An Accidental Guide to Taxes

I know what you are thinking. You are wondering whether you will be able to make it through reading this blog posting, or whether you should just give up right now. Let me ask you this:

Did the Jewish people give up when the spies returned and said that the Land of Canaan will be too hard for them to conquer?

Well, yes, they did. But they shouldn’t have. And you shouldn’t give up either.

Understanding how investments are taxed by Israel and the United States is the only way that we can answer the question about whether or not it makes sense for your money to make aliyah during The First 10 Years. Perhaps more importantly, it will also help you tax-optimize your investments in general which will save you money.

I will make it easy for you by starting with The Basic Idea and then looking at a simple comparison of The Tax Rates between the two countries. Armed with this information, you’ll be able to understand the general guideline for how to optimize your investments to find The Tax Equilibrium. As a special bonus for making it all the way into the Land of Canaan, I’ll even give you a Tax Equilibrium Calculator that you can use to write your own blog.

But, first an Important Preamble about taxes.

Important Preamble

As you already know, U.S. citizens are required to pay taxes on worldwide income. If you do not already have an accountant, your first step is to get one. You will want to have someone who understands how the tax credits work, as they can become very complicated over time. You may be tempted to avoid getting professional help for your taxes to save some money. However, this would be unwise, like the time you tested to see if the oven was working by touching it. (It was working.)

Having an accountant is a good idea because you will not want to believe anything I write about taxes on this blog. As much as I am not an expert on investing, I am even less an expert on taxes. This blog will give you a general sense of how to incorporate tax considerations into your investments based on what I have learned, mostly by accident. You should double check with your accountant on any significant questions or concerns that you have.

I suggest that an excellent way to do this is simply to copy and paste this blog into an email entitled, “My thoughts on taxes” and send it to your accountant to get his feedback. Make sure you post his response into the comments. There is nothing we like more at Investing by Accident than free advice from accountants! (Thank you, DADZ! And thank you, Taxman!)

Ok, now for The Basic Idea.

The Basic Idea

Any time you have gains in your Israeli brokerage account, taxes will be collected automatically. For your U.S. return each year, you will calculate the U.S. taxes due for all investment gains for the entire year. Then you take a credit for any taxes that you already paid to Israel.

This is very simple, but it is easy to overlook one very important detail: you cannot freely mix and match different types of tax credits. Example:

Josh makes aliyah, starts reading this blog, and invests in Israel. In 2013, he owes U.S. taxes of $500 on gains from these investments. Josh already paid the equivalent of $250 in taxes on these investments to Israel. Josh takes this as a credit against the taxes he owes to the United States and pays only $250 in taxes on these gains.

In this example, it does not matter whether or not Josh paid any income tax to Israel in that year because taxes that he paid on income cannot be credited against taxes that he owes on investment income. As the old adage goes: “what happens in income tax, stays in income tax”.

One more important point on tax credits is that leftover credits can be carried forward to the next tax year. For example, if Josh paid more taxes to Israel in 2013 than he owes to the U.S., he can carry forward the excess and use it as a credit in 2014.

For most people, it should go without saying that tax credits cannot be carried backwards. I say “for most people” because I once came up with a brilliant tax strategy which involved backward carrying credits. If you have a similar idea, let me save you the trouble: this is ridiculous and doesn’t work. If Josh has tax due in 2013, he cannot take a credit for taxes that he plans to owe to Israel in 2014.

If the tax rates are higher in Israel, you will have a leftover credit in the United States (which you can carry over). However, if they are higher in the United States, you will owe additional taxes on your U.S. return after you have already paid tax in Israel.

So which is higher?

It’s just like when the kids want to know if Tante Tali-a will be coming for Rosh Hashanah. You never really know until it happens… and even then you can’t be so sure. (Important life note: always grill tofu just in case.)

The Tax Rates

The following table summarizes the tax rates on investments between Israel and the United States:

	Israel	U.S.
Interest from Regular Bonds	15%	Ordinary income
Interest from Inflation Protected Bonds	25% for the interest. No tax on gains from the inflation adjustments.	Ordinary income, both for the interest and for adjustments to principle   according to inflation
Capital Gains	25% for both short and long gains. Adjustments for inflation are added to the cost basis (i.e., they are not taxed)	Ordinary income for short gains, 15% for long gains. Gains are calculated as the difference between the buy and sell price, in dollars.
Dividends	25%	15% for qualified dividends. For other dividends, at the rate of ordinary income.

You will need three important clues to understand this table:

Clue #1: The rate of “ordinary income” is based on your filing status and how much money you make. You can find convenient calculators all over the internet. I like this one the best because it is fun to play with to see how much tax you would pay if you were single.

Clue #2: You can think of the difference between a “qualified” dividend and a regular one much like you think about avocados in Israel: if you buy them early enough and wait long enough they should be ready to eat when you want them. For details on the waiting times, I recommend this short article on Wikipedia. Don’t you wish there was a guide like this for avocados?

Clue #3: This is not so much a clue as it is an observation. In Israel, taxes are assessed on gains only above inflation. (As Zohar would say, “בטח!”). This has a potentially significant impact on which country actually has the higher tax rate.

Clue #4: I know that I said there are three clues, but this isn’t a clue, it’s just a disclaimer. The tax table applies to stocks and bonds that you buy directly. Israeli mutual funds are a separate story entirely. As a U.S. tax payer, you will want to avoid these the same way you should avoid making noise between 2PM and 4PM. You can do it, but you will suffer potentially severe consequences. I'll explain why in a future post. For now, just trust me on this. 

Clue #5: I know that this is very out-of-line to have yet another clue, but this one was added after alert reader Max pointed out that the tax comparison is slightly different for the highest and lowest brackets. In the lowest brackets (10% and 15%), the long term capital gains and dividends are taxed at 0%. If you are in the highest bracket (39.6%), they are taxed at 20%. Additionally, if you fall into the 33%, 35% or 39.6% brackets, you will also need to pay an "Unearned Medicare Contribution Surtax" of 3.8%. Ok, I think we are finished with clues for now.

You will notice that the taxes are higher in Israel in some cases (dividends, long term capital gains), but tend to be higher in the United States in other cases (inflation gains, interest, short term capital gains). Also, as your income increases, the taxes which are already higher in the United States will become even higher.

We learned from The Basic Idea that you will effectively pay the highest tax between Israel and the United States. Knowing this, how can we optimize our investments? 

It’s really very simple. Just like in Algebra II – you just need to solve for “zero”.  Well, ok, maybe it’s more like Linear Algebra.

The Tax Equilibrium

In practice, finding the tax equilibrium can be quite a challenge because there are many variables in consideration. However, because we can carry over an extra tax credit on our U.S. taxes, we should be able to make some simplifying assumptions that over time should take us to a general state of equilibrium.

As a reward for making it this far into the blog, you are now eligible to use this worksheet to calculate the Tax Equilibrium. The only catch is that you need to be a Loyal Reader to gain access. Permissions are updated about every 24 hours; or, whenever I feel like it – whichever is later. If you want access, but don’t want to wait (or, aren’t ready to publicly de-lurk), you can email me at donny@investingbyaccident.com and I’ll send it to you.

Here is what the “default” settings will give you as the tax equilibrium, by U.S. tax bracket. (Important note for the wealthy and the poor: the tax calculator is for estimation purposes only. It is not sophisticated enough to adjust for the tax differences in the highest and lowest brackets that are stated in Clue #5.) 

U.S. Tax Bracket	Stocks	Bonds
10%	0%	100%
15%	20%	80%
25%	60%	40%
28%	65%	35%
33%	70%	30%
35%	75%	25%
39.6%	80%	20%

The reason why these allocations will tend toward a tax equilibrium is because most of the income from “stocks” will be long term capital gains and dividends for which the taxes tend to be lower in the U.S.; whereas, most of the income from “bonds” will be from inflation adjustments and interest for which the taxes tend to be lower in Israel.

In each of the U.S. tax brackets, as you increase the stock allocation, you will tend to owe more money in Israel and have a credit left over on your U.S. return. Conversely, as you invest more in bonds, you should expect that you will owe additional tax in the U.S. after you take a credit for the taxes you paid in Israel.

This calculation has many assumptions which may or may not turn out as expected, and they may be very different than what you are planning for your investments. Feel free to use the spreadsheet with your own assumptions to see what happens. Here are my assumptions:

• Bonds are equally allocated between regular bonds and inflation protected bonds
• Capital gains are all long term and are realized every year
• Dividends are all qualified

Additionally, I assumed the following annual gains:

Gain	Rate
Inflation	2.5%
Long Capital Gains on Stocks	7.5%
Dividends from Stocks	2.5%
Bond Interest (Regular)	5%
Bond Interest (Inflation Protected)	2%

   

These assumptions will never turn out exactly like this in practice. For one thing, it is unlikely that you will realize all of your capital gains every year. Also, these assumptions assume that there is no such thing as losses. In practice, of course, your stocks could lose money in any given year while you are still collecting interest on your bonds. When that happens, the taxes you pay in Israel will be much lower than what you will owe on your U.S. tax return.

But, this is ok. The Tax Equilibrium is a long term goal which you are trying to achieve over time as you carry over tax credits from years when your stocks performed much better than estimated.

Pulling it all together

The conclusion from all this is actually very simple. As soon as you can achieve a Tax Equilibrium with your investments, taxes suddenly become much less of a factor in deciding how much of your money should make aliyah. In fact, you can achieve the Tax Equilibrium even during The First 10 Years, which makes the tax exemption that you have for the first 10 years of aliyah not a very significant advantage after all.

Which money then should make aliyah? While you will want to optimize any investments that you make for tax considerations, the real factors to consider are where you will find the best investment opportunities, while at the same time being able to manage the risk of changes in currency.

See? Aren’t you glad you decided to come to the Land of Canaan?