Monday, September 19, 2016

Always Be Frontloading?

Quick apology for the hiatus. We have a new puppy, Cayenne, who is adorable and is pictured there on the right, but also wakes us up four times a night to go outside and pee, and who needs constant supervision all day, and has already given us two scares with the vet. So we're sleep deprived in the Done by Forty household, and all our attention is going to the pup, and to life, and to sneaking in short naps to stay sane. But back to the blog...

As you've surely found out by now, we've stolen all the ideas we use for financial independence. The concept itself we got from Mr. Money Mustache. We learned how to invest in index funds from Jim Collins. We learned that living with our parents well into our forties was okay from Joe and O.G at Stacking Benjamins. So, I borrow from the real experts. But what do you expect? I majored in English, not Finance.

One of the concepts we put into place over the past year is frontloading, which we liberally borrowed from the Mad Fientist. Frontloading is investing more funds in the early part of the year, instead of evenly throughout a time period. Even if you're investing the same amount of money as you would if you dollar cost averaged, by getting more of your money into investments earlier, it has more time to compound and grow.

This frontloading is being done primarily in our 401k. (Mrs. Done by Forty is still in school getting her PhD, so no 401k for her, yet.) But next year, we may do the same sort of frontloading with our IRAs.

The primary reason we're frontloading is to defer paying federal income taxes, especially those on my annual bonus. It's a big, one-time payment that hits in late February or early March. And that lump some payment puts us in a bit of a bind.

We can either pay roughly half of the bonus check to the federal government, or find some way to shield it from taxation. The tax deferral tool we have in my paycheck is the 401k. The way I figure it, we are either frontloading our 401k investments for the year, or frontloading our tax payments for the year. And when it's framed that way, it's a no brainer.

As Mad Fientist notes, since the trend of stocks is to go up in value, you are (more often than not) better off putting your money into investments as early as possible. While dollar cost averaging has some advantages, it's generally a sub-optimal strategy: you're better off getting as much of your money in play as early as possible.

And if we didn't like the notion of frontloading, the other option is paying a big chunk (roughly a third) of our federal income tax early. No thanks.

Trying to take this theory a bit further, I'm wondering if it might be prudent (or legal) to underpay our federal income taxes early in the year (i.e. - claiming a higher number on my W4), and then scaling up our federal income tax payments later in the year. We can pretty accurately estimate our tax owed. And we'd pay the same amount either way. Can't we just pay as little as possible early in the year, and then catch up in the fall and winter?

Ramping up our tax payments would allow us to incrementally front load even more, while still meeting whatever tax target we have.

Of course, there are some downsides. For one, this might not be entirely legal. The government might not like the idea of someone strategically paying their taxes as late as possible during the year. Any tax law experts or CPAs out there?

Secondly, I have to be careful frontloading my 401k, due to the way my company matches. I have to contribute at least six percent every pay period in order to get the full match. Front load too much, and I'll be missing out on a 100% match on my money in a misguided attempt to defer a few taxes and invest earlier.

Third, like just about every reader of this blog, I assume, we are investing a really big amount of money each month no matter which account we invest in. Does it really matter if I'm putting an extra $1000 into my 401k rather than a similar amount into a taxable Vanguard account? That is, minus the taxes I have to pay on any money I invest with my post-tax dollars, am I just shuffling money around by frontloading?

Alas, my lack of true finance skills puts me at a loss, and I have to rely on you kind readers again for advice. What do you think about frontloading? And am I tempting fate (or prison) if I try to pay taxes as late in the year as possible?

23 comments:

  1. Sorry, I can't leave an intelligent comment. I saw the picture of your new puppy and after that all I read was blah, blah, blah. More puppy pictures!

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    1. She's distracting, right? I find it hard to get work done sometimes when she wants to play.

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  2. OMG... the cuteness!!! I'm totally in love with your new puppy!

    OK - I have no experience with this frontloading concept - but when you're self employed the way taxes work is that you have to make quarterly payments throughout the year, and those payments must total the smaller of either the amount that you end up owing this year, or the amount you owed the previous year. I can't imagine that there would be any legal repercussions for claiming more allowances on a W-4, but your HR department should be able to tell you.

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    1. That's a good point with the quarterly payments rationale, EcoCatLady. As long as you're within their pre-defined boundaries (whatever you owed last year, or this year) then I doubt they care if you paid it on day one or day 365. Or, maybe they care, but they wouldn't notice?

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  3. PUPPPPYYYYYYY!!!! eheheheheheh...

    It was REALLY hard to read the post without constantly getting distracted by that adorable picture.

    Anyhoo...okay, so what do I think about front-loading?...well, I have mixed feelings. On one hand, deferring taxes is great and in some cases front-loading beats DCA but not always. If you had done it in 2009, it would've been great, but not so much in 2008. Also, as much as we like to think of investing as mathematically, when it comes to money, you can't avoid the emotional ups and downs of investing. So jumping right in with a big chunk of money might freak some people out. They may want to wade into the investing waters slowly, preventing themselves from panicking and selling. It also helps to have money on hand if a buying opportunity comes up. I'm more chicken shit when it comes to investing, so I tend to always pick the less risky route. Sure, I could be missing out on some gains, but I'd rather be able to sleep at night :)

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    1. "If you had done it in 2009, it would've been great, but not so much in 2008." Right, there are years where DCA comes out ahead (when market goes down) but, most of the time, DCA is suboptimal compared to frontloading or lump sum investing.

      Most of the time (roughly two thirds) DCA comes out behind. Frontloading is recommended for the same reason that index investing is: it beats the conventional-but-inferior strategy (active investing and DCA, respectively) more often than it loses to it.

      Now, for the psychological aspects, I can't speak for anyone else there. If investing more money earlier keeps you up at night, then maybe it's not for you.

      But there's a noticeable distinction to be made here: a lot of people who are advocates of DCA are actually just investing lump sums as they get them (in paychecks).

      True advocates of a dollar cost averaging strategy would get their monthly paycheck, and spread out the investment portion over the next 4 weeks, or maybe even invest daily.

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    2. True. I think in most cases, people are dollar cost averaging anyways, because they're working and investing a portion of their pay-checks or through contribution matching programs at work.

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    3. Right...though like I said, I don't think investing all of your "investment dollars" as soon as you get them in a paycheck really counts as dollar cost averaging. You're investing the dollars, literally as soon as you get them, as a lump sum. It just looks like DCA because it happens regularly.

      If you got a lump sum (say, an inheritance) and invested it regularly over time, then I'd call that DCA.

      But a rose by any other name...

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  4. Not sure on the legality of it but unless the market seemed very low at the start of the year I'd just leave it. Front load using the standard way and then get a bit of dollar cost averaging goodness by paying taxes and contributions each month.

    Love the new puppy! :)

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    1. I hear you, FIREstarter. But, the stock market goes up more years than it goes down. Whether it seems low or not, aren't the odds in favor of investing early rather than spread out?

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  5. I don't know much about investing and taxes, but that puppy is SO cute!! Congrats. :-)

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    1. Thanks, Laurie!

      I may just include puppy pictures in every post now.

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  6. I am neither an accountant nor a lawyer, but I reacted adversely to your fear of this being "illegal". That's a strong word when it comes to taxes (unless you are engaged in outright fraud/evasion).

    If things are blurry (when it comes to tax code), the worst you do is pay up (plus maybe pay a fine) if/when the IRS comes auditing and only then if you decide it's not worth it to appeal/counter-sue (because of said blurry tax code).

    Not sure if this topic is "blurry" tax code wise, maybe someone with knowledge will chime in, but in my own experience, if it's not easy to figure out doing a little web research of your own, then it is full systems go until I hear/learn otherwise.

    P.S. You just convinced me to NOT get a dog for another 5 years. My son and I have been wanting one, but my wife does not because of the work involved. Sounds like she would be proven right :-).

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    1. Yeah, maybe illegal isn't the right word. But even a fine from the IRS would not be something I want.

      It would definitely be nice to hear from a tax expert. I'm remembering that I just hired a financial planner...maybe he knows? :) Something to talk about in our next session, and maybe a good blog topic, too.

      And yeah, your wife is right on the puppy side: they're a ton of work and require a lot of attention. Personally, I think the juice is worth the squeeze. :)

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  7. It's perfectly fine to adjust your W-4 exemptions way up, way down, in order to balance your taxes owed. I do it all the time with the tacit approval of my accountant. You'd think the IRS would get sued for not paying interest on the billions in tax refunds each year.

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    1. Woohoo! Thanks for passing along what your accountant told you. I was hoping for some insight from a professional.

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    2. PS I like your bike icon too. Good taste. :)

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    3. Thanks, though the bike police are probably out to get me as I haven't ridden the thing all summer here in AZ. But it's cooling down, and will be breaking it out soon.

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  8. What an adorable puppy? What kind of dog is it? And as to front loading, adjusting W4, etc, etc...it's just doesn't seem like it's worth the effort. Does the few extra months of compounding really increase your returns that much? Plus, I'm more of a dollar cost averaging type of guy anyway, especially nowadays when I feel like we're closer to the top of the market. I don't try to time the market, but it would be painful to front load and then have the market crash.

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    1. Hi Andrew! Cayenne's a golden retriever -- just like Pepper.

      "it's just doesn't seem like it's worth the effort. Does the few extra months of compounding really increase your returns that much? "

      I wouldn't have thought so, either, but as usual MadFientist has run the numbers and the results are fairly surprising:

      http://www.madfientist.com/guinea-pig-year-2/

      "Since the market was higher at the beginning of 2015 and then took a dive in the autumn, front-loading probably cost the Optimized GP some tax-loss harvesting opportunities in 2015 but overall the strategy has been beneficial because it’s resulted in an extra $883, or 1.46%, over the first two years of the experiment."

      1.46% additional returns by just year two is pretty impressive. And as we know, compounding this small advantage leads to huge dollar differences over time.

      The part that really changed my view on frontloading is the tax deferral. The comparison isn't really "putting in an extra $1000 into investments this month vs. $1000 spread out over the year," but, rather "putting in an extra $1000 into a tax advantaged account this month, vs. paying taxes on that money this month and investing the smaller amount".

      Especially when you have something like a bonus (but still true when we're talking about your monthly paycheck) you're forced to either put more money into 401k investments or pay more money to the federal government in taxes. In a way, you're compelled to frontload taxes or investments.

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  9. If you think about probability (the stock market is more likely to go up than down) then front loads makes sense and is the most rational way to invest, assuming you wouldn't miss out on matching contributions, etc. What I would like to try is similar to DCA, I think it's called value cost averaging. I'm not sure of how to go about trying it exactly but I have a roll over IRA to play with. We will see.

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    1. You nailed it: because the general trend of the stock market is up, getting your money in as early as possible gives you the best odds.

      I don't know much about the difference between DCA and VCA, but would like to learn!

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  10. Canadian CPA here... Our tax instalment payments are done quarterly, 1/4 of your prior year taxes owing due each quarter. If any of your instalments are insufficient, Canada Revenue Agency charges 5% interest starting from the due date.
    So not illegal, but unfavourable. I imagine the IRS has a similar mechanism.

    Cheers,
    Matt

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