Tuesday, January 10, 2012

Cash Game Tax Planning Calculator - Examples, charts, and general results

If you haven't read the first post about this calculator, containing the download link and the instructions, you should do so first here.

Today, we will do a few more runs of some different plans and conditions for our example player and see how his bottom line is affected. I strongly recommend that you download the spreadsheet and play along at home with your own personal situation to see how it compares to the cases discussed here. The examples I go through will illustrate some important overall trends, but there should be substantial differences in the magnitude of the impacts from player to player.

Our example player

From the first post, we recall that our example player has the following characteristics and pays 2012 federal and New Jersey income taxes as a single taxpayer.




We had found that playing his home game ten times and making a trip to a cardroom to play $1/$2 five times led this player to effectively lose $74 on the year. How are different circumstances and decisions contributing towards this loss, and what can the player do differently to try to mitigate it?

We've seen that the negative tax effects hit the hardest on the very first sessions played in a year. Let's see how the costs look when looking at even fewer sessions than we first considered for this player.

The cost of social play, and overview of charts

Let's assume that our player is totally committed to playing his home game at least occasionally. The social value is worth it to him, even if the tax effects do end up making it cost him money on average. How much is he losing?

We run the spreadsheet for different session counts of the home game (with zero live cardroom trips) and look at the three charts produced by the file, located in the three yellow tabs at the bottom of the spreadsheet.


The first chart shows the year-end certainty equivalent as a function of the number of sessions played. The slope is more negative for the first few sessions as the player starts cutting into the standard deduction and risks a losing year. As more sessions are played, the slope increases (though it nonetheless stays negative here), which will generally be true for any game and for any set of inputs.


The second chart plots the true year-end winrate against the raw year-end winrate (the before-tax information provided by the player), again plotted against the number of sessions on the x-axis. The red line, representing true winrate, can never exceed the dotted green line of the raw winrate, though it will approach it as volume of play increases. For this particular home game, we see that it's not even close.


The third chart is similar to the second, but instead plots the marginal winrate, the per-session winrate for each additional session. We see through the jaggedness of the red line that there is more simulation error in the marginal winrate than the true winrate. A higher value of N and thus a much longer runtime would be necessary to get a perfect handle on this. Nonetheless, the trend is clear, and the overall effect here is:

In most situations, after a certain number of initial sessions to cover the biggest negative tax effects, the marginal winrates should increase as the number of sessions increases.

So, yeah, ouch. The variance is so much greater than the tiny winrate of the home game that it's a losing proposition even if 26 sessions of it are played. It turns out that our player, if playing only this home game, would have to play the game almost 200 times just to break even in certainty equivalent for the year! The loss of the standard deduction and the effect of a losing year is absolutely brutal for smaller-stakes players and where edges are thin relative to variance.

This would not be a good game to play to attempt to derive any profit from, but, if the primary motivation is having fun, it's only going to cost $114 in certainty equivalent to play this game ten times for the year. Frustrating, but probably worth it.

Adding cardroom play

Let's assume that our player will play his ten sessions of the home game no matter what. Then one of the only variables that he has any meaningful control over is the number of trips he makes to the local live cardroom, where we presume that profit is a bit more of a goal here. How many trips will he have to make before he ends up effectively ahead for the year?


Well, here's one answer — our player will, on average, effectively make money for the year if he's able to make 11 trips to play $1/$2.


Unfortunately, his hourly rate is still quite low compared to his raw winrate, showing that the negative tax effects are having quite an impact.


While the player needs to play 11 sessions of $1/$2 to make a profit for the year, it turns out that, given that he's already playing ten sessions of the home game, even a single session of $1/$2 has a (barely) positive certainty equivalent. If he weren't already playing the home game, the first $1/$2 session would be a loser (-$35 in certainty equivalent), as it would begin to delve into the standard deduction, but the home game has done that already here. This illustrates a rule that should hold true in general:

The effective profitability of any given session goes up as the number of other sessions increases.

Higher stakes

What if he were to play $2/$5 instead? His raw winrate goes from $8/hr to $15/hr, but the standard deviation increases by 180%. How will the interplay of higher winrate and higher risk affect decisions for the part-time player?

Here, I've plotted the $2/$5 results in a yellow line against the $1/$2 results in blue.


The shape of the $2/$5 curve is quite different. Playing $2/$5 instead of $1/$2 demands 21 trips to the cardroom to break even, rather than 11. However, $2/$5 will be more profitable than $1/$2 if the player ends up playing more than 23 cardroom sessions.

We also look at the marginal per-session winrates for $2/$5, plotted here without the results for $1/$2:


Comparing this chart to the prior marginal winrate chart for $1/$2 shows the difference between the different stakes. The marginal winrate is quite negative for $2/$5 at first, but reaches a much higher peak after a few dozen sessions, even coming quite close to reaching the raw winrate. This illustrates another general result:

Games with higher winrates but higher variance will take more sessions to become profitable after tax, but will converge to raw winrates faster.

The value of putting in longer sessions

Since the effect of the loss of the standard deduction is a byproduct of the necessary session-by-session accounting for amateur players, it would always be desirable to group more of a player's poker results into a single session. Since there's currently no acceptable argument that a week/month/year of poker play can be considered a single session, the only way to achieve this is to actually play longer hours in each session.

So, what if our example player had the stamina to be able to put in 16-hour-long sessions at the live cardroom instead of twice as many 8-hour-long sessions?

For $1/$2 play, we plot the original 8-hour session plan in blue and the 16-hour session plan in yellow, where we count each 16-hour session as two spots on the x-axis so that the two lines correspond to the same amount of hours played.


And, similarly, for $2/$5 play,


Considering that the length of sessions has no effect on raw winrates and does not commonly fit into how most poker players make their decisions, the positive effects of condensing one's poker hours into longer sessions are quite dramatic. The improvement is more substantial on the $1/$2 play, where the negative impact of the standard deduction issue was greater in the first place. In each case, the longer sessions help bring the true hourly rate closer to the raw hourly rate. Overall, the conclusion here is an important one for part-time amateur players getting hit by the standard deduction effect:

Playing a longer session instead of multiple smaller sessions can substantially reduce the negative impact of the potential loss of the standard deduction.

The effect of losing sessions and other itemized deductions

Restricting our attention now to the original case of ten home game sessions and five $1/$2 sessions, how much better off would our player be if he had more possible itemized deductions?

In reality, taxpayers rarely have control over their non-poker itemized deductions, but it should also be noted that this includes year-to-date losing poker sessions. For example, if the player has $4,000 in other itemized deductions for 2012 and has already booked $2,000 in losing sessions so far in 2012, the tax effects for the purposes of future decisions are the same as if he had $6,000 in itemized deductions and no losing poker sessions.

Here, the x-axis is the amount of itemized deductions that the player has already realized for the year:


We see that the cost of this tax effect is approximately constant for most smaller values of itemized deductions, as this player will be unlikely to accumulate enough losing sessions to make up the distance to the $5,950 standard deduction, but that the after-tax value of playing poker is recovered quickly as the deductions approach the amount of the standard deduction. The rightmost point on this graph, where itemized deductions exceed the standard deduction, is a case where the standard deduction tax effect is completely gone. The raw certainty equivalent here is $440, and without the impact of the standard deduction tax effect, the player is able to come much closer to fully realizing this than he does when he has no other deductions. Overall, in cases where the standard deduction tax effect would otherwise be significant:

An amateur who has accumulated enough losing sessions and other itemized deductions to come close to or exceed the standard deduction is able to retain much more of the value of his future play for the year.

Conclusion

These different cases illustrate how significant the effective costs and expected after-tax payoffs from a part-time, amateur poker career can differ based on individual facts and circumstances and as losing sessions are accumulated throughout a given year. The rules of thumb in this article can shape your intuition for understanding some overall effects, but intuition is still not going to be a reliable means of approaching this calculation. It's best to continually update and use the spreadsheet yourself.

Sunday, January 8, 2012

Cash Game Tax Planning Calculator - Instructions

Happy New Year! I have built a practical and important poker spreadsheet that I hope will make up for a lack of recent content here.

Hopefully 2012 will be a fruitful year for the poker industry — it'd be hard to be worse than 2011 — but in the meantime, while we wait around and attempt to keep our games sharp, us unwitting part-time live poker players in the US need to be mindful of our 2012 income taxes as we plan our play in a year without the volume afforded by stable online poker to help us hit the "long run" by the year's end.

I know I've written about a lot of topics that are interesting, but not quite practical. This is not one of those. This is extremely valuable practical tool that will help you guide real-life decisions and improve your bottom line. The results that you'll find will often be counter to your intuition, especially if you aren't playing very often anymore.

I have made it freely available here (and thanks to our friends at pokerfuse.com for the hosting):

(You may have to give permission for macros to run. There's nothing malicious or objectionable.)

What does it do?

This spreadsheet lets you input a plan for your cash game poker play for the year, simulates it, and computes your true bottom-line after-tax winrate.

Why should I care?

This isn't just a simple calculator for how much tax is paid on a certain amount of winnings. It accounts for important and complicated effects of the US income tax rules for poker.

In a perfect world, where poker is taxed in a consistent and fair way and where poker players are easily able to comfortably put in enough volume to get close to the "long run", a poker player would be able to realize the full value of his expected value in a poker game. We do not live in this world, and hence the variance of poker results has a real, quantifiable cost.

Four major forces act to impact a player's bottom-line payoff from a year of poker playing:
  1. There is no tax deduction or carryover for a losing year in poker — This affects both amateur and professional players and has a substantial effect on the decisions of which games to play in. For example, upon reaching the end of a year, a poker player who is close to even for the year may have to move down in stakes or stop playing entirely to avoid the "negative tax freeroll" of ending up with a losing year.
  2. Progressive tax rates induce extra risk aversion — A similar but lesser effect occurs when a player's poker activity could push them either upwards or downwards into a new tax bracket. Notably, a player in the WSOP risks $10,000 their marginal tax bracket, but will be taxed on their winnings at the highest possible tax rate if he has a big score, which eats into expected after-tax profits. This effect is much weaker at lower-variance pursuits, such as cash games, but can still impact year-end decisions significantly as seen in this model.
  3. Personal risk aversion — In my experience, this effect is much smaller than the tax effects, at least for players with reasonable amounts of wealth/bankroll, but is still worth including in the model. Utility theory is a way of approximating and quantifying personal risk aversion, and I've discussed how to construct and apply it to poker decisions it in a series of posts beginning here.
  4. Loss of standard deduction for amateur players — Amateur players cannot simply report their net poker winnings on their taxes. Instead, they must take the sum of their losing sessions as an itemized deduction against the sum of their winning sessions. If the player does not have enough other itemized deductions to offset the standard deduction, he will lose out on either the ability to deduct his poker losses or the tax break afforded by the $5,950 standard deduction. This is a very serious tax effect for amateur players who play cash games at reasonable stakes, in many cases effectively introducing a $1,000-$2,000 cost of playing ANY amount of poker during a year.
Previous models I've written about, particularly this one, have focused on effects #1, #2, and #3. I've mostly ignored effect #4 to date, treating its effects as a foregone conclusion that would almost always fully hit any player with a reasonable volume of play.

However, with 2012 being the first full year where many US players will be unable to enjoy the liquidity and convenience of stable online poker, it's going to be hard for many part-time players to put in enough volume to justify the cost induced by effect #4 or to have a sufficiently-low probability of a losing year as effect #1 demands. A winning player who made a solid profit from online poker over the last decade would have happily paid the $1k-$2k yearly "poker license cost" of effect #4, but if he is only going to be able to make a trip to a live cardrooms once a month in 2012, that cost may now exceed his expected profits.

For the suddenly-large group of American low-volume live players who will not be able to get anywhere near as close to the "long run" in 2012 as in years past, these tax effects can completely destroy expected profits. Now, much more than ever, it's necessary to plan ahead for the impact of taxes on one's poker career. This spreadsheet helps guide these decisions.

Setup

Only the cells with the white backgrounds need to be modified with the inputs for your personal circumstances. Let's walk through them all through the example of our classic "typical" player.

  • Annual Salary — Your non-poker taxable income for the year, which is treated as nonrandom. Use your best estimate. Professional poker players with no non-gambling income should set this to $0 and reflect their poker income through their poker results.
  • Prior Wealth — Your net worth at the start of this year, not including your income for this year. This is only used in calculating the effects of risk aversion, as the utility function depends on your prior wealth. A rough estimate is fine.
  • Risk Aversion — Your risk aversion parameter for the utility function built here. If you're convinced that you're completely risk-neutral, feel free to lower this, but, in my opinion, 0.80 should be reasonably accurate for most people. Don't sweat it too much, as the risk aversion effects are usually dominated by the tax effects anyway.
  • Other Itemized Deductions — This is the amount of non-poker, non-gambling itemized deductions you will take this year if you were to itemize deductions. This commonly includes state income tax paid in the prior year, mortgage interest, medical expenses, and more. Here, we'll assume that our typical player just has a small itemized deduction for his state income taxes he'll pay during 2012.

  • YTD Winning Sessions — Year-to-date winning sessions. This will start at $0 at the beginning of the year, but should be updated on an ongoing basis to give more accurate recommendations as time goes on and as results come in. The power of this spreadsheet is how it makes it convenient to keep up with dynamic reevaluations after each session.
  • YTD Losing Sessions — Year-to-date losing sessions. Note that this should be a positive number; if you have $1,000 in losing sessions for the year, put $1,000, not -$1,000.
  • File as Pro? — Amateurs will leave as "No", while professional players should change this to "Yes". Filing as a pro removes effect #4, as pros get to report only their net poker income, but pros must pay an additional 15.3% tax for their self-employed income from poker. Keep in mind that most people do not get to choose whether or not they file their taxes as a professional poker player. Consult a tax professional.


The spreadsheet allows you to project calculations based on up to three different types of games. Here, our example player expects to play in a small-stakes home game as well as some typical live $1/$2 and $2/$5 NL games. In each game, you should provide your best estimate of your hourly winrate, your standard deviation (you can draw some rough guidelines for NL holdem games from here), and how many hours you expect to play during each session.


This section is where you input how many times you expect to play each type of game. In our example, our typical player expects to play in his home game ten times this year, and to make a trip to the local cardroom to play $1/$2 five times this year.

It can be useful to run multiple game projections simultaneously to compare them. Fill in additional rows in the table provided and the program will treat them upon hitting the Calculate button. Keep in mind that each extra row increases runtime.


By clicking the Tax Rates tab at the bottom of the spreadsheet, you can modify the state and federal tax brackets to suit your individual situation. The federal tax brackets and standard deduction that I've provided are accurate for taxpayers filing as single in 2012. They should be changed if you are married, see here. You should also change the state brackets to those of your state. The first column contains the increasing tax rates in order, and the second column contains the highest amount of income taxed at that rate. For example, for New Jersey taxes, the first $20,000 of income is taxed at 1.4%, then income between $20,000 and $35,000 is taxed at 1.75%, and so on. The second column of the last row should always be a large number since the program will not properly account for income above that amount. If your state has no income tax, replace all of the percentages in the state income tax table with zeroes.

Calculation and Results

After all of the inputs are properly set, hit the big blue Calculate button to execute the calculation. This should take about 1-2 minutes per row as the program runs through N = 1,000,000 different possible yearly outcomes based on the number of sessions specified. If you just want to test only one possible session plan, leave the unused rows blank to minimize runtime.

Once the calculation is complete, the results appear in the blue cells. Keep in mind that, when you make changes to any of the inputs, the results will NOT be accurate until you've hit the Calculation button again.


  • Total Certainty Equivalent — This dark blue column is your bottom-line result. The number reported here is the certainty equivalent of the planned year of play beyond your year-to-date results, that is, it's the amount of additional nonrandom salary that would be equivalent to your planned random poker results. This is not just the after-tax amount of your original expected value; it represents the amount of nonrandom pre-tax money that would be equally preferable to your random poker results.
  • True Year-End $/hr — This divides the certainty-equivalent payoff by the number of hours played to return your true, effective average hourly rate over the entire year of play. When considering your bottom line, you should treat this as your true hourly winrate for the year. Due to the four effects detailed above, this will always be less than the raw hourly rates that you provided in your game descriptions, but if these negative tax effects don't end up impacting your results too much (i.e. as if you put in a very high volume of play), your true winrate will approach your raw winrate.
  • Marginal True $/hr — If you've run multiple rows, this shows your true winrate for executing the sessions in the current row in excess of the sessions chosen the prior row. This is intended to allow you to see the marginal true winrate over each additional sessionby running multiple rows in which one extra session of a certain game is added in each successive row.


To provide a sense of how much is being lost to the negative tax effects, the raw (that is, the unperturbed, unaffected numbers based on the game information you provided) total $/hr and marginal $/hr are provided for comparison.

In our results, we see that our unfortunate typical player is going to, on average, lose $74 this year by playing his home game ten times and playing $1/$2 in a cardroom five times. His executing this poker plan will end up effectively reducing his salary by $74 versus if he were to not play at all. The negative tax effects have created a cost of playing that exceeds the raw $440 that he would win on average.

Unfortunately, this is not an unusual result. Quite a bit more play is often necessary for a part-time player hit hard by the loss of the standard deduction to be able to break even, let alone profit! If this player doesn't have the time to play poker any more than this, he should consider forming a backing deal which completely eliminates his variance, or, sadly, not playing at all.

This simple case illustrates the need for careful planning through the use of such a calculator. The winning player looking to occasionally stay in practice likely would not expect his poker habit to cost him money, but indeed it might.

Under the hood

The core of the program is a Monte Carlo simulation of the possible year-end poker results, which basically means that the program simulates many random trials and tracks the sample average. Excel, despite having a nice front-end, is not ideal for computations of this magnitude, which is why this runs slowly. The necessary sample size (N = 1,000,000) and associated runtime is higher than I expected; since the utility function maps wide intervals in dollars into tiny intervals in units of utility, a very low standard error on the expected utility is necessary to keep the dollar results accurate.

Playing around with different sets of numbers can take some time, but it's still reasonable to update and run this program after every poker session. Really, though, this should be implemented in a more efficient language than VBA. The methodology is fairly simple.

Limitations
  • This isn't a complete solution to the poker planning problem. The truly optimal poker plan for most sets of available games will involve starting at one stake, but moving up or down based on ongoing results throughout the year. Once a decent positive profit is locked up, it becomes safer to move up to a higher-winrate, higher-variance game. I have found that this is too computationally intensive to solve in Excel via backward iteration. Updating and re-running this spreadsheet on an ongoing basis should help. The effect of this simplification to the optimization problem will be to underestimate the true certainty equivalents; when you reserve the right to change stakes in the future rather than lock into your plan, your EV might increase and cannot decrease. So, keep in mind that this spreadsheet essentially forces you to make your plans as if you had to commit in advance to playing a certain number of sessions, while, in reality, you could optimally quit or change games in the middle of the year.
  • This doesn't treat tournaments. It'd be conceptually easy to add them, but difficult to program and implement, as tournament finish probability distributions are so much uglier than Gaussians.
  • Using anything but a Gaussian distribution for cash game results would be a pain, but the normal approximation to cash game results should be good enough.
  • This doesn't currently accommodate the negative tax effects for amateur players of the infamous bad poker tax states, where gambling loss deductions are prohibited or limited for the purposes of state taxes.
  • Some other possible negative tax effects of poker that are not treated by this model are the triggering of the Alternative Minimum Tax, the loss of medical deductions due to artifically-high adjusted gross income, and effects on married taxpayers.
  • This is designed for US taxes, and I'm not familiar enough with the taxation of poker in other countries to know if this could be useful to non-Americans. However, it should be able to handle any tax system that involves a constant or bracketed percentage tax on poker winnings but disallows deductions or carryover for poker losses. In most cases, I imagine this would involve turning off the state taxes, standard deduction, and self-employment tax in the Tax Rates tab.
I welcome your feedback, suggestions, questions, and bug reports in the comments below. I apologize in advance if my calculator is the bearer of bad news for your part-time poker career, but it's much better to know the costs before you begin playing.


Continued in Part 2: Examples, charts, and general results
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