By Matt Miner
December is halfway gone, and I can hardly believe we’re not still in October. It has been a whirlwind in our family for the last month and a half, with a two week trip to see family in Tucson over Thanksgiving.
November was a reminder about why personal finance topics actually matter. As I’ve written elsewhere, money itself has no inherent value. Money that is saved and invested has value as a scorecard (your net worth). Money that is spent has value to improve your life or the world.
I was poignantly reminded of why we keep (and why you should keep) a sizeable emergency fund as I found myself and my family at a standstill east of Benson, Arizona with the transmission destroyed in our 2004 Odyssey.
On the side of Interstate 10, it’s a blessing to focus on solving the problem and not simultaneously be concerned about where the money is coming from to pay the bill. The safety and logistical challenges were bad enough, without layering a money problem on top!
I’m not smug on this topic of having a large emergency fund. We have not always had a large emergency fund. When we were paying off student debt, we only kept a few thousand dollars around. Everything else we sent to Aunt Sally. But now that we’ve been in fully-funded-emergency-fund-mode for a few years, I don’t ever want to go back. Here’s how the emergency-fund reminder came about.
The Story and our Values
It had been nearly two years since we’d made a big visit to see the family members we love in Tucson, AZ. Keeping up with extended family and friends, as well as spending time together as an immediate family, are high on the list of things that matter to us. As a result, we decided to make a Tucson trip in November.
In addition, there was a dining room set that had been given to us, but we had never collected during our moving-around-for-work years. We figured we’d get it home to North Carolina in an enclosed trailer behind our ultra-frugal (and pretty old) Odyssey. And I figured Ody tranny problems were something that happened to other people who didn’t maintain their cars as meticulously as I maintain ours. If I’m not smug about big cash reserves, I am smug about auto maintenance. My smugness was misplaced.
Climbing a grade into Texas Canyon about fifty miles from my mom’s place, I noticed the van was not performing well, with little power making it to the wheels as the tachometer whizzed easily between 1200 and 6500 RPMs. While I pulled to the shoulder, I noticed the smoke pouring from the van and advised the family to look sharp for any irreplaceable possessions, as we might need to hop out of our car and watch it burn to the ground.
Fortunately that did not happen, and the Lord was extremely gracious in his providence. A kind DPS officer blocked for us and the tow truck operators who towed the car were great. Amazingly one of them loaned us a car overnight.
Saturday morning found me up early surveying a bevy of options including transmission replacements, rental cars, new-to-us used cars, and plane tickets.
The bride reckoned she was ready for a different auto and so, badly as it pains me to write checks, we went that route. After an intense 36-hour marathon return-trip home, we arrived in Raleigh at 6:10 am Monday (just in time for work!). There’s a lot more that could be said, but since this is a personal finance blog post, rather than an article about my family, I’ll stick with these highlights.
Our pursuit of our values (seeing extended family and spending time together as an immediate family) left us on the side of the road with five-figure bills to pay. Were we doing the right thing? Yes. Was it worth it? Yes. Was it convenient and inexpensive? No, it was not. Events like these require a cash strategy.
The Cash Strategy
We are way more comfortable with a sizeable emergency fund. For us, this is six to twelve months of expenses held in three categories:
1. An inviolable six-month emergency fund, segregated from the rest.
2. An “operating fund” which amounts to a checking account with a sizeable balance that we use to handle ups and downs in the budget (home repairs, car repairs, broken appliances, dentist’s bills and the like). When we need to use a card to pay for something, it’s a debit card linked to this account, and when the hotel clerk warns us that paying with a debit card will tie up a couple hundred dollars in our account for three days, we just smile.
3. Currency – we keep it very secure and in appropriate quantities, but not including some currency in your emergency fund is a way-too-optimistic view of the world. Your emergency fund needs to work when the electricity is out from a hurricane, when your wallet has been stolen with your cards in it, and when you want to use the power of currency to negotiate price. This is an emergency fund, not an “everything’s OK and going normally fund.”
The emergency fund is your plan for two things. First, it needs to be able to absorb several months of expenses in the event of an interruption to your income. This is the context in which it is most often discussed. Second, it needs to be able to handle the big whacks that come along from time to time, such as an auto replacement, a homeowner’s insurance deductible or unexpected large house repair, or a medical expense not covered by insurance. We want our emergency fund to do both: pay a big, unexpected expense and still not leave us naked if anything should happen to my income.
Tax Tactics & Income Timing
This cash strategy supports our values, and provides a high Sleep at Night Factor (SANF). The criticism of cash is always that it’s a drag on investment returns and this can potentially be true in some instances. But cash can also give a big boost to investment returns in at least three ways:
- Not selling at the wrong time, because you can afford not to sell
- Not selling at the wrong time because you are emotionally able to handle the volatility of your portfolio
- Flexibility and tax benefits
When you have a considerable cash buffer, you can handle a cash need without liquidating investments. Having sold mutual fund shares in March 2009 to fund a home purchase, I wish I could go back and punch 29-year-old-Matt in the face and encourage him to keep a bigger cash cushion. You want to sell investments when you want to sell them, not because you need to raise money right now.
Cash serves as an anchor for your portfolio. Although this anchor effect theoretically diminishes your returns, and inflation is eating away at the purchasing power of cash, the nominal value of your cash holdings does not fluctuate with the market. It has a correlation of zero when compared to stocks. Knowing that you have months and months (even a year or two) of cash set aside will help you ride out the market’s ups and downs for the portion of your portfolio that is invested in stocks or other volatile asset classes.
Finally, and this may be the most valuable part of this article, a large cash stockpile allows you to manipulate the timing of some of your income, even in the context of an individual tax return.
If your income is highly variable like mine, by December of a given year you probably have a hypothesis of whether your income in the current year or the subsequent year will be higher (or lower).
For example, imagine you’re a high-earner with a reasonable idea that in the current year with no adjustments to the timing of your income, you will earn taxable income of $260,000, and in the subsequent year you will earn $180,000 in taxable income.
Further assume that you plan to give 10% of your gross income in charitable contributions, and that you live in a state with state income tax. Finally, because this case would become impossibly complicated, we are going to ignore AMT effects.
In 2016 if you are married filing jointly and you earn taxable income between $231,450 and $413,350, your marginal federal tax rate is 33%. If your taxable income is between $151,900 and $231,450, your marginal federal tax rate is 28%.
US income is taxed in income bands (thanks Kevin!) as below:
If you shift $40,000 in income from 2016 to 2017, and assuming no change to personal income tax laws in 2017, instead of paying 33% of the last $38,550 of income, resulting in a total federal tax bill of $64,512, you will pay total federal tax in 2016 of $48,585.
In the subsequent year, your taxable income will increase to $220,000 from $180,000. This will likewise result in an identical federal tax bill as last year, $48,585, rather than what you would have paid with no income shifting ($37,385).
As a result of this tactic, rather than paying $101,897 over two years, you'll pay $97,170 instead. This represents a reduction of $4727 in your total federal tax payments. You may also improve your state income tax picture too.
This $4727 tax savings is readily available to you, completely legally, by using the power of cash. Here’s how: Simply accelerate your charitable giving from 2017 into 2016 (10% of $260,000 is $26,000), and then add to that an additional $14,000 in state income tax withholdings. Each of these items creates a deduction in the current year and “income” in the subsequent year.
Specifically, you’ll be unwinding the charitable contribution throughout the subsequent year by not making these gifts in that year. In the case of the state income tax payments, you receive a federal deduction in the current year for the tax withholding, and a 1099G for the state income tax refund in the subsequent year. This is because state income tax payments are deductible against federal income in the year in which they are paid and not the year in which they are owed.
Another consideration: If your gifts represent a meaningful portion of the budget of the charity you are supporting (for example your church), you should advise the non-profit’s treasurer or budget committee about the timing of your gifts so they can account for this in their planning.
Of course if your situation is the reverse, and you anticipate a lower income in the current year and a higher income in the subsequent year, you would reverse these tactics, deferring charitable giving and state income tax withholdings to the subsequent year.
In any case, if you don’t have ready access to a chunk of cash, you can’t afford the $40,000 cash demand to achieve the $4727 savings. When people talk about cash being a drag on portfolio performance, they aren’t taking scenarios like this into account. In this scenario, parting with $40,000 cash in the current year results in an 11.8% return on that “investment” within about thirteen months ($4727 / $40,000). This is wealth that you rescued from the greedy clutches of the feds so you can direct your dollars according to your values and your family’s needs.
So pile up cash – you’ll sleep well at night. And you’ll be ready to meet unexpected obligations, you won’t have to sell investments into a bad market, and you may find yourself in a tax situation where access to an above-average amount of cash yields tax benefits.
Disclaimer: I’m not a tax professional, and I am not acquainted with the facts of your individual situation. Please consult qualified professionals for specific tax, accounting, and legal advice. The tax facts presented in this case are simplified and stylized. Tax situations are complex and you need to model your real numbers. But income timing strategies are a real tax planning opportunity you should not overlook.