How to improve the health care system and what I learned from Michael Moore’s “Sicko”

I recently watched Michael Moore’s ‘Sicko,’ a “documentary” (and propaganda piece) on the health care system in the United States.  Moore also contrast our system with various government-run programs around the world.  While Mr. Moore’s opinions and footage are clearly biased in favor of a government-run system, I believe he does raise some valid points.  I’ll enumerate some of them below, adding my own thoughts.   Please remember that I am certainly not an expert in this area, and that these are merely my moderately-informed opinions.  Feel free to dissent, agree and argue by posting comments.

(Note to readers: I do feel a little uncomfortable posting politicized articles on this blog next to objective financial advice.  However, I do think there’s some value in asking readers of this blog to consider some of these very important issues from time to time, even if they disagree with every word I say below.  I’ve tried to keep my opinion pieces 1) separate by clearly labeling them as political, 2) as even-handed as possible, given my personal feelings and biases, and 3) without financial advice that relies on my political opinions.  Let me know in the comments if you like seeing a political article like this every once in a while, or if you think it’s inappropriate given the other content on my site.)

1) Doctors under a government-run insurance plan do not have to worry about getting paid by private insurers and can focus solely on providing health care. One could argue that a government-run plan would be more complicated than a private one.  That may be true, but I would think even one highly complicated government insurance option would be much less complicated that the combined thousands of private plans.

2) The profit motive of private insurance and health care companies (including for-profit hospitals and drug companies) is not necessarily in the best interests of patients. Moore interviews people whose job it is to find loopholes that allow insurance companies to avoid paying claims to those who become sick.  Also, there have been studies that show doctors are much more likely to prescribe particular drugs to patients when lobbied by drug salespeople regardless of whether the patient needs the drug or not:  “[r]esearch clearly shows that doctors who report relying more on promotion tend to prescribe less appropriately, prescribe more often and adopt new drugs more quickly.”

I’m not saying that the profit motive is bad in the health care industry (in fact, I think it’s often a wonderful way to align the incentives of many different people and businesses), but it has some undesirable effects.  Without the large profits that drug companies enjoy, there would be smaller incentives to pursue groundbreaking drugs that can work wonders for people ranging from cancer sufferers to those with high cholesterol.  I think many people make the faulty argument that because drugs are so cheap to manufacture, they shouldn’t be priced so high.  However, development of these drugs requires an enormous amount of research and development (R&D) expenditures, and most drugs developed never see the light of day.   Economist Gary Becker has suggested that countries that regulate the prices of drugs to low levels are able to ‘free ride’ off the American system.  What he means is that drugs that are developed in the US, where their makers can enjoy large profits, still benefit other nations that might have stifled similar drug development in their own country with price caps.

3) Moore’s ‘Sicko’ also states that we in the US suffer from poorer health as measured by infant mortality and longevity when compared to other industrialized nations. It is certainly true that we are an unhealthy nation, but others like Becker point out that this is mostly due to our terrible lifestyle, and not to the quality of our technical skill in healthcare.  Becker shows that survival rates for diseases like cancer are higher in the US, suggesting that our healthcare system is in fact very good (although very expensive.)  While it’s true that our poor health is often due to factors like overeating and smoking, I think it’s incorrect to think that our health care system can’t help fix these lifestyle factors.  When an ‘ounce of prevention is worth a pound of cure’, why should we be so focused on the quality of the cure and not prevention?

One potential benefit of a government-run health insurance option is that it would be a perfect place for an incentive system to be set up to promote healthier lifestyles.  One could penalize people who smoke or are at an unhealthy weight through higher premiums, or reward seniors who join a gym or excercise program.  This gets into dicey territory of how to determine what’s ‘bad’ and what’s ‘good’ for people.  One might point out that obese people and smokers actually costs less to treat during their lifetime because they die sooner.  Despite this, I personally feel that we as a country have a responsibility to encourage people to live healthy lives.  Libertarians would find this paternalistic, but I believe people are generally happier if they are healthier, and I would support the government taking modest measures to raise the health of its population.  Simple things like providing information (warning labels on cigarrettes, forcing restaurant chains to display calories) shouldn’t be too objectionable.  Penalties for drunk driving are another example (which should be increased; the penalties, I mean.)*  On a larger scale, we could eliminate farm subsidies for crops that make up too much of our diet, like the corn used to make corn syrup.

4) There is a general lack of information on the part of consumers. I’m a fairly sophisticated consumer when it comes to most items.  I have a mental price list for pretty much everything I buy, and am constantly weighing benefits of one product versus savings on a substitute.  Despite the fact that I pay much more attention to prices and value than most people, I am completely clueless as to what is reasonable to spend on a night in a hospital, a routine doctor’s office visit, x-rays, or a hip surgery.  Prices are not posted for all to see and compare between hospitals as they are for other products.   Insurance options are generally not set up to encourage patients to shop cost effectively.  Combine this with the many varieties of health insurance, all with pages of descriptions on what they do and don’t cover, copays, coinsurance rates, deductibles and lifetime maximums.  These factors make it very hard to know if what you’re paying for care is reasonable or outrageous.  A government insurance option or regulation that standardizes the way policies are displayed, or a rule forcing healthcare suppliers to clearly delineate their service prices in a fashion that’s easy to compare, would go a long way towards helping patients make better decisions for themselves.

5)  I also perceive a lack of competition between health care providers and insurers within localized areas. This could be partially fixed if the government would equalize the tax benefits of health care between individuals and businesses.  Currently, a business gets to deduct its health insurance premiums whereas a wage-earner with an individual plan generally cannot.  This provides a huge incentive for people to be insured through their employer, which creates problems of choice, since companies typically don’t offer many insurance options from competing providers.  Transportability, by which I mean the ability for a person to keep their insurance when switching (or losing) jobs, is also an issue when insurance is tied to employment.  Individuals do have some options to avoid paying taxes on their out-of-pocket health expenses, like Health Savings Accounts, but usually not their insurance premiums.

In addition, I would guess that businesses get to write off health benefits at the corporate tax level of 35%, whereas even if individuals could write off thier insurance premiums it would be at their federal income tax level, which would be much lower for the vast majority of people.  Because of this last issue, I would suspect it would be easiest for the government to eliminate the tax breaks that businesses get on health care, and simply let individuals deduct their personal insurance costs.**  I think that if the onus were put on individuals to buy their own health insurance, and if policy terms were more standardized, it could lead to a situation more like car insurance, where it’s very easy to compare policies and switch to get the best deals.

6) Lastly, I think the importance of personal security and risk aversion is overlooked by opponents of government health insurance. As Moore’s film shows, experiencing a traumatic health event without proper insurance (or finding out you didn’t have what you thought was proper insurance) can be catastrophic to individuals and families.  (You’ve probably heard the oft-quoted statistic that about half of the bankruptcies in the US are related to illness or health care expenses.)  People gladly pay more to avoid unsustainable losses; that’s what insurance is all about.  I think that covering the majority of the 40-50 million Americans without health insurance with at least catastrophic care, and forcing insurance companies to not drop patients when they get sick would help alleviate the hardship individuals would feel in the event of a serious illness.  Plus, catastrophic care combined with preventative visits could save money through early prevention and by lowering emergency room visits by those without insurance.

Conclusions

I think its important for both sides of the health care debate to realize the successes AND defects of our current system.  (For extra reading, Becker does some of this in his analysis of the Swiss health care system.)  My point here is not to illustrate that government-run insurance is better than private insurance (I think we should have both, assuming the government option can be done right.)  Rather, I want to stress the importance of improving the current system, which is not working for many Americans, notably those in the bottom income percentiles.  Standardization and flexibility in individual choice in policies can help consumers navigate the system and make better choices.   Making sure that all Americans, especially children, since they have no choice in the matter, have affordable health coverage is also important.  I believe we should take things a step further and find ways for our health care system to alter our lifestyles for the healthier.  I’m frankly dismayed that a nation as wealthy and resourceful as ours has continued to allow many of its citizens to exist in a condition so inferior to that of the rest of us.  Because I believe that the individual happiness gained from increased wealth diminishes rapidly at a certain point, it is shameful and stupid for us not to a have a more egalitarian society, especially with respect to basic services like health insurance.  It is my hope that Americans will one day view basic health care in the same way most view education or protection from violence today, as a benefit that should be extended to all, regardless of race, sexual orientation, gender, or income.

* There is an important distinction that economically-minded people like myself make when discussing government-imposed penalties and incentives.  1) Incentives designed to compensate for the damages a person or company does to bystanders.  These are known as ‘negative externalities’.  A common example is pollution which affects those who are not the cause of the problem.  2) Incentives designed to modify behavior towards some kind of (subjectively) preferable alternative, despite the fact that this behavior is only harming the individual that persists in it.  Strict Libertarians would argue that government should never step in under these situations, since that would be infringing on individual liberty.

The problem with this position is that it assumes people are always rationally doing what they want to, and that no one outside of that person has a better idea of what would make the self-inflicter better off.  This may make economic calculations easy, but it’s difficult to apply in real life.  Few people question that a child should be forced to do certain things that will make them better off in the long run, like attending school or avoiding sharp objects.  Yet once a person is an adult in the eyes of the law, this idea that others can sometimes look out for a person better than the person themself is thrown out the window by those who hold “liberty” as the ideal that trumps all others.  For example, an economist would say a drug addict shooting heroin into his veins and living in a dumpster is doing what’s ‘best’ for himself, given his desires and position.

However, I doubt that few people, including the addict himself, in his more-lucid moments, truly believe such a person wouldn’t be better off if he were able to kick the habit.  Moreover, we frequently hear people saying they don’t want to do something, and yet they do it anyway.  While this makes me react cynically and irritably toward such people, I still think we as a society have a responsibility to take their words at face value and try to help them.  This might be on the ‘local’ level of a family member forcing someone into rehab, or it might be on the government level of subsidizing rehab centers or criminalizing (to a reasonable extent) the use, or at least the sale, of drugs.

** Labor unions dislike this idea because it jeopardizes the benefits they can offer people.  However, it’s important to remember that health insurance is just one part of employees overall compensation package, so less benefits would be theoretically made up in higher salaries (minus the difference in tax subsidies that the business was enjoying.)  Plus, instead of subsidizing health insurance premiums at the corporate level, government could provide additional subsidies to individuals to make up any differences.

Buying a home for the first time (guest post)

Guest post from Greg Uratsu, a dashing 26-year-old man-about-town who recently bought a townhouse in Seattle, his first home purchase:

I recently closed on a townhouse, and Ward asked me to write a guest post about my experiences on his blog.  This is the first blog I have ever made so Ward, you have my blog virginity [Editor’s note: Uh, thanks?].  I am blogging about the process of buying and closing on a townhouse.  Remember: this is a townhouse.  I don’t know if the process is different for a condo or house.  Thank you for taking the time to read about my experiences.

When this all started I knew close to nothing about buying real estate.  My parents didn’t really help me because they wanted me to learn the process on my own.  This has benefited me greatly because I know a lot more now.  First, I went to a bank to find a loan.  The person giving out the loan is called a lender.  When talking to my lender I needed to figure out how much I could afford so I didn’t waste time looking at townhouses that were out of my price range.  When talking to lenders, they all basically ask you the same questions:

  1. What kind of loan do you want?
    1. 15 year fixed
    2. 30 year fixed
    3. Interest only
    4. There are others but I can’t remember [Editor: like Adjustable Rate Mortgages (ARMs) where your interest rate fluctuates.  I recommend getting the plain vanilla ’30 year fixed’ like Greg did.]

2.  How much do you want to put down?

If you put down less than 20% you have to pay monthly mortgage insurance.  The cost of this insurance varies depending on your loan amount.  A $300,000 loan will have you paying about $100-$125 per month in mortgage insurance on top of your mortgage payment.

There are a few ways to get out of mortgage insurance even if you put down less than 20%. Number 1 is to pay off 20% of the principle over time.  So if you put 10% down, you just need to pay 10% more of the principle over time and BOOM, no more mortgage insurance.  The other way to do this is as follows: say you have a $100,000 loan and you put down 10%, which is $10,000.  Over time the property value goes up to $110,000.  Since you have $10,000 in and $10,000 profit on the place, you add up the two values and have 20% into the $100,000 loan, and therefore the mortgage insurance goes away.

3.  Information from you (be sure to have answers to all these questions)

a.  How much do you make per year?

b.  What are your assets: car, debt, every single bank account, 401 K, IRA, Roth IRA?

c.  How long have you been working at your job and address?

d.  Social security number so the lender can run a credit check.

e.  Eventually the lender will need W2’s from the last 2 years, your past 2 pay stubs, and your residence history (to answer this, it helps a lot if you rented.)

4.  Interest Rates

a.  I didn’t realize what a big difference 1% can be on a mortgage payment.  I put down 20% on a $339,000 dollar place, and 1% can change my mortgage payment $168 dollars per month! The first time I talked to my lender the interest rate was 4.875%, after 1 month the rates went up to 5.875%, a difference of 1% in 1 month, damn…  I didn’t think it was that big of a deal until I did the math: $168 dollars for 360 months (30 year loan) is a lot of money, over $60,000! After gambling and letting the market change, I was able to get a final interest rate for a 30 year fixed rate of 5%.  Whew… I got lucky that the interest rates went back down.  Just for some comparison of interest rates, 5% is pretty damn low, I know people in 2006 that locked in at 8-8.5% which is a lot higher.  My parents in the 80’s locked in at like 12%, or something silly like that.

[Editor: Greg illustrates the importance of getting a low interest rate.  The higher your credit score, the lower your interest rate.  Read this to check your credit score and learn more about the importance of good credit.]

b.  It is important to know what you can and cannot do with each lender because they have different rules.  Once I found a place and had an address to give a lender I was able to lock in an interest rate for free on that day.  This is how it works everywhere.  However, this is where things change.  Some places charge up to $1500 or even more to unlock an interest rate and re-lock yourself.  Luckily, the lender I went with (Bank of America) let me unlock my interest rate after X number of days (I forget how many but at least 1 month) for free.  The catch is I can only do this once and I HAVE to use it within 30 days or else I get charged a large fee in the thousands.  The lender can waive this if your closing date is late and it’s not your fault, but it’s best to close on time.

c.  It’s wise to shop around at multiple lenders to get the best interest rate.  I also had 2 lenders try and beat out the other lender.  If you tell one lender that another lender is giving you say 5%, the lender talking to you may crunch some numbers and give you 4.875%.  It’s just like negotiating for a car, let people bid against each other.  In the world of interest and real estate, this can equate to thousands in savings over time.

After the lender collects information from you they take about 1-2 business days to process your information.  Once they process your information they pre-approve you for some amount.  In my case, I knew I wanted to find a place in the $300,000 dollar range at 20% down, so I applied for a $240,000 dollar loan and I got it.  Now I could go shopping!

One last tidbit before I talk about shopping.  How does money change hands from buyer to seller?  Well there is a middle man called escrow.  Escrow takes care of all the money changing hands.  So at closing, my lender will wire the money to escrow and then escrow will give them money to the seller.  I didn’t know this and this is important information for later on in this blog.

I had no idea where to look for real estate, I also needed an agent.  I will talk about finding an agent later.  First, let’s look at the places online to shop for a home.

1.  Craigslist.com

2. http://www.residentialseattle.com/

3. http://www.realestate.com

4. Ziprealty.com

My favorite choice was craigslist.com.  I looked up the places for sale and found one I liked.  But what to do?  There was an agent’s number but I didn’t know what to do.  Do I need an agent to talk to this agent?  Do I tell him/her I want to look at the place but I have no agent.  Well I learned that you do not need an agent at the time, and when you call the agent listed for a piece of property you tell them you’re interested in looking at the property and they schedule a time for you.  I looked at about 20-25 places before finding the one.  I found my agent that I wanted after the 3rd place I looked at.  She seemed really nice and very flexible on meeting times so I decided to use her as my contact.  When I found a piece of property I was interested in seeing I would call her up and tell her I wanted to see that.  You do not have to use the agent listed with the property to see the place because all property agents have access to keys.

When looking at the different places I learned that it’s nice to go with someone.  Luckily I have a girlfriend who didn’t mind going with me and she was a big help.  It not only helps to get the eye of a women, but also to keep you focused.  All my focus was on was the living room and how I could setup an L shaped couch and my TV to watch sports.  There were many places I saw that had a great setup but the bedrooms weren’t as nice, the kitchen was not nice; she really helped in reminding me to look at the other things.  She also brought in a different view point by asking questions like:

1.  What schools are close to here (when you sell you want to be able to appeal to all kinds of people and that includes families with kids)

2.  What is the neighborhood like?

3.  Is there a lot of easy parking for friends

4.  Is there easy access for the freeways?

5.  Is there a lot of crime?

These questions are important and it was sometimes hard for me to focus because I was only concerned with the living room, the kitchen (because I like to eat), and the backyard (I didn’t want a big one or one I would have to work on).  She also looked at the bathrooms, bedrooms, storage space, closet space, layout of the dials, bells and whistles on the walls, ability to easily to move in furniture; a lot of stuff that helped with my decision.

During the many hours and trips spent in looking at a place I realized that the $300,000 price range was not going to cut it.  I had to contact my lender and ask them if I could qualify for $340,000 home with a 20% down payment for a loan of $271,200.  After processing, I was qualified and I had more wiggle room to find a place.  My goal was to live in Seattle but in an area that I felt would be stable and wouldn’t become run down with crime.  The places I said no to were Beacon Hill, Central Area, International District, and West Seattle.  (The latter is nice but it’s a hassle to get to the freeway for work).  I wanted either Greenlake, Fremont, Wallingford, Belltown, or Greenwood.  After looking at the price range of what I wanted I found out the Greenlake/Greenwood area was the best without sacrificing space and amenities.

My goal was to find a place that was about 3-4 years old so that I would have some history on the townhouse to see if it had any leaks or problems.  A 3-4 year old place is new enough that it won’t be run-down, I wouldn’t have to do maintenance to it (because I am NOT A HANDYMAN), and it would up to date.  The problem is 3-4 year old houses were built during peak real estate prices in Seattle.  Typically your first 5-7 years of mortgage payments go towards interest only so the homeowner’s paying the mortgage for 3-4 years are not paying off any principle.  Therefore they still owe a large amount on their mortgage and if they are selling the place they are selling it for prices that are either at or ABOVE a brand new upgraded townhouse in today’s market.  I was surprised with the number of 3-4 year old places that lack today’s standards.  A prime example is a kitchen without granite tabletops and stainless steel appliances.  If I go out and meet a girl I want to be able to tell them I have stainless steel appliances and granite table tops at my place.  That’s how I got my girlfriend.  [Editor: Coincidentally, that’s also why my wife married me.]

A brand new upgraded townhome SHOULD include:

1.  Granite tabletops

2.  Stainless steel appliances

3.  Hardwood floors

4.  A thermostat in every single room

5.  Motion detector for the garage

6.  Gas Fireplace

The luxuries are:

1.  Security System

2.  Radiant heat (I had no idea what this was: it’s a web of pipes that go through the floor or wall of every single room.  Since each room has a temperature control you can set the heat to whatever you want.  Therefore not only does heat come out of a vent, but if there are pipes through your floor, the water heater shoots out warm water and therefore heats your floor as well.)

3.  Marble tops for the bathrooms

4.  Anything else I am forgetting.  Maybe a balcony?

Luckily, I had all the upgrades and luxuries except for marble tops in my bathroom, I even have a balcony.  [Editor: Boss baller!] This was all for a price much less than for a 3-4 year old townhome of similar square footage and location with non-upgraded amenities.  I realized that I should buy a brand new place and I did.  The only risk I have is I don’t know how the place is going to hold up.  Another reason why I picked my place are personal attractions as well.  The sun hits the back side of my place and is blocked by the other buildings so my place stays cool, I don’t want to live in an oven.  I live near a turn-around so there’s no traffic and it’s quiet.  I live away from the main street so there’s little dust and noise.  It has little to no yard to maintain.  It has a balcony.  It has a lot of storage space.  All of these upgrades and luxuries for today’s homes make me realize what a time capsule my parents live in since they have upgraded nothing since 1979.  Radiant heat in the Uratsu household?  More like fire in a pit for warmth.  Ok maybe not that primitive, but it’s still outdated.

So after finding a place and telling your agent you need to make an offer,  ohmygosh there’s a lot of paperwork and legal mumbo jumbo you have to go through.  Luckily my girlfriend also came with me for this. It’s nice to have a second set of eyes for this.  Off the top of my head, this is the timeline after making an offer:

1.  Builder or Seller either agrees or disagrees on the closing date and price (of course there’s other stuff but the closing date and price are the most important things most people look at).  If the builder or seller do not agree then they send you something back.  A quick tip on the closing date:  You want to close as close to the end of the month as you can.  Once you close you have to pay property tax for that month and it’s nice to buy a place at the back end of a month so you don’t owe that much in property tax for that month at closing.  My big obstacle was the closing date, we agreed on a price fairly quickly, but it took 3 offers to agree on price and closing date.  One thing to do is also add into the contract things that can be added to the house.  I asked for a stainless steel fridge and washer dryer.  It was agreed upon that they buy me that and install it.  I also asked for blinds but I didn’t get it.

2.  Once there is a mutual agreement then a lot happens.  Here is the order of things. First you need to make a check called “earnest money” to the seller.  Since the person is taking the house off the market for you they don’t want the chance of you walking away.  Remember, each day the owner is paying property tax and utilities so it’s not free for them to have the house sit there unsold.  If you were to walk away under certain rules, then the seller gets to keep the earnest money.  Typically the earnest money is 1-2% of the total price of the place.  If you decide to buy the property then the earnest money goes towards the down payment.

3.  You need a house inspection.  It costs about $300-$500.   The inspector has an eye that the normal person does not have and recommends places within the property that need to be fixed, touched up, and makes sure all the appliances work and there are no leaks

4.   You must check with the city to see if there are any additions to the area that the community will be responsible for.  For example, you might buy a place and then 2 months later they re-pave the streets in your area.  The community might have to pay for those streets and you will be responsible for the bill.  You are making sure you aren’t surprised by any extra bills you may have.  If there is something you don’t want being done in the near future with respect to extra bills, you can walk away from the purchase and get back your earnest money.

5.  You need to schedule an appraisal from the lender.  The lender sends a property expert to look at your place.  They also survey surrounding properties and how much they sold for.  This is done because the lender wants to make sure they are letting you borrow money for a place that is indeed worth at least how much you’re buying it for.  This costs about $500.  If the appraisal comes out lower than the agreed price, you can walk away and get your earnest money back.  If it appraises for more then more power to you, good job.

6.  You must find someone to insure your home.  Usually there is a Home Owners Association (HOA) for townhouses and condos which charges you about $100-$200 a month.  The HOA protects the outside of your home from falling trees, fire, and other stuff.  Usually you need to buy extra insurance to insure anything INSIDE your place incase of theft.  The HOA also maintains the building you’re in.  Luckily, I do not have HOA dues, so I needed to get approved for not only the outside of my home but the inside as well.  I needed the insurance to be approved for the purposes of getting the mortgage loan as well.

7.  There is a title you must agree to.  The title states the land that you own (if what you are buying includes land), and states addendums that are in place for that area.  For example, maybe 40 years ago it was agreed that oil could be drilled under your land.  You will know about these agreements as far back as a title company can go to see if there were any agreements that were agreed upon in your area.  If you do not agree with the title because you are scared someone has the legal right to do certain things to your area you can walk away from the deal and get your earnest money back.

8.  You must have your mortgage loan officially approved by your lender by some arbitrary date that you and the seller agreed to on the contract.  Otherwise, the seller has a right to walk away.  They also have the right to take your earnest money since you wasted their time.

9.  For a brand new place , you have a walk-thru with the builder to make the last minute touch-ups to the place.  This is where the inspection comes into play because you list off anything the inspector said should be fixed or touched up.  I asked for the entire place to be dusted, cleaned, and vacuumed before I move in.  I also asked for touch-ups to the paint and anything I deemed not reasonably perfect for a brand new place.  If you notice something after you close,  it would be your responsibility.  You do not want to have to do something the builder forgot or didn’t do.  I also made sure to receive my keys and garage remote at closing.

10.  The last thing is the closing.  At this point, the money from my lender that was put in escrow was officially wired to the seller.  Once that was initiated the place was officially mine (under the 30 year slavery contract I have with my lender.)  Remember also that there are closing costs which typically amount to $6,000-$10,000 when you consider all of them.  You need that much more over the top of what you’re paying for the place.  Poop.  I got my keys, my garage door opener, and the responsibility of up keeping up my new home.  The last thing I did was transfer all utilities from the seller’s name to my own and that isn’t hard.  I was finally done!  Housewarming party!

– Greg Uratsu

Do average Americans benefit from lower capital gains tax rates?

The answer, according to some well-reasoned arguments voiced by Fairmark.com‘s Kaye Thomas, is ‘not much.’  Here’s some interesting thoughts from Mr. Thomas’s article regarding taxable stock capital gains in the US.  (Bolding and italics mine):

“[I]t may be true that 100 million Americans own stock, but most stock held by middle class Americans is in IRA or 401k accounts, where the capital gains rate doesn’t apply. The tax rate matters for stock held outside these retirement accounts, and most of that stock is owned by extremely wealthy individuals. The bottom 60% of households own just 9%, while the top 10% of households own 70%. Over half of all capital gains go to households with income over $1 million. That’s roughly two-tenths of one percent of the population getting more than half the benefit of the cut in the tax rate.”

[…]

“Advocates of lower capital gains rates (and lower corporate tax rates, and other tax benefits for business) often cite the statistic that 100 million Americans own stock, implying that the middle class will receive an ample share of the benefit. Yet ownership of stock is highly concentrated in the hands of wealthy individuals, a small fraction of the population. The vast majority receive little direct benefit, or none at all. To borrow an analogy from John Kenneth Galbraith, the “100 million” argument is like justifying the cost of feeding more oats to the horses by pointing out that some will fall to the ground and be eaten by sparrows.”

Living and working outside the US in a foreign country? This guide’s for you.

I have a sister who currently lives in Norway.  Since she’s related to me by blood (and a US citizen), she can’t help but wonder “do I need to pay US income taxes?”  or “can I use foreign income to fund a Roth IRA?”

If you’re a semi-permanent overseas traveler like her, you might have some of these same questions.

A good place to start answering them is IRS Publication 54.  Below are several guidelines for working and living abroad that I’ve gathered from Pub 54 as well as other IRS-related sources.  Unless otherwise stated, the dollar amounts used below assume you are filing a 2009 tax return and are single.  Also, the guidelines below are NOT for those living in US possessions like Puerto Rico or Guam.

DISCLAIMER:  Despite spending countless hours reading briefings on the IRS’s website, I am NOT an accountant and do not hold any accounting certificates (CPA, etc.)  This is strictly an informational post that could contain inaccurate interpretations of tax law (although I try my best to get things right.  If you’re familiar with these tax rules, please post any corrections, clarifications as comments.)  You can read further about anything I say before you use it yourself, or better yet, consult a qualified tax professional.

1) Filing requirements

You generally do NOT have to file a US tax return if you are not self-employed and made less than $9,350 in 2009.  Take 2 minutes to answer a couple of questions here to determine if you need to file a return.  Of course, if you had any Federal withholding that you want to get back, file a return!  (Generally the same filing rules apply whether you are working in the US or abroad.)

If you get paid in foreign currency, you must translate that into US dollars for the purposes of calculating your foreign income on your US tax return.  The IRS says to “[u]se the exchange rate prevailing when you receive [income], pay, or accrue [an expense.]  If there is more than one exchange rate, use the one that most properly reflects your income.”  I.e.: use the exchange rate that’s valid at the time you get paid.  This might seem a little difficult, but you can easily make a spreadsheet with historical exchange rates on the days of your pay periods to figure it out.

(Hint: make 4 columns, the date you got your check, your payment in foreign currency, the historical exchange rate on that date, and a calculation multiplying your foreign income by the exchange rate to get it in US dollars.)

2)Foreign income tax exclusion

You can generally exclude foreign income of up to $91,400 (in 2009) from your US tax return if you are a resident of the foreign country.  You can meet the residency requirement in two ways:

a) be a ‘bona fide resident’, meaning you’ve been residing “uninterrupted” for at least 12 consecutive months, including an entire tax year.  Brief travel & vacations to other countries (like a month to the US for the holidays) are allowed, as long as your intent on these trips is clearly to return to the foreign country of residence.

b) Meet the ‘physical presence’ test: “You are considered physically present in a foreign country (or countries) if you reside in that country (or countries) for at least 330 full days in a 12-month period. You can live and work in any number of foreign countries, but you must be physically present in those countries for at least 330 full [24 hour] days.”  Generally, travel within these foreign countries counts towards your full days, so don’t worry if you’re on the move a lot.

Note that people in the US Armed forces are NOT included in this definition and do NOT qualify for the foreign income tax exclusion.

3)  Social Security

From the IRS: “In general, U.S. social security and Medicare taxes do not apply to wages for services you perform as an employee outside of the United States [with a few exceptions.]”  HOWEVER, if you work in one of the below countries, a ‘totalization’ tax agreement states that you will not have to pay dual social security coverage.  Generally, you’ll pay social security taxes to the (foreign) country in which you are a resident.  Here’s a link to the Social Security Administration’s international info site.

Australia Greece Republic of
Austria Ireland Korea (South
Belgium Italy Korea)
Canada Japan Spain
Chile Luxembourg Sweden
Denmark Netherlands Switzerland
Finland Norway United
France Portugal Kingdom
Germany

4)  Individual Retirement Account (IRA) contributions

If you want to contribute to an IRA (Roth or Traditional), any foreign income you exclude from your US tax return can NOT be counted as compensation.  Recall that you can only contribute to an IRA what you’ve earned in compensation (wages, tips, salary.)  Therefore, if your sole income for a tax year was $50,000 in foreign income AND you excluded that foreign income from your taxes (a smart thing to do), you could NOT contribute to an IRA for that year.*  However, if you also had, say, $2,500  in US income, you could contribute that to an IRA and still exclude the $50,000 in foreign income.

5) Foreign housing exclusion

You can also claim a foreign housing exclusion up to ~$27K ABOVE a minimum base housing amount of $14,624.  That means that if you spent less than $14,624 on valid housing expenses (which DON’T include purchasing a residence), you don’t get any exclusion.  (So this really only helps those with expensive housing.)  If you spent $30,000, you could exclude $30,000 – $14,624 = $15,376.

6) Prorating the foreign income tax exclusion

If you split your working time between the US and another country (while still meeting the residency requirements in the foreign country), you can prorate your taxes accordingly.  For example, say you earned a salary of $60,000 and worked 20 days in the US and 240 abroad.  You would have to include (20/240)*60,000 = $5000 on your US tax return since you earned that much in the US.  (The remaining $55K would be excluded under the foreign income tax exclusion.)

If the foreign income and/or housing tax exclusions might apply to you, fill out Form 2555.  (This form and its instructions should also help you in figuring out if you qualify, and how to calculate your exclusions.)

Remember that once you elect to take a foreign exclusion, it remains in effect until you revoke it.  Also, you can’t take any foreign income tax credits while excluding your foreign income (ie: no double benefits for the same income.)  You also would not qualify for the Earned Income tax credit, so consider that if you have a low income, especially if you have children.

* A special case for those with low incomes in foreign countries:  if your foreign income was less than the standard deduction + personal exemption ($9,350), you wouldn’t owe any taxes regardless of whether you took the foreign income exclusions.  Therefore, you could still contribute some of that income to an IRA (up to $5000 for 2009) and simply NOT elect to exclude your foreign income.

Stay away from leveraged mutual funds and leveraged ETFs!

I just read a good article at ‘Seeking Alpha’ on the dangers of leveraged mutual funds and ETFs (Exchange-Traded Funds.)  A leveraged fund is one that uses fancy sercurities like derivatives and options to double or triple the daily returns of an index (like the S&P500, for example.)  However, this does NOT actually double (or triple) the total return for several reasons.

1) Constant rebalancing: Leveraged funds must buy more stocks when markets go up in order to maintain a certain ratio of leverage to investment (1:1 for a ‘double’ fund.)  Similarly, in down markets these funds must sell off their investments.

This creates a large amount of trading (read: transaction fees) and short-term capital gains (read: taxes.)  If you don’t know already, rapid active trading is a dumb investment strategy because the fees and taxes eat away your potential gains.  (You’re better off buying and holding broad, low-fee index funds, or an ETF of that index fund.)

2) Interest payments: All that debt that leverage funds use doesn’t come free.  These funds pay interest and fees to use fancy securities, which comes straight out of your pocket.  As you can see in the article I mentioned above, this results in woeful underperformance in bear markets (= market going down), with only slight overperformance (of the underlying index) in bull markets (= market going up.)

I would bet that over the long-term, these funds & ETFs will underperform the market, or at least not come close to making up for their huge risks and volatility with increased return.  Instead of looking for a get-rich-quick scheme by leveraging to the hilt, look at much better places to put your money.

Bottom Line: Stay away from leveraged mutuals funds and ETFs, they could be hazordous to your wealth!

(As an aside, I should note that the idea of leveraging (slightly) an index for the long term is not altogether a bad thing, and may be helpful if done in the right way.  However, the current set of leveraged ETFs and mutual funds that take on monster leverage and result in high fees and constant trading are BAD.  That’s not to say that an individual investor couldn’t use index funds in a margin account or other options (that the Seeking Alpha author suggests) to use leverage intelligently.  However, that’s a topic for another day, and one that I really don’t think anyone reading this needs to be worried about.  As of today, I use NO leverage in any of my financial securities (= stocks & bonds) investments.)

In-state college tuition is only for “true” state residents

I quick note to prospective college students and their parents:

I was asked about a myth regarding students qualifying for in-state tuition rates when they go to school out of state. The MYTH is that if a student goes to an out-of-state school for 1-2 years (the typical school residency period), they become a resident for the purposes of receiving in-state tuition at public universities.  This appears to be FALSE!

It is true that there is usually a 1-2 year consecutive period that a person must live in a particular state in order to become a resident for the purposes of in-state tuition.  HOWEVER, the general rule is that IF the person attends school full-time during any quarter or semester in the 1-2 year period, they are a NON-resident and do NOT qualify for in-state tuition.

If you’re thinking about having the student live with Grandma in the state of University X for a year to qualify, think again.  I’ve also read rules that stipulate that prospective students who are dependents (which most kids are) of non-residents (like their parents living in another state) are also NON-residents, regardless of their stay in the new state.

It appears that loopholes are hard to come by for in-state tuition to those who are not residents of a state for any other purpose besides school.  Given that college tuition is expensive (but worth it), you’d better start saving today.

Top 5 places to put your money TODAY

This is NOT the place for your hard-earned dollars!

Where should you put your money?  There are a ton choices including credit card debt, retirement accounts, mortgage payments, that new Le Creuset stockpot that you’ve always wanted, a trip to Tahiti, etc.  Below is a list of where I think most people should put their money in order of priority.  That means that I recommend maxing out the first item on the list before going down to the others.

This list assumes a couple of things:

1) You have some cash to put towards these things.  If you don’t, you need to read Rule #1 of personal finance, cut costs where you can, optimize your spending, and automate your savings.

2) You are not endangering your health, have proper levels of insurance, and aren’t making yourself miserable by living like a total pauper because you’re following my savings suggestions to the extreme.

3) You’ll tailor this order to your own personal situation.  (But even so, I strongly recommend following items 1 & 2 in that exact order.)

Okay, ready?  Numero Uno for where your money should go is….

1) Employer 401k matching

If you’ve read my articles on retirement, you’ve heard me say this before: don’t leave free money on the table!  What type of return do you  historically get from a risk-free investment?  Treasury bonds have returned about 4-5% annually.  What is your employer match return?  If you get matching of 50 cents on the dollar up to 6% of your salary, your return on that first 6% saved is an instantaneous, huge, risk-free 50%!!! There’s no better investment in the world that I’m aware of.  Max this out no matter what!

2) High-interest debt, like a credit card

– Some readers might quibble with this as #2, I can hear them now: “What!? Paying off your credit card balance is always the first thing you should do!”  There may be emotional benefits to making this #1 that you should consider, but  if your employer matching is 50% instantly, and your credit card rate is 25% annually, you’ll do way better to first max out your 401k matching.  After that, put the rest of your cash towards that VISA balance.

(Of course, if you have a rate as outrageous as this one, you may want to switch to paying this off first…)

3) Emergency fund (3 – 6 months worth of living expenses)

You need to have some money socked away for unforeseen expenses or losses of income.  While you should at least have long-term disability insurance to protect yourself against injury, you also need a shorter-term stash of cash to tide you over if you lose a job, get sick, or have to replace something valuable, like a car.  The general rule for insurance is to insure things which you wouldn’t be able to replace relatively quickly and that would cause you hardship if you had to go without them.  This includes your home, life, health, and possibly your car or jewelry, depending on the retail value of these items and your personal savings.  (Make sure to avoid useless insurance.)

Expenses you can afford should be ‘self-insured’ by your emergency fund or other savings.  Raising insurance deductibles and banking (NOT spending) the difference in premiums is a good way to self-insure against small losses ranging from a few hundred to a few thousand dollars.  Store emergency money for unexpected car repairs, insurance deductibles (which can be large if you have catastrophic health insurance like I do), or high vet bills for your disgustingly-cute Cavalier King Charles spaniel.

Whether you need more or less living expenses saved depends on how steady your income is & how many liquid assets you already have (like non-retirement stocks that you could tap.)  The more financially secure you already are, the less of an emergency fund you need: a self-employed person with few liquid assets needs more emergency funds than a union schoolteacher with 20 years seniority and a sizable investment account.

Like all short-term (less than 3-5 year) savings, your emergency fund should be investing in something that is not only stable and liquid (easily accessible), but that will also give you a decent return on your investment.  High-interest savings accounts like the kind from INGDirect* fit the bill for very short-term savings since the principal is guaranteed by the FDIC.  Bond funds, which may vary slightly in principle but generally yield a higher return than savings accounts or CDs, work better for money that might sit there awhile.  I use a low-fee, highly-diversified bond index fund for my emergency fund due to the higher returns compared to high-interest savings accounts.

(Read this for an advanced way to juice your emergency fund interest rate while keeping your principal safe & accessible.)

4) Tax-advantaged retirement accounts (401ks, Roth or Traditional IRAs)

After you’ve maxed out your employer retirement matching, paid off your debts (except perhaps your lower-interest mortgage or student loan), and stored money for emergencies, it’s time to go back to saving for your retirement.  Read up on the Roth IRA, and then read this to see if it would be better for you to put your retirement savings in a pre-tax account like a 401k or an after-tax account like a Roth IRA or Roth 401k.  For people in high-ish tax brackets (25% and above as a rule of thumb) and who don’t already have a large pre-tax dollar nest egg saved up, I recommend putting the bulk of your retirement savings into a 401k plan (or a Traditional IRA if your employer doesn’t offer a 401k.)

If retirement is still 5-10+ years off, invest in broad, low-fee stock-market index funds like those that track the S&P 500 or the total stock market.  Index funds outperform mutual funds about 70-80% of the time and require no maintenance on your part since they passively track the entire market for you!  Any good 401k plan should offer at least one of these indexes.  If you’re investing in a Roth or Traditional IRA, select a mutual fund company that offers a good selection of  low-fee index funds like Vanguard or Fidelity.

Putting money into a tax-free retirement vehicle is critical to building up a nest egg for the future.  Assuming you’re in the 25% tax bracket (and some other things**), an investment in a tax-advantaged retirement account made when you’re 25 will be worth about 55% MORE in real dollars when you’re 65 than would an equivalent investment in a taxable account.  (Obviously, if your tax bracket is higher, it’s even more advantageous to avoid taxes.)

5) ‘Regular’ taxable investment accounts & short-term savings for big purchases

After you’ve either maxed out your retirement options (you’re a beast!) or decided you’re contributing enough to retire how you want to at a given age, it’s time to look at plain ol’ taxable investment accounts for long-term savings.  (Index fund recommendations still apply.)  I like to think of these as early retirement accounts; the more you sock away now, the quicker you can exit the rat race (or do something for lower pay that you like more.)

Also, you should be saving regularly for big purchases like a house, wedding, vacation or new car.  For these short-term items, I use the high-interest savings sub-account technique that I learned from Ramit Sethi (you could also use the Roth IRA ‘hack’ I mentioned in priority 3 above.)

Simply open an ING high-interest savings account*, then create multiple savings accounts, labeled according to each item you’re saving for (‘Wedding’, ‘San Francisco trip’, etc.)  Then, set up an automatic monthly contribution to each account based on the amount of time you have to save and the amount of money you’ll need.  For example, if you need $30,000 to put down on a house in 2 years, that’s $1250 per month that you need to be saving ($30,000/24 months = $1250 per month.)

Note that you might sometimes rank some short-term savings goals as higher priority than maxing out your retirement accounts (#4.)  That’s fine, but do NOT neglect your retirement.  Investing early, even with just a little bit of money, is the most important factor to building wealth.  Saving for retirement will be way easier if you start today with whatever you can.

Conclusion

So there you have it, the rank-ordered top 5 places to put your money: 1) Max out employer matching contributions before anything else, 2) pay off high-interest debt like credit cards, 3) create an emergency fund of 3-6 months worth of expenses, 4) put as much as you can into tax-advantaged retirement accounts, and 5) bankroll anything left into short- & long-term (taxable) savings/investment accounts.

Take each step one at a time until you’ve successfully mastered it, then move on to the next one (don’t try to do it all at once!)  Once you’re eventually able to do all of these things, consider yourself pwning your money!

Now that you know where to put your money, find out WHAT to invest it in here.

[And just for good measure, here’s a link from the Motley Fool’s insurance page, which should contain some complimentary info to this post.]

* If you want to set up an ING Direct high-interest savings account, the first 24 people that email me can get a referral link that will get them a $25 bonus if they deposit at least $250 when setting up the account (I’ll get a $10. referral bonus.)

** This assumes dividends & capital gains remain at the historically low rate of 15% for those in the 25% and up brackets.  It also assumes an effective tax rate at retirement of 16%, which corresponds to an income in today’s dollars of about $90K for a married couple.  If dividend or capital gains rates go up, tax-advantaged accounts perform even better against taxable accounts.  On the other hand, if your tax rate goes up relative to the capital gains rate after you’ve retired, tax-advantaged accounts lose some of their edge (but they’re always better.)

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