Wednesday, February 26, 2014

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:

Interest from Regular Bonds
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. 
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 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

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:

Long Capital Gains on Stocks
Dividends from Stocks
Bond Interest (Regular)
Bond Interest (Inflation Protected)
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?

Wednesday, February 19, 2014

Taxes During "The First 10 Years”

There is a lot to talk about when it comes to taxes. I have even heard it said that some people make entire careers out of it. Let’s start by considering the question that I hear most often:

Does it make any sense to invest money in Israel during the first 10 years of aliyah? 

During this time, gains from your pre-aliyah investments in America are not taxed by Israel. Won’t this savings outweigh the benefits of having the money in Israel?

From what we have learned so far at Investing by Accident, here is the summary of the relative advantages/disadvantages of investing your money in the U.S. versus in Israel for these 10 years:

Dollars versus Shekels
Shekel value exposed to the risk (or gain) from a weakening (or strengthening) dollar
Shekel value not exposed to currency risk
Investment Opportunities
Exposure to wide variety of U.S. investment options
Exposure to a limited (but potentially attractive) set of Israeli stocks and bonds as we saw in The Coffee Hypothesis and Fixing Income in Shekel
Special Tax Liability in the First 10 Years
Tax due only to the U.S.
Taxes due in Israel and in the U.S.

The first two considerations make a very good case for investing some of your money in Israel. In general, tax liability does not impact this one way or the other, as you will be obligated to pay taxes to both Israel and the U.S. on gains from investments regardless of where the money is invested. The only exception to this is the taxes that Israel will collect during the first 10 years of aliyah.

In my particular case, I started investing by accident in Israel with money I earned in Israel. In this case, the exemption for the first 10 years did not apply. However, even if it did, the benefit of this tax exemption depends on how the taxes are calculated.

Unless you really make a mess of things, you will not pay tax twice. For gains on your investments in Israel, you will pay taxes to Israel. Then, when you calculate your U.S. taxes, you will take a credit for the taxes that you already paid to Israel.  

If the tax rates were exactly the same between Israel and the United States, then it would be fairly obvious that it doesn’t matter where you invest your money during the first 10 years (or at any other time, for that matter). If this were the case, the credit from the taxes you would pay in Israel would be exactly the same as the taxes you would owe in the United States. Obviously, that is not the case, or I would not have pushed off writing about taxes for so long.

If taxes are higher in Israel, then for the first 10 years, you would be better off keeping your money in the U.S. and avoiding the higher taxation. On the other hand, if taxes are lower in Israel, then it won’t be costing you any more in taxes to have your investments in Israel.

So which is higher?

The answer is something that could only happen when politicians write the rules, state departments negotiate treaties, and accountants help you understand it all.


Wednesday, February 12, 2014

Special Bonus Discussion Topic

We are supposed to talk about taxes this week, but I’m going to do everything I can to avoid it. I’ll even go so far as to give you a Special Bonus Discussion Topic, even though I generally try to stay on the taking side of bonuses. Here it is:

What is up (or down?) with the interest rates on bonds in the United States?

I am a self-certified non-expert on the matter, but after last week's blog, I just can’t stop thinking about this. Why would someone invest in a 10 year bond that returns just 2.64%? In a best case scenario where inflation remains below average, there is hardly any gain at all. For the 5 year bond at 1.65%, the investment stands to lose money after adjusting for inflation.

Having devoted my amateur thinking to this for at least a few minutes, it seems to me that there are really only two reasonable explanations for this:

A. People think there will not be any inflation (or even, that there will be deflation)

B. The bond market is in a bubble

Perhaps if I were an expert, I would be able to consider Option A. In that case, I would suggest that if we compare the rates between regular bonds and inflation-index bonds (“TIPS”), we can infer what the market thinks about inflation, like this:

5 Year
10 Year

The logic beyond this comparison is that the investor who buys the regular bond instead of the inflation protected bond thinks that inflation will be less than the difference between the interest rates. If he thought that inflation was greater than the difference, he would have bought the inflation protected bond and not bothered worrying about the risk of inflation at all.

This means that the market of investors believe that inflation in the next 5 years will average less than 1%, and no more than about 1.75% over the next 10 years. Inflation this low happened in 1953-1965. It is certainly possible that it could happen again; although since 2008, inflation has averaged 2%. In general, markets tend to return to the average, but you never know when exactly that will happen.

Another possibility in Option A is that we are headed for a period of “deflation” like what happened in the Great Depression. I have trouble even thinking about what this would mean. Maybe it’s because I always had trouble reciting the alphabet backward.

I’ve read what some of the experts say about deflation, and they are pretty sure that the U.S. Treasury will do everything it can, including “quantitative easing”, to “stave off” inflation. I think you should never trust anyone that uses the phrase “stave off”. However, in this case I will make an exception because “quantitative easing” sounds both pleasant and harsh at the same time, and I’ve always liked sweet and sour chicken.

The other possibility is Option B, which is simply that there is no logic to these interest rates and the bond market is in a bubble. For this to be the case, we would need to demonstrate that the two most important symptoms of a bubble are present. First, there would need to be someone who would claim there is a bubble while most people do not think so. Second, we should be able to make the case that “this time is different”.

I have singlehandedly accomplished the first criteria. (You’re welcome.) For the second, plenty of experts have commented about the unique market conditions that we are facing, but I am the only one to propose this baseless conjecture:

This time is different because of the aging baby boomers. As the population ages, we have more people than ever before who are rebalancing their portfolios to place more and more money into bonds. As this happens – and it will continue for a while as the baby boomers are just starting to retire – the bond prices will remain high (and yields low) like they are today.

I thought this conjecture was so compelling that I did everything I could to prove it. As it happens, the evidence points in the opposite direction, as money has actually been moving out of bond funds into stock funds in the past few years.

Maybe it’s a bubble or maybe this time is different. Either way, I simply can’t justify investing in bonds in the U.S. at these prices. In my U.S. accounts, all the money I have allocated for “bonds” is sitting in cash.

What say you, loyal readers?

Wednesday, February 5, 2014

Fixing Income in Shekel

By now, you have finished drinking up The Coffee Hypothesis. If you’re like me, you only have another few minutes before the caffeine wears off and the world begins to look bleak once again. 

Sure, you have some good opportunities in the Israeli stock market, but you are not planning to put all of you money into the stock market. What about the Israeli bond market? How does it compare to the options you have in America?

I would say that it is very much like the difference between the way children in America and Israel eat pizza.

Mostly, there is no difference at all. In both cases, it’s a pretty messy deal. The cheese (or whatever it is that Israelis use) can get very goopy and the sauce has a way of making its way all over their faces. The main difference is that only Israelis think that it is perfectly normal to put a full color, high resolution picture of this on the menu.

Bonds are similar in this regard, just without the messy children. Mostly, they are the same, but in some ways they are different.

The Same

In both countries, you can buy bonds. Basically, this means that you lend some money (“principle”) at a certain rate of interest (“interest”). The borrower pays you the interest until the bond matures and then returns the principle to you. Like any loan, there is a risk that the borrower will spend all of his money on pizza and not be able to pay you back (“credit rating”). Bonds issued by the government are generally considered to have the lowest risk, because governments can always take away your money if they spend all of theirs (“taxes”).

In both the U.S. and in Israel, you can invest in government bonds. Here is a snapshot of rates from earlier this week:

5 Year Bond
10 Year Bond

The rates in Israel are slightly higher which makes sense considering the difference in credit ratings between the two governments. I have heard people argue that they prefer the U.S. government bonds because they are considered “no risk” in terms of default; whereas, the Israeli government bonds have some risk, even if it is small. I find this odd because after deciding to live here, you have already placed a large amount of faith in the Israeli government. Basically, this is saying that you are willing to take the risk with your life, livelihood, and the future of your family; but, when it comes to your bond investments, what’s where you draw the line.

I think that money you have designated for government bonds will be more-or-less just as well off in Israel. The only difference is that when it is in Israel, it will not lose any of its value in shekel; whereas, if you keep in dollars it could gain or lose as the exchange rate fluctuates.

The Different

The real difference between the bond markets is found in corporate bonds. This is because Americans and Israelis have a different understanding of what money is. Example:
George has $100 today. He keeps this money in an entirely realistic U.S. bank account that pays him 2% interest every year. In five years, George has $110.14. George believes that he now has more money.

Zohar has 100 shekel today. He keeps this money in a strictly hypothetical Israeli bank account that pays him 2% interest every year. In five years, Zohar has 110.14 shekel. Zohar believes that he has less money than he started with.

Has Zohar had a bit too much of that leftover hummus for breakfast? Probably, but that’s not what is causing him to think this way about money. The difference between them is that Zohar thinks about money in terms of what it buys; whereas, George thinks about the absolute amount of money that he has. Zohar understands that with average annual inflation of around 2.5%, his 100 shekel is worth much less five years later. The interest of 2% that he received is not sufficient to make up for the effects of inflation.

In Israel, looking at money through inflation-protected lenses is prevalent everywhere: in the way the banks like to sell mortgages, in how payment plans are structured, and even in the way taxes are assessed. Israelis believe that inflation adjustments are just natural adjustments to the very same money; whereas, Americans believe that if you have more money than you started with, you have received interest regardless of how it was calculated.

When Zohar invests in bonds, he expects that his investment is protected against inflation unless he explicitly seeks out the alternative. This is why in Israel you can invest in inflation protected bonds not just from the government like you can in the U.S., but also from corporations.

But just like we say to Israeli pizza photographers: “just because you can do something, doesn’t mean that you should.” It is nice to have the option, but you will need to consider the credit worthiness of corporations before you invest in their bonds.

Inflationary Interests

Comparing interest rates between inflation indexed bonds in the U.S. and Israel is difficult, but I’ll give it a shot because I already started writing this blog.

For government bonds, the comparison is straightforward. We find a difference in interest rates similar to what we saw earlier with regular bonds:

5 Year Bond
-0.50% + inflation
0.26% + inflation
10 Year Bond
0.52% + inflation
1.42% + inflation
Corporate bonds are much like comparing blueberries to pomegranates. The credit ratings are measured differently, so you will need to take any comparison with a grain of powdered sugar. Nevertheless, here is an approximate comparison based on the highest rated corporate bonds from each country:

U.S. Corporate
Israel Corporate
5 Year Bond
1.27% + inflation
10 Year Bond
3.00% + inflation

For those already inclined to invest in corporate bonds, the Israeli corporate bonds present an interesting opportunity to consider.

For investment in both the U.S. and in Israel, you need to evaluate whether the interest rates are fair considering the risk that the corporations will not be able to pay you back. Also, for both you need to evaluate whether the rates are reasonable for the length of time that you are lending them money.
However, with the U.S. corporate bonds, you will also need to consider the risk that the 1.95% or 3.35% return will not sufficiently outpace inflation over 5 or 10 years. For the bond investment in Israel, the corporation that borrows the money assumes this risk and pays out the interest and the principle on the bond with adjustments according to inflation.

Same Same But Different

I’ve been making the case that your money should make aliyah to protect you against a weakening dollar. In an attempt to fortify you against the tough times ahead, I’ve given you a caffeine high with The Coffee Hypothesis by showing you that money you want to invest in stocks has a lot of opportunity in Israel. For bonds, it’s no worse off and may have a few advantages. Basically, you could say that it is 8 pieces of one and 8 triangles of the other, with some advantages to consider around the corners.

So… who’s ready to talk about taxes?