I recently saw a claim by a fellow blogger that he expects the Wealthfront Direct 100 indexing option to juice investment returns by 0.5% -1% per year for anyone with a $100,000 taxable portfolio. He also claimed that “almost anyone” with that size portfolio would be in the 25% tax bracket. I don’t believe either of these claims to be true for a second and I’m definitely NOT pursuing that strategy. This post got so long that I’m splitting into two. On Thursday, I will reveal my current investment portfolio.

I’m firmly on the NO-ROBO side of the fence.

I have no shame in opining that the Direct 100 Indexing offered by Wealthfront is simply an investing gimmick. I don’t think it’s a smart strategy. The only robo I can really get behind is Motif. Motif filled the void of being an efficient way for folks to dabble in a group of individual stocks. The other robo’s? A solution to a problem that does not exist for the vast majority of the population. If you want to farm out your investment management to a diversified holding of stocks and bonds – balanced funds have existed for decades and are perfectly reasonable choices for the vast majority of people.

Tax Bracket Dishonesty or Tax Bracket Confusion?

The IRS recently released the 2017 tax bracket information:

In America, in the year 2017, just for being a living and breathing self-sufficient adult human, you get to take a standard deduction of $6,350 and a personal exemption of $4,050. So you’re first $10,400 of income is actually not taxed at all. Period. That 25% tax bracket starts right around $37,950 of TAXABLE income for a single person. That’s taxable income though. For taxable income, you get to reduce your income by all those exemptions and deductions first. So, for a single joe schmoe, you’d need $48,350 of income next year to hit the bottom of the 25% tax bracket.  If you’re married, you’re pushing six figures of combined annual income before you hit the bottom of the 25% bracket. Why does the 25% bracket matter? Because if you stay under that number, your long term capital gains and qualified dividends are actually TAX FREE.

There’s “phase outs” with exemptions and deductions, and the “Alternative Minimum Tax”, but I’m more privileged than many, and I’ve never come close to hitting a deduction or exemption phase out or the AMT.

But….there’s more. If you have a six figure taxable account, you’re probably a heavy saver, which probably means you’re contributing a lot (perhaps the $18,000 maximum per person?) to your 401(k), and perhaps you’re maxing out your HSA too. That $48,350 for a single jane schmoe just turned into roughly $70,000 or so of income for a normal working stiff. Again, double that for a married couple.

Don’t Forget Itemized Deductions!

Maybe you live in a state with a high state income tax or you own a house with a mortgage or a high property tax bill? Maybe you donate to charity? More deductions! Have a kid? You get another personal exemption for each child, and perhaps even a child tax deduction or credit depending on your income level! Going to school? There are education tax credits for that. Essentially, you need to make a CRAP TON of taxable money to find yourself both in the 25% tax bracket AND with a six figure taxable investment portfolio.

Less Costly Lifestyle = Less Income Needed = Less Taxes Paid

Realistically, the people who have a six figure taxable investment portfolio, apart from the very wealthy, are either going to be heavy savers whose expenses are on the low-ish side, probably those who don’t have full access to retirement accounts at their work place, and people who benefited from a one-time financial windfall such as liquidating a real estate investment. Or some combination of the aforementioned.

The more expensive your lifestyle is, the more income you need to fund it. Living in a country with some pretty steep progressive taxes on earned income – especially on dual earner married couples – and far more favorable taxes incurred on investment income than job income, it should make sense why you’d want to replace as much as income as you possibly can from earned income into investment income, and the way you do that is pretty simple: doing a lot of long term investing within a taxable account. I’ve never understood why I should strive for sky-high employee incomes when I would lose much so much more of that income to taxes.

Lower Taxable Income When Not Working.

If you’re reading this blog, you might be on the path to early retirement or embarking on a mini retirement like I soon will be experiencing. I do have more than six figures in my taxable account, and a good portion of that is due to realizing a mostly tax free gain in a real estate sale from last year, but I will still be well under the 25% tax bracket next year, even with a couple months of working my current full time job AND the potential for freelance income. When most of your income is investment income below the 25% tax bracket, you suddenly have a lot more plausible taxable investment strategy options at your disposal vs. an equivalently compensated working person.

I went to a low cost actively managed strategy in my retirement accounts a couple years ago (where taxes on distributions are irrelevant) and I’ve never looked back. Knowing that my taxes on my investment income would be negligible in 2017, I recently implemented the strategy across my taxable accounts as well, especially since I feel like the indexes are looking pretty frothy at the moment with the likes of Facebook, Apple, Google, and Amazon etc all dominating the S&P 500 Index.

Indexing Is Not The Only Way.

There’s an unusual amount of dogma in certain index fund supporters. Index funds are a solid investment product, and while certainly adequate for everybody, they particularly make sense for people who have very high earned income due to the massive income taxes incurred on those in the very high income tax brackets during a typical working career. Not because index funds have any sort of secret sauce for investing, but because of the inherently low turnover which causes a significantly lower “tax drag” than your typical actively managed mutual fund. Berkshire Hathaway would be a great holding for the same reason. No dividends. Plus Warren Buffet gets to manage your money. I think some people think that fund managers are idiots throwing darts and I’ve never understood that mentality at all.

When my mutual funds holds a stock for longer than a year and sells a stock for a profit, I get to collect what is essentially a bonus dividend in the form a long term capital gain distribution. Behaviorally, I like this while taking a year off from work. If I stay under the 25% tax bracket, that income is tax free too. There might be SOME short term capital gain distributions in my funds, but certainly not enough for me to worry too much about. Behaviorally, I like the idea of not having to sell shares even if it is mathematically equivalent to receive a distribution vs selling a share.

What if Taxes Change in the Future?

Hey, if my tax situation (or the country’s tax laws!) drastically changes at some future date, I can always sell the shares of these funds (for a long term gain at the lower tax rate). No big deal. I sold some funds for short term gains this year to transition away from broad indexes into the current strategy. No harm no foul. Even after taxes, I still earned more than I would have had it been sitting in a bank account the whole time.

Dodge and Cox recently came out with a White Paper – The Case For Active Management and I was nodding along the entire time because so many of the reasons mentioned are exactly the reason that I like to use active funds myself. This might be a controversial thing to say, but I feel like it’s fairly easy to toss out the obviously terrible actively managed funds. They have loads, sky high expenses, they have fund managers who would never personally invest their own money in the funds. On Thursday, I’ll disclose my allocation and specific fund holdings and the reasons why I’ve chosen said funds.

Readers – How many of you who have the good fortune of $100,000 invested in taxable assets are running to the nearest robot to try to mimic the S&P 500 Index Fund with 100 random large cap stocks that, as an example, might tax loss harvest Coca Cola stock with Pepsi stock? 😉