Section 179A has since been repealed, and the IRS never actually put out formal guidance on how the recapture rules work. All we have is an 11-page notice, IRS Notice 2007-43.

For housing developers: the Energy Efficient Home Credit

If you’re a housing developer who specializes in building energy efficient homes, you’ve probably been watching this provision in Build Ba—er, the Inflation Reduction Act—for months. But for the sake of thoroughness, we’ll note that section 13304 extended the Energy Efficient Home Credit (in section 45L of the Internal Revenue Code) to 2032, increased the credit’s size, and modified the eligibility requirements.

The old version of the credit provided $2,000 to eligible contractors for each newly constructed or “substantially reconstructed” home if the home consumed 50% less energy than a comparable dwelling unit and had a building envelope that accounted for at least 1/5 of the energy reductions. The Inflation Reduction Act increases this amount to $2,500 for homes meeting Energy Star requirements and $5,000 for zero energy ready homes, assuming the project meets new prevailing wage and apprenticeship requirements.

The new credit rules apply to dwelling units acquired after December 31, 2022.

How the credits interact with utility rebates

One final thing I’ll mention is how the tax code treats utility rebates, and how those rebates interact with the tax credits I’ve described in this blog post.

In general, utility rebates are taxable income. But section 136 of the Internal Revenue Code says a taxpayer’s gross income doesn’t include “any subsidy provided (directly or indirectly) by a public utility to a customer for the purchase or installation of any energy conservation measure.” This section also says taxpayers can’t claim a tax credit or deduction for any amount paid for with this sort of utility rebate.

So, if you claim a rebate from your local utility for a purchase that meets the statute’s definition of an “energy conservation measure,” you won’t need to pay income tax on the amount, which is good. But you’ll also need to subtract that amount from the purchase price first before calculating any tax deductions or credits. For example, if you install solar panels on an apartment building you own and claim a utility rebate for the panels, and the rebate counts as an “energy conservation measure” under Section 136, you’ll need to subtract the rebate from the cost of the panels before calculating the credit.

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Tax Strategy Tuesday: Real Estate Professional Tax Strategy

Stephen Nelson CPA — Tue, 01 Feb 2022 16:39:26 +0000

A few weeks ago, I talked about one way to get big real estate tax deductions onto a tax return, the vacation rental tax strategy.

This week, I discuss a second way to qualify for big deductions. The real estate professional tax strategy.

If you’re a high-income taxpayer who wants to put big real-estate-related tax deductions onto a tax return? Yeah, this is an option you want to consider. Further, now, at the very beginning of a new year, is the time you want to start using this strategy.

But let’s dig into the details…

Note: We been blogging every Tuesday about tax strategies. Click here to see the complete list: Tax Strategy Tuesday.

Real Estate Professional Tax Strategy in Nutshell

The real estate professional tax strategy works mostly because of the depreciation deduction an investor enjoys.

Suppose you purchase a rental property for $1,000,000. Perhaps using a $100,000 down payment and a $900,000 mortgage. Say the tenants pay you $60,000 of annual rent. Suppose that amount covers the operating expenses and even pays the mortgage payment.

In economic terms, this arrangement may work beautifully. The property may be appreciating. The steady mortgage payments may over time pay off the loan. Probably, you’re making money.

But tax accounting rules allow you to add a large depreciation deduction to your return. In other words, even though your investment may slowly be growing in value, you can write off a loss each year on the property. Maybe, in fact, around $30,000 annually for a property like the one just described?

The problem is, most high-income investors don’t get to use that large depreciation-derived tax deduction. (Middle-class investors do by the way.)

Example: George and Martha earn $200,000 from jobs and own an investment property that generates a $30,000 loss due to depreciation. They would like to use the $30,000 loss to shelter some of their earned income. But they cannot. Tax laws limit their passive loss deductions.

Tax laws allow some taxpayers to use these passive losses, however. And one group who can? Real estate professionals.

Example: John and Abigail also earn $200,000 from jobs and also own an investment property that generates a $30,000 loss. John and Abigail can use the $30,000 loss to shelter some of the income they earn in their jobs. And the reason? Because John qualifies as a real estate professional.

Tricks that Make Real Estate Professional Tax Strategy Work

The trick to making the real estate professional tax strategy work? Qualifying as a real estate professional.

Essentially, tax law looks at two things.

First, does a taxpayer or one of the taxpayers on a married joint tax return work in “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”

Tip: By the way? The key word to pay attention to in the quoted language (which comes from the statute)? The word “any.”

Second, to qualify as a real estate professional, an individual must:

Spend more than fifty percent of their work time and more than 750 hours working in one or more real estate trades or businesses in which they materially participate.
Materially participate in the real estate investment generating the passive loss.

One final note about working in a real property trade or business. An individual qualifies as working in a real property trade or business if she or he owns a sole proprietorship or is a partner in a partnership that, for example, does development, construction, rental, management, or brokerage. And an individual qualifies as working in a real property trade or business if she or he works as an employee of a corporation and owns five percent or more of the business. But the work might rise to the level of material participation.

Example: John and Abigail, the married couple mentioned in the preceding example, show $200,000 of income from jobs on their tax return and a $30,000 real estate loss. They get to deduct the $30,000 loss because John qualifies as a real estate professional. One way John might qualifiy? If he owns more than five percent of a corporation that operates a construction trade or business and he materially participates by working more than 500 hours.

Possible Tax Savings from Real Estate Professional Tax Strategy

Structured correctly, a large depreciation deduction or a collection of deductions often shelters other highly taxed income a taxpayer earns.

Example: A single, self-employed real estate broker earns $300,000 working full-time at his business. He also invests in real estate properties and materially participates in their operation. As result, any loss generated by the investments shelter his income. If an investment breaks even in terms of cash flows but generates a $100,000 loss due to depreciation, for example? He nets the $300,000 of broker earnings with the $100,000 of the rental losses. The result? He pays income taxes on $200,000 and so probably annually saves $30,000 to $40,000 in federal and state income taxes.

If a married couple files a joint tax return and combines a high-earner with a real estate professional, the tax return can use real estate losses to shelter the non-real-estate-professional’s income.

Example: A married couple includes a high-earning spouse who makes $1,000,000 in a W-2 job and a spouse who works half time (so roughly 1,000 hours a year) managing the family’s rental property portfolio. The rental portfolio generates a small positive cash flow but on paper due to depreciation shows a $400,000 loss each year. The couple pays taxes on the $600,000 net income and probably saves about $150,000 in federal and state income taxes.

Turbocharging the Real Estate Professional Strategy

Typically real estate investors depreciate commercial property over 39 years and residential property over 27.5 half years.

If an investor buys a $1,000,000 property that represents $200,000 of land and $800,000 of building, the investor depreciates just the $800,000 of building.

To calculate the annual depreciation for an $800,000 commercial building, the investor divides the $800,000 by 39 years. So nearly a $20,000 annual depreciation deduction.

To calculate the annual depreciation for an $800,000 residential property, the investor divides the $800,000 by 27.5 years. So roughly a $30,000 annual depreciation deduction.

Taxpayers interested in larger deductions, therefore, may wish to focus on residential properties.

Further, tax laws do provide real estate investors with a trick to load more depreciation into the early years of ownership: cost segregation.

Cost segregation breaks down the building part of the property’s cost—so $800,000 in the preceding paragraph—into real property (depreciated typically over 27.5 or 39 years) and personal property (depreciated very quickly and maybe even mostly in the first year or two of ownership).

A $800,000 apartment building for example might be cost segregated into $600,000 of real property that the taxpayer depreciates over 27.5 years and $200,000 of personal property depreciated mostly over the first year or two of ownership.

Limits to Strategy

Starting in 2021, however, tax laws limit the excess business losses a taxpayer deducts in any one year to the amount of trade or business income shown on the tax return plus another $262,000 in 2021 and $270,000 in 2022 if unmarried or $524,000 in 2021 and $540,000 in 2022 if married.

This limitation means that the highest income taxpayers can’t always shelter all their W-2 income via the real estate professional tax strategy.

Example: A married couple includes an executive earning $2 million annually in W-2 wages and a spouse who manages the family’s real estate rentals. The property manager spouse qualifies as a real estate professional. And the rental portfolio loses (on paper) $1 million annually. For 2022, the couple however can only use $540,000 of real estate losses to shelter the W-2 income.

How This Strategy Can Blow Up

When it fails, the real estate professional tax strategy fails for one of two reasons. First, it fails because careless or poorly informed taxpayers lose some of their hours. Those lost hours? Investor activity hours when a taxpayer isn’t involved in daily operations. And property manager hours when a taxpayer hires an outside property manager.

Example: Thomas spends 1000 hours working in his real estate trade or business. That amounts to more than fifty percent of the time he works in a trade or business. And that time would appear to count as material participation. Accordingly, Thomas assumes he qualifies for the real estate professional tax strategy. Unfortunately, because he doesn’t get involved in daily operations of the properties, he cannot count 150 hours of investor-type activity. Further, because he hired an outside property manager, he cannot count 150 hours of property-management-type activity. With only 700 hours counting toward the 750-hour minimum threshold, he fails to qualify for real estate professional status.

A second reason the real estate professional tax strategy fails? Because an investor fails to create a time log that an auditor accepts. This is a sort of an unfair trigger to failure. The tax laws suggest a reasonable approach to the recordkeeping works and that estimates are okay. Auditors, however, often seem to want extremely high quality contemporaneous time records as well as third-party proof.

The Real Estate Professional Strategy Works Best for These Taxpayers

The real estate professional tax strategy works well for full-time real estate agents, brokers, and property managers who want to also directly invest in real estate.

The strategy also works well for individuals who own and operate real estate trades or businesses. So, like construction company owners.

Finally, high-income married couples can often make the strategy work extremely well. If one spouse earns a large income (say $1,000,000) and the other spouse manages the couple’s rental portfolio and generates large paper losses due to depreciation deductions (say $500,000 a year), the spouses can dramatically reduce their income taxes by netting the W-2 wages with real estate losses.

Other Information Sources

The passive loss limitation rules and the material participation rules get covered in depth in the Treasury Regulations for Section 469. That information merits close scrutiny.

We’ve also got some blog post that discuss in more detail how the real estate professional trick works, how investors count real estate hours, and how the IRS audits real estate professionals. That information should also be useful to people learning more about this gambit.

Finally, and as always, taxpayers want to discuss a strategy like this with their tax advisor. He or she knows the details of your specific situation. And this plug for our CPA firm: If you don’t have a tax advisor who can help, please consider contacting us: Nelson CPA.

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Tax Strategy Tuesday: Avoid Real Estate Net Investment Income Tax

Stephen Nelson CPA — Tue, 25 Jan 2022 16:27:09 +0000

Are you a real estate investor? And, just to get the awkward part over, have you been pretty successful with real estate?

I thought that might be the case. Which brings me to the point of this blog post. You should explore whether you can avoid net investment income tax on your real estate rental income and gains.

The net investment income tax—you may think of it as the Obamacare tax or NIIT—runs roughly 3.8 percent on your real estate profits. So 3.8 percent of your net rental income. And 3.8 percent of your gains when you sell property.

And then the reason for bringing this strategy up now, at the very start of the year. If you are going to avoid net investment income tax? You want to adopt the tax strategy discussed here now. At the very start of a year. That works best. It works easiest.

Note: We’ve been posting a new tax strategy for high income taxpayers every Tuesday for several weeks now: See here for the complete list: Tax Strategy Tuesday.

The Avoid Real Estate Net Investment Income Tax Strategy in a Nutshell

You maybe already know this. But if a single individual’s modified adjusted gross income exceeds $200,000 or married taxpayers’ joint return shows modified adjusted gross income that exceeds $250,000? The taxpayer or taxpayers pay a 3.8 percent net investment income tax on some or all of their real estate profits.

Note: Modified adjusted gross income essentially equals adjusted gross income. In most cases.

Many real estate investors, however, can sidestep the net investment income tax. The U.S. Treasury’s regulations describe a handful of ways to do this. But the easiest and cleanest way? Qualify as a real estate professional who materially participates in your investment properties.

The rules for being a real estate professional work pretty simply, fortunately. The taxpayer (if single) or one spouse (if a married couple files a joint return) needs to meet a material participation threshold and then also needs to spend more than fifty percent of work time and more than 750 hours a on something real-estate-y. Like being the family’s property manager.

A variety of material participation rules work. But the IRS provides a safe harbor formula for these folks that suggests 500 hours a year of participation. (The safe harbor appears in Reg. Sec. 1.1411-4 paragraph (g)(7) near the end of the page.)

Possible Tax Savings from the Avoid Real Estate NIIT Strategy

The savings from avoiding net investment income tax on real estate? Substantial for high-income real estate investors.

Say a married couple earns $200,000 in non-real-estate income. Maybe the income comes from a job. Or from retirement benefits. Further, say the investor also earns another $400,000 in real estate profits. This money might be from rental income. It might be from selling a property for gain.

If the married couple can’t avoid NIIT, they pay the 3.8 percent tax on $350,000. (The tax applies to the lesser of their real estate income or the amount their modified adjusted gross income exceeds $250,000.) That means roughly a $13,000 annual NIIT tax bill.

If they qualify as a real estate professional and meet the material participation requirement, however, bingo. They avoid the roughly $13,000 tax.

Turbocharging the Avoid Real Estate NIIT Strategy

First, and sadly, we regularly see returns for taxpayers who paid NIIT even though they clearly qualified as real estate professionals and should not have paid NIIT. Probably this error stems from either someone self-preparing their return or someone working with a low-skilled preparer who didn’t know enough to handle NIIT. The good news if you happen to be in this situation? You should be able to amend the last two or three years of tax returns. (Discuss this as soon as you can with your accountant.)

A second comment: If there’s a year in which you know you’ll report a big profit from your real estate investing—perhaps a property sale—that’s the year to work hard to qualify as a real estate professional.

One other thing to mention someplace in this blog post: At least a couple of other techniques for avoiding real estate net investment income tax appear in the Treasury regulations. Self-rental situations should often let someone avoid NIIT on real estate income, for example. And real estate developers who rent a property they’ve developed also have an easy way to at least temporarily avoid NIIT on rental income.

And then the regulations hint at some other possibilities. Like short-term rentals. And loopholes for farmers and ranchers.

The bottom line here: If you can’t get the real estate professional designation to work, don’t give up. Ask your tax advisor if one of the other loopholes let you avoid paying NIIT.

Limits to Avoid Real Estate Net Investment Income Tax Strategy

You, or your spouse if you’re married, needs to not only qualify as a real estate professional. You also need to meet material participation thresholds. That means you can’t use this tax strategy to avoid NIIT on passive real estate investments. Sorry.

Further, as we write this, the status of the Build Back Better Act is unclear. But the version of the legislation circulating right now (which may differ from the version that passes) closes this loophole for real estate investors who enjoy a taxable income of more than $400,000 if single and more than $500,000 if married.

We discuss how this proposal works here: Build Back Better Hits S Corporations and Active Real Estate Investors. But in a nutshell, someone with a taxable income that exceeds $400,000 or $500,000 begins losing their ability to avoid NIIT on real estate income, and these folks completely lose the ability to avoid NIIT once taxable income rises to $500,000 or $600,000.

The Avoid NIIT Strategy Works Best for These Taxpayers

The avoid real estate net investment income tax strategy only practically works for taxpayers with direct real estate investments. (Only these folks can usually pass the material participation test.)

It also works most easily for situations where the taxpayer or a spouse qualifies as a real estate professional because they already work 750 hours a year or more in a real estate trade or business. So, for example, someone already self-employed as developer, redeveloper, construction contractor, rental agent, property manager, real estate broker or agent. Or someone who already owns five percent or more of a firm engaged in these activities.

Note: Tax law provides this definition of a real estate business. “…the term ‘real property trade or business’ means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”

Other Information Sources

The IRS’s treasury regulations for passive losses and net investment income tax should be read thoroughly and referenced by the tax accountants using this strategy.

The taxpayer who runs this strategy probably also wants to get a good grasp of the rules for real estate professionals and particularly the mechanics of counting real estate hours. A person might also want to peek at the earlier Tax Strategy Tuesday post on real estate professionals.

Finally, confirm with your tax advisor about whether this strategy even makes sense. You might not want to go to the work of being a real estate professional if the savings amount to only a few hundred dollars a year, for example. And then, as always, if you have not yet found a tax advisor, please consider becoming a client of our CPA firm.

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