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My first encounter with AMT (Alternative Minimum Tax)

Life Planing & Money

Steps to Wealth

Saving = Income – Expense
Networth = Asset – Liability
Accumulating networth is a process by which one controls the expenses and trickle down the savings into growable assets, while reducing liability. 

Sounds simple?  Yes, it’s easier said than done.  But that’s how it always is.  If you don’t get a lottery income, or don’t inherit a substantial asset base like most people, then accumulating networth is a fairly slow process most of the time.  Definitely it requires lots of patience and fiscal disciplines.

Now let’s look at the two equations more closely.  The first equation describes the fruits of your daily activities.  By earning your income and controlling your expenses through budgeting, you can have savings.  These savings are the very first step to your wealth.  However small the savings may be, without it, one simply cannot get ahead financially.

In the second equation, it describes more of the passive side of money.  The liability or debt should remain fixed or paid down.  When acquiring new debt, you must have very good reasons, such as helping to increase your curent income or grow your asset faster.  Unless there is an extraordinary reason, you should always pay down at least the interest on the debt so that it doesn’t increase as time goes on.

The Asset term in the second equation is the most tricky and difficult one to handle among the four input terms on the right hand side.  How to invest your money in the right assets is an aged old question.  Your return on investment or ROI must exceed the general inflation rate, or else you will be losing purchasing power.  Investing can be active, but preferably be a passive activity.  How to invest is another topic all by itself.  However, both Saving and Investing are equally important to reaching wealth.

In a nutshell, save to increase your networth; invest to maintain (or increase) your existing wealth.

How I earn extra 1.45% return without risk in my 401k account

The annual 401k contribution limit is $15K in 2006 now.  Every year I always contribute to the max allowed by the law.  My company allows the worker to contribute up to 60% of the salary.  60% of my salary of about $100K is $60K, far exceeding over the $15K annual limit.  At the first thought, one would think that 60% is probably for the people whose salary is around $25K, but choose to crazily contribute 60% of the income into 401k account.  Obviously, I don’t know of anyone who can live on a $25K – $15K = $10K pre-tax income.  But after a little consideration, I find out this trick of earning extra 1% return without any risk in my 401k account.  Here is how I do it.  I simply contribute at the maximum possible rate of 60% at the beginning of every year.  My investment choice is usually cash/bond at Fidelity which is yielding about 3.8% APR.  Now if you look at the following comparison table, using 26 bi-weekly contributions:

   

1

 

     

576.92

 

   

2,307.69

 

   

2,307.69

 

   

2

 

     

1,154.69

 

   

2,307.69

 

   

4,618.76

 

   

3

 

     

1,733.30

 

   

2,307.69

 

   

6,933.20

 

   

4

 

     

2,312.76

 

   

2,307.69

 

   

9,251.03

 

   

5

 

     

2,893.06

 

   

2,307.69

 

   

11,572.24

 

   

6

 

     

3,474.21

 

   

2,307.69

 

   

13,896.84

 

   

7

 

     

4,056.21

 

   

1,153.85

 

   

15,071.00

 

   

8

 

     

4,639.06

 

   

 

   

15,093.03

 

   

9

 

     

5,222.77

 

   

 

   

15,115.09

 

   

10

 

     

5,807.32

 

   

 

   

15,137.18

 

   

11

 

     

6,392.73

 

   

 

   

15,159.30

 

   

12

 

     

6,979.00

 

   

 

   

15,181.46

 

   

13

 

     

7,566.12

 

   

 

   

15,203.65

 

   

14

 

     

8,154.10

 

   

 

   

15,225.87

 

   

15

 

     

8,742.94

 

   

 

   

15,248.12

 

   

16

 

     

9,332.65

 

   

 

   

15,270.41

 

   

17

 

     

9,923.21

 

   

 

   

15,292.72

 

   

18

 

     

10,514.64

 

   

 

   

15,315.07

 

   

19

 

     

11,106.93

 

   

 

   

15,337.46

 

   

20

 

     

11,700.08

 

   

 

   

15,359.87

 

   

21

 

     

12,294.11

 

   

 

   

15,382.32

 

   

22

 

     

12,889.00

 

   

 

   

15,404.81

 

   

23

 

     

13,484.76

 

   

 

   

15,427.32

 

   

24

 

     

14,081.39

 

   

 

   

15,449.87

 

   

25

 

     

14,678.89

 

   

 

   

15,472.45

 

   

26

 

     

15,277.27

 

   

 

   

15,495.06

 

Do you see how I end up extra (15495.06 – 15277.27) / 15000 = 1.45% at the end of the year?  After the year is over, all the money in both cases will be earning at the 3.8% APR.  However, by simply paying myself first before IRS every year, I end up getting extra $217.79 or 1.45% yield every year.  I have been doing this for the past five years, and IRS has never complained (since my 401k account gets to the money first).

This strategy is definitely not for everyone.  There are three problems with this:

  1. You need to have a sufficient cash reserve in the beginning of the year to cushion the lack of after-tax money coming in.
  2. Your contribution now is not at the even rate, and therefore, if you choose to contribute to other investment choices, you have extra risks of getting into market at the wrong time (or right time for that matter).
  3. If your company has 401k match, it is possible that you may lose some match dollars with this uneven contribution rate.

In any case, this shows clearly the advantage of paying yourself first over the tax man (especially if you are a business owner).  You can also do this outside of the 401k account, in the W9-form, where the paycheck withholding amount can be reduced in the beginning of the year, but then you pay extra at the end of the year to avoid underpayment tax penalty.  I use my tax calculator near the end of every year to underwithhold a little bit throughout the year, but catch up with extra tax payment at the end of year.  But of course, in that case, your extra dollars may or may not as far because although the total amount is not limited to $15K, whatever extra money that is earning returns needs to be taxed (at some 20, 30% marginal tax bracket) unless you put the extra money into your Roth IRA or (spousal) IRA accounts.  So don’t delay your contribution to Roth or regular IRA accounts until the April 15 of the next year.  You pay yourself extra one-time return by contributing on Jan 1st of that tax year which is 1 year and 3.5 months earlier than contributing at the last minute.  And if you do this every year, those extra one-time returns are not a one-time event, but a consistent annual extra return dollars that you pay yourself.

Gold & Money

Stock Option As A Leverage

Using Leverage / OPM&T: Other People’s Money & Time

About Life Insurance

How I Bank

I actually started online banking back in 1998/1999 when I first read an article on online banking in BusinessWeek.  I don’t remember which other bank it compares to, but I chose to give NetBank a try.  NetBank was one of the highest yielding banks in the nation at that time according to www.bankrate.com, and has been so until recent last 2 to 3 years.  I made sure that NetBank was listed at FDIC http://www2.fdic.gov/idasp/main_bankfind.asp database, and then I started my online banking.

In the beginning, I didn’t have a lot of trust.  So I started by depositing some small amount of money, and tried to withdraw money from my account by checks & ATMs.  After everything seemed to work fine without any problems, I started to move majority of my cash holdings to NetBank. 

Because of the inconvenience of online banking, mainly due to very few free ATMs, I keep accounts at two local banks.  In one local bank, I only have saving account to reduce the amount of money that I need to keep for minimum balance to avoid fee, since checking account usually has a higher minimum balance.  In another local bank, I have both checking and saving accounts, so that I have at least a checking account locally.  And my rationale to have two local banks is to simply increase the total number of free ATMs that I could use in a short distance from wherever I was.  Of course, if you don’t have enough cash reserve, you probably want to limit the number of banks you have.

This strategy of having an online bank and two local banks have served me well.  I can easily access my small cash need, while I can keep the majority of my cash in a higher yielding online account. Depending on your comfort level for accessible cash, you can put that amount in local banks, and put the rest in online accounts.  Since I conduct most of my purchases through credit cards, my need for cash is low.  I usually only keep about one thousand dollar in local banks, but it could vary from a few hundreds to just less than two thousands.  And to avoid all kinds of ATM & bank fees, I define my accessible cash as any amount over the minimum balance that is required to avoid monthly fee.  And I always use the ATMs of my banks.

I also take full advantages of (free) online payment offered by NetBank.  Every month or quarterly, depending on the bill frequency, I pay my electricity, gas, water, trash, home owner association dues, and two of my credit cards automatically.  My phone bill and auto-insurance is paid automatically through credit card instead of NetBank, since I can get the 1% cash rebate on credit card charges.  Having all the bill paying arrangements, I spend probably less than 10 minutes for viewing or paying all of my bills, excluding credit card bills.  And I make sure that there is sufficient amount of money for payments by setting up an automatic transfer of an upper estimate of the total bill from my major high-yielding money market account to the checking account that allows unlimited withdrawals.

In summary, I try to achieve the followings for my banking needs:

  1. Easily accessible cash by having two local banks.
  2. Higher yields for most cash in accounts at my online banks.
  3. Avoid any bank or ATM fees by using ATMs of my banks.
  4. Take full advantage for online bill payments to save time & stamps.

By the way, I opened accounts at INGdirect a few years ago, and now I’m still debating whether it is worth my time and trouble to move my INGdirect accounts to EmigrantDirect for their exceptionally high yields.

Marginal Tax Bracket

What’s marginal tax bracket?  The bracket determines how many cents you get from every additional dollar that you earns.  My marginal income tax bracket is about 25% federal + 9.3% CA state = 34.3%, which is more than one third.  Despite the original intention of our US progressive tax system, the payroll tax (social security & medicare taxes) of about 7.65% actually makes our tax system regressive, especially for the working people.  To illustrate this, I’ve done a couple of plots of marginal tax bracket for all the income and payroll taxes that you need to pay, starting from the very first earned dollar.

[plot for single, couples, couples with children]

As you can see, the marginal tax bracket is actually higher in the range of most working people.  Our government is really placing the tax burden on the majority of the working class.  And even with all the surpluses of social security and medicare taxes collected, our US government still out-spend the last dollar and shows a big red deficit in the final unified budget.

I have constructed a tax calculator for you to accurately calculate your taxes.  You’re welcomed to use it for your tax planning, or simply experimenting.

Inflation

Modern money is paper money since the world came off from the gold standard in early 1900.  One problem with paper money is that it is based upon confidence and trust, which can be fickle and fleeting sometimes.  When the confidence is suddenly gone, then you have an Asian currency crisis or Mexican Peso crisis.  The other serious problem with paper money is that government can print it in unlimited quantity.  Pretty much with any forms of government human can conceive of, all forms of government leads to monetary inflation.  The basic reason is that money can translate into power, and all forms of government are power-hungry.  With more money, politicians can please their voters in various ways they choose.  And so they either choose to print more, or borrow more, and both ways are inflationary.  The cycle of more money more power, and then more power more money is self-perpetual.  In this process, paper money gets debased constantly, and therefore you have inflation.

Monetary inflation complicates the savers’ goal.  Without inflation, the savers can simply save and store his or her wealth in whatever form he or she chooses.  He or she does not need to worry about losing purchasing power of his or her dollars in cash.  However, with constant inflation, even when it’s low, it’s simply a process during which the government steals from its dollar holders.

With inflation, the price of everything goes up, including the wage of the labor.  The lower class people who have minimal savings don’t have much to lose.  (Forgive me to use this political incorrect word “class”. )  Their wage is usually behind the curve of inflation, and therefore, their lives are a constant struggle to catch up with the last payment that is due.  The middle class people who have some savings face similar situation as the lower class people.  In a low inflationary environment, they can try to maintain their purchasing power with the limited venues of investment choices that they have.  But the most distinct advantage of middle class compared to lower class is that their major asset is their home which goes up in value via inflation, while their mortgage debt remains constant.  The upper middle and upper class people, because of their plentiful resources, usually have substantial wealth invested in assets and/or owning business that will go up in value in an inflationary environment.  Inflation always benefits more to the people who get their money first, such as businesses or government, while the inflationary effects propagates last to the wage earners.

Here is a calculator from US Federal Reserve,

http://minneapolisfed.org/research/data/us/calc/

As you can see, from 1913 to 2006, the US dollar has depreciated from $1 to $20.45, an astounding 95.1% loss in purchasing power, but only about 3.3% inflation rate compounded annually.  Is your bank account yielding more than 3.3%?

? Investing

Assets
If you think that first step, saving money, is difficult, the second step, investing, is actually more than twice as hard. However, when you get to the second step of the money problem, you should congratulate yourself. Because you have solved the first problem of money of not having enough money for your needs, now you’re onto the second problem of figuring out what to do with the extra money for your immediate needs.
Obviously you can’t begin to invest your hard-earned money, if you don’t know how much you have and what you currently own. To figure out your networth, you should inventory and categorize everything that you own. Here is the table for my networth:
[table for my networth]
Notice that the sum comes out to be 100%, which is my networth. Some people make a pie chart for their assets, which is a little misleading. The pie chart cannot show negative percentages for your liability. You can have very little networth, while having both a lot of assets and liability. In accounting terms, the amount of liability over your networth (which is called equity), or the debt/equity ratio indicates your ability to borrow money. Your financial leverage is directly proportional to the amount of assets over your networth. This leverage is a dual edged sword, and it can either help you or hurt you. I have reserved the details in another section if you are interested.
So the question comes why is investing important to your wealth? There are two reasons: 1. The power of compounding. 2. Inflation. Everyone knows the power of compounding. It’s the time value of the money available today. Compounding for positive returns in time the same money will worth a lot more in the future years. But it’s a lot easier to understand this than actually getting a consistently compounded return. In fact, there are many smart people spending their every second on Wall Street and other financial markets, constantly trying to figure out how to get more money out of existing money. I will continue in why investing, and leave how to invest in another section (Efficient market & frontier).
The second reason that you should invest is because of inflation. Ever since the world comes off the gold standard, we are faced with ever growing and diluting supply of paper money. If inflation rate is zero, then there is no urgent need to invest. Since the creation of the US Federal Reserve System in 1913, $US purchasing power has been diluted by more than 95% ($1 in 1913 can buy $20.45 in 2006). It means that if your compounded annualized return of investment is not more than 3.3%, you would have lost your purchasing power. I don’t know about yours, but my money market account at NetBank (bank websites) only yields 3.52% APY, barely above 3.3%, and it’s one of the highest yields in the nation. Inflation is basically an on-going robbery by governments stealing from middle and lower class people. People in lower class have no other financial resources besides their time and labor which tracks behind the general inflation trend. People in middle class have limited amount of savings to rely upon, but often cannot generate sufficient returns to combat the erosion of purchasing power by inflation. Their biggest asset is often the home that they own which fortunately tracks inflation, while at the same time, their fixed mortgage debts are debased through time and inflation. Therefore, under normal circumstances where housing price tracks general inflation, I will advise anybody to buy a home for both inflation reason and also for the amount of financial leverage that it can provide. The leverage comes in when you make just a down payment for the asset that you purchase. A 20% down payment gives you 5 times the financial leverage, and a 10% down payment gives you 10 times the financial leverage. Your return on your down payment is essentially multiplied by the amount of financial leverage that you have, whether it’s positive or negative! Therefore, under normal circumstances, since housing price always track inflation rate, and that inflation rate is pretty much guaranteed to be positive 2 to 4%, buying a home will be the single best investment that you can make, assuming that you can afford it (Again, I emphasize normal)!

California housing boom or bubble?

For the people who don’t live in California, you may be thinking that I got to be joking to have a gain of $260K on a small condominium, which can be more than the price of a single family house in some other states. But for the people in California who are not home owners of a single family house, this is a harsh reality that they need to face everyday.  Most people can't ever make up the wealth gap of $300K to even $600K comparing to the lucky homeowners.

For the people who argue for the continuing of the housing boom, their list of upside reasons is endless: California has very good weather, plentiful jobs and diversified economic growth, increasing population & immigration, etc.  But none of them can tell me why the housing price was half or even a quarter of the current price eight years ago, when everything that they claim was also true six years ago.  It's almost like saying that group A (in 2000) took a placebo pill (which is the good weather & economy), and that group B (in 2006) also takes a placebo pill, but group B recovered from the disease, mainly because of the effectiveness of the placebo.

To me, I believe that the single most influential factor was the interest rate cuts by US Federal Reserve.  The list of why California is better may help the boom compared to mid-west, but is definitely not the direct reason.  Without holding the short-term interest rate at 1% for more than 1 year, real estate wouldn't never go as high as it did without any doubt.

I'm personally in the bubble camp for 6 years and counting.  The entire process of watching the house that I really want to buy for my family, to keep going up without an end in sight, has been simply tormenting.  I wish 6 years ago I was either wealthier or had my current salary.  Everytime when my networth finally increased by another $100K, the housing price simply has gone up by more than that amount.

So when will the housing stop going up, or will it?  According to Didier Sornette, the author of "Why stock markets crash", his prediction is this year in mid-2006: http://arxiv.org/PS_cache/physics/pdf/0506/0506027.pdf

Or click on "Is There a Real-Estate Bubble in the US?" at his web page: http://www.ess.ucla.edu/faculty/sornette/books.asp

I don't know if it's true, but his theory on the mathematical behavior of an unsustainable bubble is the one of the most interesting readings so far that I've come across.

Markets can be temporarily (or for a long time) out-of-synced with the fundamentals.  The market price is always the fair price at the current moment between buyers and sellers, but that does not preclude one to come up with a valuation measure on its price.  I've constructed a comprehensive housing valuation calculator to objectively assess the price against the owner's equivalent rent (which is used in CPI or Consumer Price Index calculation).  I don't know how much fudging the bureau of labor statistics has done in the housing component of CPI.  But certainly housing price has out-paced the owner's equivalent rent used in CPI, when almost 70% of the people are home owners, and only 30% are renters.  Talked about fudging CPI, if they start to switch over to use housing price while it's in decline, they can certainly produce even lower CPI both at ramp-up and ramp-down of the housing market.

Why is your home the best investment?

Well, I should really qualify the title of this, by not buying the home in a bubble.  Whether our current housing market is a bubble or not is debatable.  Under normal circumstances however, buying a home is usually your best investment.  And the reason is inflation.  Historically, housing price tracks inflation fairly well.  Since inflation is seldom zero, or negative, buying a home is a financial transaction that has two very big advantages, assuming that you acquire the home with some amount of mortgage.

  1. Leverage: A leveraged transaction means that your return (or loss) is magnified by the amount of leverage that you use.  In a leveraged transaction, you use less amount of cash to take control of a much bigger amount of asset with debt.  If the asset goes up in value, then you are rewarded with extra returns.
  2. Inflation: Your home value is almost guaranteed to go up in value in a very long term perspective (I’m talking about 10+ years) because of inflation.  Since you repay your mortgage debt by cash gradually, the debt burden actually goes down as your wage gets inflationary increase.  $100K owed now will be less burdensome 10 years later, even if you have not paid down a cent in principal.  Inflation is the best for debtors, but worst for creditors.
  3. Tax: At least in the United States, federal tax laws clearly have a preferential treatment for homeowners.  You can deduct mortgage interest which is also AMT-deductible.  Possibly you can deduct your usage of home as home office.  The property tax is deductible too.  And the best thing is that the capital gain on the home is usually tax-free under $250K for singles, and $500K for couples.

That is why real estate is often touted as a good investment because it is really true, with the following assumptions:

  1. You didn’t buy it in a bubble.
  2. You have sufficient positive cash flow to carry you through enough years for inflation to increase your return.
  3. You can take good care of the home or property.

I have constructed a Buy vs Rent calculator for you to experiment the outcomes of the two choices.

Money is not everything; Time is money too

There are many things more important than money.  Health and family especially are not only much more important than money, but they are really priceless.  Sometimes, you simply can’t spend enough money to regain your lost health or the lost time with your family.

How about Time?  I usually consider my time more important than money.  However, time and money are often exchangeable entities, but not always.  You can use your time to earn more money; vice versa, you can use money to buy more leisure time.  Time and Money are really the two most important resources that we have.  Life is about trading between time and money. Most of the time we trade our time for money by going to work; occasionally, we use money to buy some precious time for our families, or buy ourselves for more time in retirement. But the fact is that we will almost always have time to earn money later (if you are not too old, and still have time).

The task that everyone faces daily is how do I do my “trades” such that I can use less time but end up with more money for more time.  One must make a proper balance spending his time or money on every item or task.  And hopefully to reach his or her eventual retirement quicker.

Although a penny saved is two pennies earned (see Tax), I always tell myself, not to sweat on the small pennies.  I consider myself frugal, but it’s important to strike a good balance between trades of time and money.  If a financial decision amounts to 50% of my networth, then I will surely spend all of the time that I need to carefully examine my options.  If the thing only involves 0.01% of my networth, then I prefer not to make a fuss about it.  But if there is a recurring event or action, then I will weigh its importance by multiplying the amount of dollar and the number of times that it will recur.  A frugal spending habit should be an important recurring action that everyone should pay attention to.  Yes, it doesn’t matter for once or twice.  It won’t matter for a couple of months, but after years and years, it really adds up.

Budgeting

How can you keep the money in your pocket, if you don’t know how it comes in and how it goes out? Granted, the most painful part about saving money is not to spend it. Deferring immediate gratification for the future takes some real discipline. Having a realistic financial goal in sight with a proper plan and budget will help one to succeed on this difficult saving path.

The most important things about making a good budget is that you must be truthful, realistic, and comprehensive. A budget is a detailed plan that you and your family can achieve, not some math exercises on additions and subtractions on paper. You can make up a balanced budget, with wrong or unrealistic numbers in them, or leaving out certain spending items. Or you can make a budget with some 5% to 10% head room on every item, plus a line for miscellaneous spending for general breathing room on the entire budget, or to account for little things that are not accounted for.

Budgeting is essentially the time to be honest with yourself and your family. Try not to persuade yourself either into believing that vacation or the morning StarBucks coffee is a one-time event that you don’t need to budget it for. Once you have a budget on paper, you should re-visit and refine your budgets every once in a while to check if all the numbers are realistic, and see if your budget still truly reflects on the ways that you spend your money. Go over your old utility and credit card bills, and see if your budget is correct. Also go over your bank statements to see if your projected savings have gone into your piggy bank accounts. If not, you should check and see why your budget plan has gone wrong. In fact, this self-discovery process can take a couple of years to get everything right. Quite often, you may over-spend your annual budget for Christmas gifts or vacation travels, and still don’t know how the money disappears.

In summary, making a good budget involves the following:

  1. Be comprehensive.  Don’t leave out any items that are more than about 3% of your total spending.  Budget monthly by dividing 12 for those annual one-time events.
  2. Be realistic and at ease.  Don’t try to be 100% accurate on every item.  You can either leave some room for every item or add a misc item for your total head room.
  3. Negotiate and compromise with you & your family member to make financial sacrifices for the long term well being.
  4. Verify the correctness of your budget, and make modifications if necessary.