NWP Monthly Digest | April 2024
Happy April Fools Day! Full disclosure: there will be no April Fools jokes in this month’s newsletter. Whether that is fortunate or unfortunate is debatable. I will leave you to celebrate the prankster’s favorite holiday on your own today.
With tax day being just a little over two weeks away, however, I have been thinking about numerous conversations that I have regarding taxes and the general awareness level that people have regarding their own tax situation. It also got me thinking about some of the topics that come up over and over again in regards to personal finance that I think people get wrong the most. I have focused on three of them that we’ll hit on today.
Taxes, no doubt, are complicated. In America, our system and tax code are not easy to understand. A few years back, I saw a wonderful meme (and I’m paraphrasing) that went something like this:
Me: How much do I owe in taxes?
IRS: We don’t know, yet. You have to tell us.
Me: Oh, OK. How will I know if I am correct?
IRS: We’ll tell you once you finish. And then we’ll fine you penalties and interest if you don’t do it correctly.
Me: Why can’t you just tell me what I owe?
Taxes and Tax Rates
Probably the biggest misconception that people I come in contact with have regarding taxes is a misunderstanding regarding how MARGINAL TAX RATES work. Below you’ll find the tax brackets for 2023:
The common mistake I see most people make is an assumption that their ENTIRE tax due moves up at each incremental level of income on the bracket. For example, if you’re a single filer and you made $95,376 in taxable income for 2023, you aren’t bumped up to the 24% tax bracket for ALL of your income, only your last $1 over the 22% threshold is taxed at 24%. For this individual, they would be assessed the following in taxes:
From $0 to $11,000 - no tax
From $11,001 to $44,725 - 12% on $33,724, which would equal $4,046.88
From $44,725 to $95,375 - 22% on $50,650, which would equal $11,143
From $95,375 to $95,376 - 24% on $1, which would equal $0.24
Total tax due for this individual is $15,190.12. Their EFFECTIVE TAX rate is 15.9% (total tax due divided by taxable income). No matter how much money you make, you don’t pay taxes on your first $11k of income, then only 12% up to $44,725, and so on. It is vastly more important to understand your effective tax rate then it is to worry about the next tax bracket you’re bumping up against.
Once you get past the income brackets and understanding your effective tax rate, you need to go backwards and start from the beginning. You have to calculate your TAXABLE INCOME, first.
You start with all sources of income, wages, capital gains, interest and dividends, business profits…etc. If you made money in any capacity, you have to report it. (Some types of income are not taxable, like life insurance proceeds, child support payments, or gifts up to $17,000)
You then take your “above the line” deductions, such as tax-deductible IRA contributions, HSA contributions, health insurance premiums (if you don’t have coverage through work), and many more. These adjustments to your income can be claimed by anyone and reside on Schedule 1 of your tax return, and this allows you to calculate your AGI, or your ADJUSTED GROSS INCOME.
And finally, we get to the step where you decide to utilize the standard deduction or itemized deductions to arrive at your taxable income for the year. The standard deduction for 2023 is $13,850 for single filers and $27,700 for married couples. It is estimated that 13% or less of people filing taxes will itemize. The majority of Americans will take their AGI and reduce it by the standard deduction to arrive at their taxable income number for 2023. From there, you just utilize the different brackets to calculate what you owe.
And one final point…what you owe in taxes is very different than the amount you withhold from your paycheck. Your tax refund or additional tax due is only a function of the difference between the amount of taxes you owe and the amount you withheld or paid throughout the year.
Risk and Reward - why stocks can help you generate superior long-term returns on your money
Stocks go up and down. At this point, I feel like this should be widely understood. For the most part, I think it is. But we still get questions about the stock market and whether or not it’s too “risky”.
The reward you get from investing in stocks is due primarily to the risk you are taking with your capital. Without risk, there is no reward. We try to reduce certain risks in client portfolios by adding diversification and analyzing individual companies and asset classes as a whole to see which investments are more attractive vs. others, but, at the end of the day, the stock market still has drawdowns and rough patches where it gets tough to watch.
What I think would be surprising to most investors is that stocks go up more than they go down. Roughly three out of every four years, the stock market goes up. But even in those up years, the market will experience very difficult drawdowns. A drawdown is a period of negative performance from a high-point to a low-point.
Here is a chart that shows historical calendar year returns for the S&P 500 and the worst drawdown the market experienced in that same year.
It is not uncommon for the stock market to have periods of negative performance of 5-10% or more in the same years that it shows positive overall performance. In fact, it’s normal for the market to experience these negative 10% corrections. While it doesn’t feel great when it’s happening, you have to learn to deal with the fact that the stock market has to correct prices from time to time. These price corrections create a healthier environment for investors in the long-run, because the stock market can become extremely overvalued just as it can become extremely undervalued.
If seeing the negative performance is just too much for you to handle, I would suggest not looking at your accounts or statements but for once a year.
There is no “get rich quick” method
While the stock market is a great way to increase the value of your portfolio over time and help you hedge against rising prices and inflation, it is not a “get rich quick” scheme. But neither is investing in real estate, or bitcoin, or your friend’s business…or anything.
Getting rich slowly should be the goal and embraced by everyone. I understand there is a huge movement of people trying to retire early, but a lot of things have to go your way to make this happen. When you read a story on CNBC about someone that retired early to pursue their passion, it almost inevitably started off with a very generous gift from their parents or family.
I wrote back in February about the blocking and tackling of personal finance. Understanding how to manage your cash flow (because the word budget makes people angry) is the single most important thing you have to get your arms around. I would say the second is to learn to have patience and let the markets work for you.
The one area of the stock market that you actually have control over is the length of time you hold your investments. The longer you hold them, the less risky they become. This chart below shows you how volatile the S&P 500 Index can be in any given year. But the longer you hold those stocks, the chances of you getting a negative return starts to disappear. In fact, as of this writing, there has never been a 20-year holding period where stocks have produced a negative cumulative return, while your average return increases.
Things We’re Reading and Enjoying
What If You Invested at the Peak Right Before the 2008 Crisis, by Ben Carlson of Ritholtz Wealth Management (blog post)
Market timing doesn’t work. Yet investors constantly worry about finding the perfect time to invest their cash. What if you had horrible timing, though?
“Of course, if we extend this back a little longer there was an extended stretch of no new highs following the Great Financial Crisis. The S&P 500 peaked in October of 2007, bottomed in March of 2009 and didn’t reach new highs again until March of 2013. That means no new all-time highs for five-and-a-half years.
The stock market can be feast or famine.
How to File Taxes: Tax 2024 Filing Guide, by Nerd Wallet
If you insist on trying to handle your taxes on your own, this article from Nerd Wallet can help you get more prepared.
Even for the most confident first-time filers, doing your taxes can feel daunting. If you’re wondering what options are out there, here’s a six-step cheat sheet on how to do your taxes and how to make tax filing easier.
Die With Zero: Getting All You Can from Your Money and Your Life, by Bill Perkins
Imagine if by the time you died, you did everything you were told to. You worked hard, saved your money, and looked forward to financial freedom when you retired.
The only thing you wasted along the way was…your life.
Die with Zero presents a startling new and provocative philosophy as well as practical guide on how to get the most out of your money—and out of your life. It’s intended for those who place lifelong memorable experiences far ahead of simply making and accumulating money for one’s so-called Golden Years.
“There is nothing noble about being superior to your fellow man. True nobility is being superior to your former self.” - Ernest Hemingway