Britton Gregory

In the last post, we talked about the basics of ESPP’s, and I warned you that the tax situation warranted a post in and of itself. Well, here it is! With a few pictures, hopefully it will come clear.

Let’s start with the basic diagram below. At this level, the tax situation is rather simple: the difference between the price at which you bought the stock and the price at which you sold it is income, and thus is taxed.

Sounds simple, right? Well, the trick is how it is taxed. There are three options:

Compensation (ordinary income): Part of your ESPP income is taxed as compensation, i.e. at your normal income tax rate.

Short-term Capital Gains: If you held your shares for a year or less after you purchased them, the part of your ESPP income not taxed as compensation is taxed as short-term capital gains. Currently, that means they’re taxed at the same rate as compensation.

Long-term Capital Gains: If you held your shares for more than a year after you purchased them, the part of your ESPP income not taxed as compensation is taxed as long-term capital gains. Currently, that means they’re taxed at 15% or 5%, depending on your income.

OK, that doesn’t sound so bad. So that means that all we have to do is figure out how much of the income is compensation, and we’re home free, right? Well, yes…and that’s the tricky part. There are two situations we need to go into: “disqualifying dispositions” and “qualifying dispositions”.

Disqualifying Dispositions: If you did not hold your shares for more than two years after the “grant date” (beginning of the offering window; see previous post) and more than one year after purchasing them, this is a “disqualifying disposition”. In a disqualifying disposition, the difference between the amount you paid for the shares and the amount they were worth when you bought them — in other words, your discount — is counted as compensation income. The rest — the difference between the amount the shares were worth when you bought them and the amount they were worth when you sold them — is capital gains; long-term if you held the shares for more than a year after purchasing them, short-term otherwise.

Sounds relatively straightforward, but what if your stock drops after you buy it? Well, the sad fact is that it the discount still counts as compensation income, even though you didn’t see a red cent of it! To be sure, the capital losses offset your income — but only up to $3,000. (The rest must be carried over to future years.)

Qualifying Dispositions: If you held your shares for more than two years after the grant date and more than one year after purchasing them, this is a “qualifying disposition”. In a qualifying disposition, your compensation income is equal to the difference between what you paid for the shares and what you sold them for or the discount (difference between what you would have paid for the shares and what they were worth) on the grant date, whichever is lower. The rest is long-term capital gains since, by definition, you held the shares for longer than one year. So an ideal situation would look like this:

That’s good — more of your income is taxed at the (lower) long-term capital gains rate. But here’s a bizarre twist: in the following situation, you would actually pay more in taxes for a qualifying disposition than for a disqualifying disposition!

Note that if this were a disqualifying disposition, your compensation income would be much smaller (look back at the second graph), and the capital gains much larger. Ouch — good things do not, apparently, always come to those who wait!

And that’s how ESPP taxes work. You’ll remember that forever, right? Well, if perchance you think something more important might displace its spot in your memory, feel free to bookmark this article and refer back to it later. (Heck, I’ll probably end up doing that myself!)

So…now what? This theoretical knowledge is all well and good, but what we should actually do with our ESPP shares? Do we participate in our company’s ESPP, or no? Do we sell some or all of the shares immediately? How long should we hold on to them? I’ll discuss all of these questions in the final post in this series.

Employee Stock Purchase Plans are, like much in the stock-related world, a double-edged sword. Depending on how you swing them, they can either be a handy supplement to your paycheck or just another source of complexity and, in the worst case, a way to flush income down the drain. As many of my fellow geeks have access to them — though not as many as a decade ago — I’d like to take some time to talk about them. Even if you’re already familiar with ESPP’s, it’s a good idea to know what’s out there – not every company’s plan works the same as yours, and it’s handy to know what the possibilities are when you’re job-hunting!

The idea behind the ESPP is relatively simple: as part of the benefits your employer is showering upon you — like manna from the heavens — you are given the opportunity to buy their stock at a discount. Nothing in the world of employer benefits is ever that simple, of course, so I’ll walk through the caveats.

The money for purchasing this stock is withheld from your paycheck. In this way, ESPP’s are much like 401(k)’s: you allocate a certain amount of your paycheck to be withheld, and that amount never graces your bank accounts. Also, there are heavy restrictions on when you can change that allocation; generally you can jump out if you like, but you can’t jump back in until the beginning of the next ESPP period.

The stock is often (not always) purchased in one chunk, at the end of the ESPP period. In this case, rather than buying stock each time you get a paycheck, it’s all purchased at the end of an ESPP period (generally 3 or 6 months). You can expect to see fun little jumps in your employer’s stock price on that day, as some/many/most employees (depending on the company) turn around and sell their newfound shares (and speculators buy or sell in response to this).

There is a cap on how much you can purchase. The cap can be either a maximum percentage of your paycheck, or a maximum number of shares bought, or both.

The discount varies greatly with the employer. Most common is a range from 5%-15%; alternately, the company may “match” your contributions to the ESPP up to a certain percentage of your income. Also, the discounted price is not always the fair market value on the day the stock is bought; it could be the lower of that price and the price at the beginning of the period, or even the price at the beginning of a window of periods! For example: say your employer’s stock price was $10 when you joined a year ago, $20 at the beginning of the last period, and $30 today, the end of the latest ESPP period. Depending on your employer, the buy price could be 5%/10%/15% of $30, $20, or even $10!

Depending on the company, it may not be a guaranteed win. In most cases, if you sell immediately you’ll lock in your profit and get a nice bonus. However, if you work for a company with a highly-volatile stock price (e.g. a “microcap”), you can lose your discount (and more!) by the time you sell your stock.

The taxes on ESPP’s are…interesting. So interesting, in fact, that I’ll be devoting my entire next post to them!

See you then! In the meantime, tell us about your ESPP — has it done well by you? And does it fall into one of the above descriptions, or is it a variant that wasn’t covered?

99% of the time, when people talk about investing, they talk about investment choices. What are you investing in? What do you buy or sell, and when? Have you found the next Apple or Google? It’s fun to talk about — a co-worker of mine recently told me about how he invested in copper mining companies in anticipation of the Beijing Olympics — but I’d like to offer some numbers, and some perspective.

To keep things simple, let’s say you’ve got a retirement investment portfolio that returns 10%, year-on-year. Of course, no portfolio is actually going to do that — anything returning 10% is going to carry a lot of risk, and thus, will vary quite a bit from year to year — but that’s okay for what we’re looking at. For this imaginary portfolio, if you invested $200 every month — $2400 a year — after 30 years, you’d have $452,098. (Edit: of course, the assumption that you’re investing a constant amount for thirty years, rather than increasing your investment as your income increases, is also unrealistic (not to mention unwise!). But again, this is okay for our purposes.)

Not too shabby, but most people I know would want more in their retirement accounts before they’d feel comfortable calling in rich. The first thing people generally think about is how to increase that return rate. Maybe you have an awesome hedge fund, or a killer advisor, or the perfect asset allocation, or you consistently pick more good stocks than bad every year for thirty years. If they’re really, really good, maybe you’ll get an extra 2%, net of fees (whether they’re charged by the hedge fund, your advisor, or your brokerage for all those trades). Now, that may not sound like much, but don’t be fooled — that extra 2% will get you $689,993, almost $250,000 more than (over 1.5x) what you would have gotten otherwise. (For the rest of this illustration, though, let’s assume you didn’t get lucky and are earning 10%.)

But wait — we forgot about taxes. If this is after-tax money in a Roth IRA, then our illustration still stands. But what if it’s in a normal brokerage account? Well, at current capital gains rates, 15% of your returns would go to Uncle Sam every year, bringing our nominal 10% rate down to 8.5%. (Edit: to be fair, this is an unrealistically worst-case scenario. By letting your money compound for as long as possible before selling, you can reduce this hit significantly.) Suddenly, your ending portfolio goes down to $330,141; you’ve lost over $120,000, almost a quarter of that bundle.

OK, so we definitely want to take taxes into careful consideration. But what if we go a step further and boost our savings rate — maybe we invest in a 401(k) with a company match, or simply max out our allowable IRA contributions? Well, if we upped that $200 to $400/month, we’d end up with $904,195. (Yes, that is exactly twice the $200/month number — the distributive property in action.)

Alright, that’s almost a million dollars, and it’s all in tax-advantaged accounts. But there’s one more thing we can do — what if instead of increasing our savings, we had just started investing earlier. Thirty years represents a 35-year-old waking up one day and saying, “hey, if I want to retire at 65, I better get a move on” — what if we started saving $100/month right out of college? After 44 years, you would have one million, eight hundred ninety-five thousand, five hundred and three dollars.

I can’t make the point any clearer: start saving for retirement now. Even if you can only go with $50 or even $25 a month — start with the basic advice here, and refine your investing strategy as you go. Yes, investment choices, taxes, and putting a lot away are all important, but they all pale in comparison to starting as soon as you can (and gradually increasing your contributions over time).

Photo by Journey Photographic.

In case there was every any doubt: investing is not an exact science. After all, it depends quite literally on predicting the future, and as the Galbraith quote goes: “The only function of economic forecasting is to make astrology look respectable.” So it’s no surprise that there are as many ideas on investing as there are people, which can make for a lot of confusion. Let’s take a look at two of them: what I’ll call the Academic and the Businessman.

The Academic looks at investing in a very abstract sense. His main goal is to balance risk versus reward, using his knowledge of Modern Portfolio Theory. He knows that the two often go hand-in-hand, but that diversification is key, which will greatly reduce the risk while still keeping a good reward over time.

The Businessman, however, knows that owning stock is like owning a business. He does a good deal of research on each purchase he makes, and he makes sure to understand the business model of each company he invests in.

When purchasing a stock, a Businessman will often look at the “fundamentals”, aspects of the company such as earnings, cash flow, debt, assets, and dividends. The Businessman is especially interested in stocks that are priced lower than they should be — either because the company is out of favor (e.g. Ford during late 2008), or because its growth is even higher than expected (e.g. Apple, starting at around the same time). They look down on “di-worsification”, buying stocks in companies without a rock-solid reason for each purchase.

An Academic, however, rarely purchases an individual stock. He concerns himself more with the proportion of various asset classes (large and small, domestic and international, “value” and “growth”, and most importantly, stock and bond) in his quest to balance risk and reward. He believes that in this modern era of free-flowing information, picking an individual stock that significantly outperforms its current price is generally due to luck, and thus that consistently doing so is nearly impossible.

If you’re looking at investing sites on online, you’ll find a lot of Businessmen in the “Motley Fool” community, as well as in the sizable group of those who look to Warren Buffett for their investing inspiration. Meanwhile, the community known as the “Bogleheads” (after Jack Bogle, founder of Vanguard) fall firmly the Academic camp, along with academic researchers exemplified by Eugene Fama and Kenneth French.

Me? I’m an Academic…mostly. The research is compelling, and I trust it more than I do Wall Street or most financial publications. That said, I keep a small part of my portfolio set aside for specific companies to scratch the Businessman itch!

How about you? Are you an Academic, a Businessman, both, or neither?

God grant me the serenity to accept the things I cannot change,
Courage to change the things I can,
And the kind of money where I don’t really care either way.

OK, not really, but yesterday’s announcement that Apple would be giving some of its tens of billions of dollars back to its stockholders in the form of buybacks and dividends sparked a conversation with a friend of mine, so I thought it would be a good time to talk about emotions and the stock market.

Anyone with spare cash will often find themselves invested in the stock market. Those who are compensated partially in stock (hello, fellow engineers!) pretty much have no choice. And everyone will, sooner or later, find themselves selling that stock at a particularly bad time, and slapping themselves in the face because of it. “If only I had sold sooner/later!” How do we avoid this?

First, know that you’re going to get it wrong sometimes. People have varying takes on how efficient the market is, how predictable it is, and how much it’s just a random walk (see Burton Malkiel). I side with the random walkers, but pretty much everyone admits that there’s some amount of “noise” in the market, some amount of movement that you simply cannot predict without getting lucky. Accept that and move on. Yes, you could have timed things better, or put more into this stock when it was low, but you didn’t have a crystal ball, so don’t beat yourself up over it.

Accept that you are heavily biased. Humans have all kinds of cognitive biases, and most of us refuse to believe that we’re affected by them. A particularly deadly one is the fact that we tend to ”accept wins at face value and tend to explain away losses”, per this paper among others. In the stock market, this encourages us to take more risk than we really should, and to overestimate our skill. The first step to countering this is to acknowledge our weaknesses. The second step?

Develop a plan, stick to it, and leave your emotions at the door. Do NOT go with your gut; when it comes to the stock market, your gut is lying. Make a plan: I will buy at this predetermined point, and I will sell at this point. (“Dollar-cost averaging into a broadly diversified portfolio and regularly rebalancing” is a good start.) If the market starts plummeting or soaring, keep ignoring your gut: following the crowd is a recipe for buying high and selling low. (And make no mistake: blindly doing the opposite of the crowd is almost as bad.)

Diversify. There’s a common saying in the financial planning world: diversification is the only free lunch. If you have individual stocks, keep them under a small percentage of  your portfolio (say, 5%), and during your regular rebalancing session, make sure they don’t exceed that percentage. [Edit: This means the rest should be in a diverse allocation of mutual funds. I'll talk about that more in a future post.] This has several advantages: it will help you limit your risk of a single company causing your portfolio to nosedive, it’ll help you sell the winners at a good time, and it’ll help you obsess a little less over your company’s fortunes. Speaking of which:

Don’t own stock in the company you work for. Unless stock options are your main form of compensation, you’re already heavily invested in your company: they’re the ones writing your paycheck! Don’t double down, even if you work for Apple: if your employer gives you stock, in the form of options or ESPP’s, sell it as soon as it vests and invest it elsewhere. (Worried about taxes? You shouldn’t be. I’ll cover that in a later article.) For every story of an employee who retired rich off his company’s stock, I can give you 10 (at least!) of employees who wiped out their wealth by failing to diversify in this way.

Above all: unplug, unplug, unplug. Watching “Mad Money”, reading articles like “5 Stocks To Watch”, and the like will just give you heartburn and tempt you to ditch your plan. They certainly won’t help you make money; make no mistake, they’re entertainment. Following the latest trends just leads to buying high and selling low, because there are thousands of people watching and reading the exact same media. Get the information it takes to follow your plan, only as often as your plan requires. (Hint: if it involves checking prices and other research more than once a quarter, it’s probably too involved.) If you think you may want to change your plan, force yourself to go slowly: wait until next quarter — or next year! — before even beginning to implement that change.

In other words: mind the gap.

My friend Daniel Hope is presenting a marriage workshop series, and I was honored to give a talk on marriage and money at last week’s session. By all accounts, the most useful piece of that talk was a framework for setting up accounts that I call “Yours/Mine/Ours”, so I figured I should share it with the world at large.

Yours/Mine/Ours is a “middle way” between two extremes I’ve seen in the married world for handling shared finances. On one end, you can share everything between the two of you. It makes things very simple — everything goes in one pot, and everything comes out of one pot — but after a while, things can get…hairy. Maybe he has a habit of overspending on things she doesn’t care for. Or maybe he doesn’t want to spend money on anything, so she feels guilty any time she so much as buys new socks. (Modify genders as you see fit.) Resentment builds, and you either argue about it or, worse, you just don’t talk about it and let the pressure quietly build up to explosive levels.

At the other end, you can decide not to share anything, finance-wise. You have completely separate accounts, and you split the check for everything. Not only does this quickly get complicated — mortgages don’t really lend themselves to being “split” — but it doesn’t reflect reality very well. Does one of you really own all the groceries, and the other all the utilities? And of course this sort of arrangement precludes one spouse from ever leaving work (for example, to raise children).

Yours/mine/ours is a compromise between the two that looks like this:

As you can see, all income first goes into a joint account (“ours”). All shared expenses are withdrawn from that joint account (mortgage, groceries, utilities, child expenses). Also, at the beginning of every month, some amount is transferred into separate, personal accounts (“yours” and “mine”). This money is for individual spending; he can’t say boo about what she does with the money in her personal account, and vice versa. He doesn’t even have to be able to see into it.

This method has several advantages:

It heads off control issues. There’s no question as to whose money it is, or who is ultimately in control. Everything is “ours” first, then “yours” or “mine” second. This is especially key in situations involving disparate income, or where one spouse isn’t working at all; even in the situation where one spouse is a homemaker, this method makes it clear that they have an equal stake in the household’s finances. (And yes, each spouse should have an equal stake, if you want a strong and healthy relationship. Income is irrelevant.)

It’s relatively simple. It’s nearly as simple as sharing one account for everything; the only wrinkles are (a) an automatic monthly transfer from “our” account to “yours” and “mine”, and (b) the fact that you now use your personal account for personal expenses.

It gives each spouse their own space. Everyone needs space to be who they want to be, and this is no less true in the area of personal finance. The “yours/mine” accounts allow you to buy whatever you want, without having to run it by the other spouse. (Note: I don’t recommend attaching a credit card to a personal account. One spouse going into debt “on their own” is a great way to freak out the other one.)

It allows gifts to be that much more meaningful. When you buy a gift for your spouse using your personal account, it means something more than if everything were shared. I mean, this is money that was specifically allocated for your to spend on yourself, and you chose to spend it on your spouse! (Not to mention the fact that this allows for you to more easily surprise them, because they can’t see your bank statements!)

How about you? If you have a similar arrangement, let us know how it’s working out for you in the comments. (And if this kind of sharing doesn’t work for you, let us know that, too!)

To cut to the chase: being a lover of systems and automation, I’ve created a monthly e-newsletter with practical, straightforward reminders and tips to help you stay on top of your personal finances. I’ll talk about checking your credit report, updating your budget,  paying estimated taxes, staying on the same page as your significant other…you know, all the stuff you feel you should do, but keep putting off.

Of course, this will be free, and you can unsubscribe at any time. Sound interesting? Subscribe here.

So now you know all about the difference between and RIA and a CFP (and that you should choose an advisor who is one if not both of the above) thanks to last week’s post. But almost as important as their certification level is how exactly they get paid. Yes, both RIA’s and CFP’s have a fiduciary obligation to you — which is definitely a step up from, say, a stockbroker — but financial advisors have developed a reputation for coinciding their best interests with yours, while following the strict definitions of the law. As they say: follow the money. Financial advisers are generally paid in one of three ways: hourly/flat fees, retainer fees, and fees plus commissions.

Hourly/flate-fee: Like lawyers, CPA’s, and many other professionals, some financial advisors charge an hourly rate for their services, or a flat rate for a financial plan. That’s it. They have no vested interest in selling you a particular product, nor do they care whether you have a thousand socked away or a million — their only interest is in doing right by you, so as to get your referrals and repeat business. That said, if you only have a thousand dollars to your name, paying five hundred dollars or more for a plan — a not-unlikely scenario — might not make sense.

Retainer fee: While retainer fee advisors also have no vested interest in selling you a particular product, they do care how much you have in your investment accounts — quite a bit, as they charge a percentage of your assets on a yearly basis (and will generally have a required minimum of several hundred thousand dollars). Generally, it amounts to 1%, with the percentage becoming lower as your account balance goes higher. In return for this fee, they manage your assets for you, leaving you to focus on other things. There are two potential issues with this: for one thing, 1% is a deceptively low number, but when compounded over time can really eat at your total returns. The other problem is more insidious: by handing over the keys to your wealth, the temptation is to just “let them handle it” and disengage from how your wealth is handled. Not only is it not the most responsible thing to do, but as 2008 showed us, it can be downright dangerous.

Commision-and-fee: Another term for this is “fee-based”, which can be somewhat misleading. These advisors generally charge an annual fee — one much lower than that of a retainer-based advisor — but on top of that, they are also paid commissions by mutual fund and insurance companies to sell their products. Most advisors associated with big brand names, like Ameriprise (formerly American Express Financial Advisors), Wells Fargo Advisors (formerly A.G. Edwards), and Edward Jones, follow this model. The potential for conflict of interest is clear, and while some shops steer the straight and narrow, others have developed a reputation for heavily incentivizing their advisors to push high-margin products (e.g. Variable Universal Life insurance policies) onto customers that would be better served through other vehicles. Translation: beware, here there be dragons!

So: from my descriptions, you might think that I’m a big fan of hourly-fee advisors — and that’s not untrue. But while it’s easy for someone to paint all advisors who fall under a certain category with broad strokes, it really all comes down to the individual. You could get an incompetent or unscrupulous hourly-fee advisor, or the world’s best commission-based advisor. And to be honest, a good commission-based advisor could be the most cost-effective, if they point you towards low-cost, no-load mutual funds. But if you’re looking to avoid conflict of interest and remain engaged with your assets, I strongly recommend hourly/flat-rate advisors. 

(Full disclosure: as part of my financial coaching services, I myself serve as an hourly-rate RIA. However, I’m not recommending them because I am one; rather, it’s the other way around. I chose to go this route specifically because this was the only way I would feel comfortable charging for investment advice.)

So how exactly do you find a good advisor? If you don’t already know one, there are two fee-only networks I recommend: NAPFA – the National Association of Personal Financial Advisors — and the Garrett Planning Network. Pick out several in your area — not necessarily in your neighborhood, you won’t be visiting them that often — and look up their Form ADV’s. You’ll be able to get a lot of information there (like how long they’ve been in business, their cost structure, and how many clients they have) that you can use to narrow down the list. Don’t make a final choice until you’ve at least talked to them on the phone. Ask them to explain their investment strategy to you, and how they generally handle cases such as yours (due to confidentiality, they won’t be able to give you specifics). See if they listen as much as they talk.

Last week’s post notwithstanding, everyone’s financial situation is different; sooner or later you’re probably going to want to consult a financial planner. However, the financial services industry has such a bad rap that a lot of people I know have opted for doing the research themselves, with varying degrees of success. (I can’t tell you how many engineers I know invested in a “sure thing” — Dutch auctions, municipal bonds, a bevy of stocks picked by a program they wrote — that promptly collapsed in 2008.) If you don’t have the time, inclination, or trust in your own financial wizardry, you’re going to want to hire a planner. But how to find one that won’t take a huge bite (as it were) out of your investments?

To answer that question, first let’s take a quick look at the two designations: RIA/IAR and CFP.

Registered Investment Advisor/Investment Advisor Representative:

The terminology here is a little bit confusing. A “Registered Investment Advisor” can refer to either a company or an individual in business for themselves; in either case, it means that they have registered with the SEC or state securities board and are licensed to give investment advice. (“Investment Advisor Representative” is the term used for a licensed individual working for an RIA.) Important things to note about an RIA(or IAR — from now on, when I say “RIA” assume I mean “RIA or IAR”, unless I explicitly state otherwise):

• You don’t necessarily have to be an RIA to give investment advice. I won’t bore you with the details, but your accountant, broker, or lawyer can legally give you “incidental” investment advice without being an RIA. So if they do, don’t assume anything about their investment credentials.
• They have passed one or more tests regarding their investing and legal knowledge. Exactly which test varies depending on whether they also intend to act as a broker — it could be a Series 7, 63, 65, 66, or some other. Not only does it cover investing, but it also ensures that an RIA knows exactly where their legal boundaries are.
• They are held to a fiduciary standard. This means that every recommendation they make must be in the client’s best interest; their ultimate loyalty is explicitly to the client. Any potential conflicts of interest must be made clear through their brochure (see the next bullet point). Contrast this with the “suitability” standard, to which brokers are held, which states that recommendations must not be “unsuitable” for the client; however, their ultimate loyalty is to the broker-dealer company they work for. As you might imagine, this subtle distinction can make quite a bit of difference.
• You can look up their information online in a centralized database. The online search tool is called IAPD, and it’s a great way to check up on an RIA or IAR and see if they’ve committed any past indiscretions. If you look up an RIA, you’ll get a “Form ADV”, which outlines everything you ever wanted to know about their practice (and a lot you probably didn’t). The bit of awesomeness, however, is that RIA’s are required to create what’s called a “brochure” for part 2 of the Form ADV, which must be in layman’s terms and must contain certain information, including details on any possible conflicts of interest. If you’re wondering about commissions your RIA might be getting for certain investment products, this will lay it out.

Certified Financial Planner

Whereas RIA/IAR is a legal designation for dealing with government bodies such as the SEC or state securities boards, CFP is a private, professional certification.

• CFP’s must meet certain education requirements. This includes having a bachelor’s degree, taking a very specific set of coursework on various financial planning topics, from insurance planning to estate planning, and a prescribed amount of continuing education each year.
• CFP’s must have three years of financial planning experience. 
• CFP’s are also RIA’s/IAR’s. So you can look up their information in the IAPD database, and they’re held to the same fiduciary standard, in addition to a Code of Conduct enforced by the CFP Board.

Now you know a bit about the designations financial planners use. There’s more to a planner than their designation, however — next time, we’re going to talk about how different types of planners make their money. It’s more important to you than you might think!