Adventures in Taxland, Part I

As a sideline, I do taxes for other people. It is hard to make much money, since it is only a part time seasonal gig, but I enjoy the work, and the stories are terrific. I plan to share some of those stories on this blog (with identities suitably masked), and this is the first from this season.

Since I started with my current company, I have always heard bad things said about our largest competitor. There are a number of players in the paid tax preparation market, ranging from CPAs to cash advance stores to sole practicianers who work out of their homes. But our competitive focus is on the large, multi-office chains. The biggest of these shall remain nameless, but their initials are JH.

I have always heard it said that "we don't do things like JH" or "those guys at JH don't care what they put on a tax return." If we were a bar, we would make cracks like "you can't find a clean glass in that place." I have always taken that trash talking with a grain of salt. After all, we're not over there every day; how do we know what they are doing? Still, running down the other guy is a good way to build morale in your shop.

But this week a woman came in asking us to review the work she had had done at JH. According to the woman, they had prepared and filed her tax return using her last pay stub from 2011. Once she had received her W-2, she realized that it did not agree with what she had filed, and she asked us to take another look.

IRS regulations say you are not supposed to file a tax return without the W-2 in hand. If a client comes into our office without one, we try and find one online, or failing that, we turn them away until they get that all important document from their employer. Clients don't care about this, of course. In their rush to get their hands on a tax refund, they will say or do anything to try and short circuit the process. But the paid preparer is supposed to care.

In this case, the pay stubs had not shown all of the earnings and withholding from the woman's job. Because her withholding was not all reported, it reduced her refund. Since she received both Child Tax Credit and Earned Income Credit, those were undercalculated as well. All told, not following the rules would have cost this woman hundreds of dollars in her refund.

To get the rest of her refund, the new client will have to file an amended return. The amendment will have to be mailed in, and she will have to wait a couple of months to receive the balance of her refund. Since my office will get paid for reworking her return and preparing the amendment, she will end up with less money then she would have gotten if she had come to us in the first place.

So maybe there is a difference in tax preparation services after all.

Mitt Romney's Tax Returns

Mitt Romney really took a beating over his failure to release his tax returns before theSouth Carolina primary. What I think he should have said was this:

"The Republican nominee traditionally releases his tax returns after he is designated the nominee, typically in April. If I am my party's nominee, I will follow that tradition. My opponents in this primary want me to release my tax return information now. They claim it is that is so that I can be 'vetted' by they and the media.

The real reason they want that information is so they can attack me for having more money than they do. I can understand that, but I'm not going to indulge them. As President, my policies will not be about attacking the rich (like the current administration), or about blaming the poor (like some of my opponents in this primary). Instead, my administration will concentrate on policies that create an economic environment where everyone's talents will take them as far as they can go. Americans aren't focused on envy of those who have more--they want the chance to do better on their own, without handouts from the government.

Yes, I'm wealthy. But nobody gave that money to me. I earned it by helping build businesses that returned money to their investors. I think that the Democrats are the party of class warfare and income redistribution. Republicans are the party of opportunity. So I'm not going to open the door for my primary opponents to attack me in that fashion."

Of course, he didn't say anything of the kind. He waffled on the issue, and it cost him. Big time.

Liquidity Preference, Opportunity Costs, and Arbitrage: Home Mortgage Edition

I was at a social outing last week, and during the conversation the subject turned to mortgages. The host averred his strong preference for not carrying a mortgage. “Just pay it off, and then you don’t have to worry about making that payment every month. Besides, I can’t stand paying all that interest every year.”

Now, most Americans do not have the wherewithal to pay off their mortgage 100%. Indeed, for most people paying off a car loan would be a stretch. But I could, and yet I continue to carry both a car loan and a home mortgage. So I thought I would write about why it can be a good idea to continue carrying debt, when you have enough assets to pay it off.

First and foremost, cash keeps your options open. Let’s say you have $100,000 in debt. Also suppose you have $100,000 in cash. You could extinguish all of your outstanding debt. But then, you would no longer have any cash on hand. You better hope the transmission in your car doesn’t go out, or the roof doesn’t leak, or any of a hundred possible contingencies does not occur. Because then you’ll wish you had held on to more of that cash.

The desire to keep cash on hand to cope with life’s curve balls is what finance professors call liquidity preference. Personal finance experts recommend you keep three to six months worth of cash on hand for just that reason. Okay, but going back to our hypothetical example, unless you’re a member of the 1%, you probably do not need $100,000 on hand to fund your lifestyle for six months, or even a year. Why not pay down the mortgage?

You give up the chance to do something better with the money, what economists call opportunity costs. Let’s run a more complicated version of our original scenario. This time we’ll start from the same place: a $100,000 mortgage and $100,000 in cash. Now we decide to hold $50,000 in cash for emergencies. We can use our remaining $50,000 in one of two ways. We can either pay off $50,000 of our mortgage, or we can pay $50,000 of Verizon stock. Verizon currently has a dividend yield of 5.15%, so our fifty grand would give income of $2575 a year. There is a little risk with holding the stock, but unless people stop making phone calls it is a pretty safe bet.

For the mortgage, assume a 15 year fixed rate mortgage at 3.5%. If you borrow $100,000, you will pay $3418 in interest the first year, and have dividend income of $2575. The net cost of the borrow and invest strategy is $843.

If you down debt and only have a $50,000 mortgage, you will pay $1709 interest the first year. Paying down debt will cost you $866 over the alternative strategy. Since the interest payments will drop each year of the mortgage, but the dividend payment should remain constant, the borrow and invest strategy will outperform the pay down debt strategy by a greater amount every year. By the fifth year, you will be $1152 ahead with the borrow and invest strategy.

Borrowing at a low interest rate and investing at a higher rate is an example of arbitrage, and it is one of the ways that the big boys on Wall Street earn their huge bonuses. They add a lot more zeroes to their numbers, of course.

I’m not saying you shouldn’t pay down debt, and there is something to the psychological lift you can get from not owing any money. But being debt free is not necessarily the best strategy for maximizing your financial well being.

The EEOC muddies the waters.

The New Year opens with a classic example of regulatory overreach. The EEOC has issued an opinion letter questioning whether employers who require a high school diploma for job openings are not violating the Americans with Disabilities Act (ADA). The EEOC’s reasoning is that a blanket requirement would discriminate against individuals who have a learning disability that prevents them getting a high school diploma, but who could learn to do the job in question with reasonable accommodations.

Frankly, although I have not yet heard of a potted plant graduating from high school, I suspect anyone with a pulse who showed up every day could. A for effort and all that. I just have to wonder how severe a learning disability has to be if you can go to school every day and still not complete the requirements for graduation. Based on my experience hiring high school graduates, the requirements for graduation certainly don’t include literacy.

Businesses don’t require high school diplomas because of the intellectual content of the job. It is more of a determinant of character than anything else. If you can’t make it through high school, you have to suspect problems like lack of focus, disrespect for authority, or sheer laziness. All characteristics that don’t exactly endear you to first line supervisors. Maybe over time those problems get resolved. After all, almost everybody eventually grows up. But if that is the case, you can always go back and get a GED.

Approximately 10% of Americans between the ages of 16 and 24 are classified as high school dropouts. Maybe some small percentage of that group has learning disabilities that prevent them from graduation, but don’t prevent them from being good employees. My own highly unscientific survey leads me to think the number is higher with advancing age. Given enough time a river will rub all the rough edges off all the stones in the streambed. But in the meantime employers should be allowed to impose filters on the applicant pool, to narrow the choice of candidates for a job offering. A high school diploma is one that has stood the tests of time and experience.

It’s not clear to me why the EEOC is inserting the government’s snout into private relationships like the hiring decision without presenting any evidence that a large pool of applicants is being discriminated against. Or, for that matter, telling employers what would constitute a reasonable accommodation.