I was a guest on the Thinking Poker Podcast, a fantastic podcast which I highly recommend. On this episode, I joined Andrew and Nate to chat about my poker life, discuss the most interesting pieces from this blog, and help delve into some game theory and strategy analysis.
Check it out here: Thinking Poker Podcast, Episode 45: Mike Stein of Quantitative Poker.
Showing posts with label risk management. Show all posts
Showing posts with label risk management. Show all posts
Tuesday, August 27, 2013
Friday, February 15, 2013
An open letter: A simple, sensible change to fix almost all amateur poker income tax inequities
To the IRS, and to the legislators, regulators, and operators of future US online poker markets:
A longstanding quirk of the US tax code relating to how non-professionals must report their poker income has persisted despite the explosion in poker's popularity over the past decade. This tax rule creates effective surtaxes on amateur poker play that vary wildly with a player's personal circumstances and very frequently exceed 100% of a player's actual earnings. It is long overdue, and more pressing now than ever as we stand on the verge of domestically-regulated internet poker, that our tax code catch up with modern poker by taxing its earnings in a reasonably consistent way.
The problem
Amateur poker players currently cannot simply report their net poker winnings. Instead, they must report the sum of their winning poker sessions (gross poker winnings) as income, taking the sum of their losing poker sessions as itemized deductions.
An amateur poker player's bottom-line income is correctly calculated as his or her net income for most tax considerations. However, there are several intermediate steps within the process of determining a taxpayer's income tax obligation that can trigger off of or otherwise treat as proxy for true income the taxpayer's Adjusted Gross Income (AGI), a figure which includes gross amateur poker winnings before losses are deducted.
Consider an amateur poker player who, for simplicity, alternates between winning $100 and losing $100 in a weekly poker game for a year. Although he has made no money, his poker play contributes $2,600 to his AGI, as he reports $2,600 in Gambling Winnings and takes $2,600 in Gambling Losses. There is no meaningful theoretical or practical sense in which gross poker winnings represent actual income. Not only is our example a net loser at the end of the year, but he or she certainly has not had $2,600 of any sort of income. He or she never even possessed that much money at any point during the year!
Having any aspect of the tax code consider this player to have $2,600 of some sort of income is akin to taxing corporate revenue as if it were its income, or to considering the holder of this stock to have had $1,000 in investment earnings over this year ($1,000 being the sum of returns only over days in which the stock increased in value).
Of course, this is not how taxes work on these sources of income, but this is the problem that amateur poker players face. Depending on an amateur poker player's level of play, choice of game, and frequency of beginning and ending sessions, his or her AGI can very easily exceed his or her true income by tens or even hundreds of thousands of dollars, with no upper limit to the potential AGI inflation for higher-stakes amateur players.
What are the impacts of an artificially-inflated AGI?
The tax code appears to be designed so as to consider AGI to be a reasonable measure of a taxpayer's income, and it seems that amateur poker play is one of the few common ways that a taxpayer's AGI can significantly exceed his or her actual income. An artificially-inflated AGI can bring about the following inequities for a taxpayer:
They're not currently paying these taxes, of course. That the status quo has gone untouched for so long is almost certainly due to the low tax compliance rate on poker income, whether it be due to conscious tax evasion of unreported income or to a lack of awareness that a losing year of poker would have any tax implications at all.
A solution that covers all nine inequities
This can be achieved by defining the length of a poker session to be an entire year of play. The definition of a poker session is currently lacking modern guidelines from the IRS anyway and will already require explicit or implicit clarification when the first domestically-licensed sites start reporting player results, so let's do it right.
Why is this a sensible solution?
To define a session as an entire year of play is actually quite appropriate for poker. Even many amateur poker players are, by the very nature of the game, quite businesslike in planning their financial risk, managing a segregated poker bankroll and focusing on long-term expectations for their play.
Reporting net instead of gross income for amateur poker players would also have the benefit of being consistent with what almost every reasonable American would expect and perhaps how many amateur poker players incorrectly report their poker income currently. There'd be no need to file any poker activity during a losing year, and, while contemporaneous records should still be required, the players who inevitably fail to keep proper session-by-session accounting would nonetheless have a reasonable chance of estimating their total win or loss at the end of a year.
Why should you care about fixing this problem?
IRS & Legislators: Fair public policy should never tax an activity at more than 100% of the income it generates. Even if you believe that there should be some sort of extra "sin tax" to discourage activities that may be resemble or enable gambling, the more appropriate way to address that should be a stable, flat fee that players could easily plan and account for.
Regulators: Proper consumer protection involves being transparent about the costs of using a service. Regulated online poker should absolutely involve compulsory reporting of winnings to the IRS, but to have that in place before repairing this issue is to set a trap that millions of Americans would unknowingly fall into and is an abdication of regulatory responsibilities.
Operators: Communicating the current state of amateur poker tax reporting to your online players would turn many customers (rightly) away, yet failure to do so will likely lead to a dramatic drop-off in your player base. A delayed-impact, often-unanticipated and occasionally-large annual fee for losing is not good for customer retention. This will have to be fixed eventually for your customer base to subsist and grow, so out of respect for your customers, please expend resources towards fixing it now.
Conclusion
This simple and sensible change will eliminate an undue and capricious tax burden on millions of present and future American amateur poker players. To fail to correct this prior to the spread of domestically-regulated internet poker is to ensure an inefficient outcome for all parties involved.
Frankly, this rationale applies to traditional gambling activities as well. However, the need for change is most crucial for poker, a competitive strategy game which naturally lends itself towards narrow edges over regularly-occurring play, compels conscious maintenance and management of a bankroll, and attracts intelligent, price-sensitive competitors.
I don't know exactly how the poker community goes about changing this part of the tax code. I suspect that players cannot do it alone. We need our industry to stay aware of this problem and to represent our mutual interests. Keep the dialogue going.
Sincerely,
Mike Stein
A longstanding quirk of the US tax code relating to how non-professionals must report their poker income has persisted despite the explosion in poker's popularity over the past decade. This tax rule creates effective surtaxes on amateur poker play that vary wildly with a player's personal circumstances and very frequently exceed 100% of a player's actual earnings. It is long overdue, and more pressing now than ever as we stand on the verge of domestically-regulated internet poker, that our tax code catch up with modern poker by taxing its earnings in a reasonably consistent way.
The problem
Amateur poker players currently cannot simply report their net poker winnings. Instead, they must report the sum of their winning poker sessions (gross poker winnings) as income, taking the sum of their losing poker sessions as itemized deductions.
An amateur poker player's bottom-line income is correctly calculated as his or her net income for most tax considerations. However, there are several intermediate steps within the process of determining a taxpayer's income tax obligation that can trigger off of or otherwise treat as proxy for true income the taxpayer's Adjusted Gross Income (AGI), a figure which includes gross amateur poker winnings before losses are deducted.
Consider an amateur poker player who, for simplicity, alternates between winning $100 and losing $100 in a weekly poker game for a year. Although he has made no money, his poker play contributes $2,600 to his AGI, as he reports $2,600 in Gambling Winnings and takes $2,600 in Gambling Losses. There is no meaningful theoretical or practical sense in which gross poker winnings represent actual income. Not only is our example a net loser at the end of the year, but he or she certainly has not had $2,600 of any sort of income. He or she never even possessed that much money at any point during the year!
Having any aspect of the tax code consider this player to have $2,600 of some sort of income is akin to taxing corporate revenue as if it were its income, or to considering the holder of this stock to have had $1,000 in investment earnings over this year ($1,000 being the sum of returns only over days in which the stock increased in value).
Of course, this is not how taxes work on these sources of income, but this is the problem that amateur poker players face. Depending on an amateur poker player's level of play, choice of game, and frequency of beginning and ending sessions, his or her AGI can very easily exceed his or her true income by tens or even hundreds of thousands of dollars, with no upper limit to the potential AGI inflation for higher-stakes amateur players.
What are the impacts of an artificially-inflated AGI?
The tax code appears to be designed so as to consider AGI to be a reasonable measure of a taxpayer's income, and it seems that amateur poker play is one of the few common ways that a taxpayer's AGI can significantly exceed his or her actual income. An artificially-inflated AGI can bring about the following inequities for a taxpayer:
- Taxpayers who reside or play in one of about a dozen "bad poker tax states" owe state income tax on their gross wins, with no state deduction permitted for gambling losses.
- A taxpayer who would otherwise take the standard deduction will either be unable to take gambling losses as an itemized deduction, or will lose out on the difference between his or her "real" deductions and the standard deduction.
- That taxpayer's spouse also loses his or her standard deduction, even if filing separately.
- The deductibility of medical expenses is limited by AGI, which includes winning poker sessions before losing poker sessions are deducted.
- Roth IRA contributions cannot be made by taxpayers whose AGI exceeds $127,000. Traditional IRAs have similar limits in cases where the taxpayer is covered by an employer pension plan.
- The Free Application for Federal Student Aid uses AGI instead of net income in determining the financial capability of a family to pay for a child's college education.
- Most non-poker itemized deductions are phased out at certain AGI thresholds.
- ... as are exemptions.
- A 3.8% surtax is applied on the investment income of "high-income" taxpayers, again determined by AGI.
They're not currently paying these taxes, of course. That the status quo has gone untouched for so long is almost certainly due to the low tax compliance rate on poker income, whether it be due to conscious tax evasion of unreported income or to a lack of awareness that a losing year of poker would have any tax implications at all.
A solution that covers all nine inequities
All nine inequities would be instantly and completely alleviated if amateur poker players could simply report their net annual poker winnings instead of reporting gross winnings and deducting gross losses.
This can be achieved by defining the length of a poker session to be an entire year of play. The definition of a poker session is currently lacking modern guidelines from the IRS anyway and will already require explicit or implicit clarification when the first domestically-licensed sites start reporting player results, so let's do it right.
Why is this a sensible solution?
To define a session as an entire year of play is actually quite appropriate for poker. Even many amateur poker players are, by the very nature of the game, quite businesslike in planning their financial risk, managing a segregated poker bankroll and focusing on long-term expectations for their play.
Reporting net instead of gross income for amateur poker players would also have the benefit of being consistent with what almost every reasonable American would expect and perhaps how many amateur poker players incorrectly report their poker income currently. There'd be no need to file any poker activity during a losing year, and, while contemporaneous records should still be required, the players who inevitably fail to keep proper session-by-session accounting would nonetheless have a reasonable chance of estimating their total win or loss at the end of a year.
Why should you care about fixing this problem?
IRS & Legislators: Fair public policy should never tax an activity at more than 100% of the income it generates. Even if you believe that there should be some sort of extra "sin tax" to discourage activities that may be resemble or enable gambling, the more appropriate way to address that should be a stable, flat fee that players could easily plan and account for.
Regulators: Proper consumer protection involves being transparent about the costs of using a service. Regulated online poker should absolutely involve compulsory reporting of winnings to the IRS, but to have that in place before repairing this issue is to set a trap that millions of Americans would unknowingly fall into and is an abdication of regulatory responsibilities.
Operators: Communicating the current state of amateur poker tax reporting to your online players would turn many customers (rightly) away, yet failure to do so will likely lead to a dramatic drop-off in your player base. A delayed-impact, often-unanticipated and occasionally-large annual fee for losing is not good for customer retention. This will have to be fixed eventually for your customer base to subsist and grow, so out of respect for your customers, please expend resources towards fixing it now.
Conclusion
This simple and sensible change will eliminate an undue and capricious tax burden on millions of present and future American amateur poker players. To fail to correct this prior to the spread of domestically-regulated internet poker is to ensure an inefficient outcome for all parties involved.
Frankly, this rationale applies to traditional gambling activities as well. However, the need for change is most crucial for poker, a competitive strategy game which naturally lends itself towards narrow edges over regularly-occurring play, compels conscious maintenance and management of a bankroll, and attracts intelligent, price-sensitive competitors.
I don't know exactly how the poker community goes about changing this part of the tax code. I suspect that players cannot do it alone. We need our industry to stay aware of this problem and to represent our mutual interests. Keep the dialogue going.
Sincerely,
Mike Stein
Wednesday, January 16, 2013
Cash Game Tax Planning Calculator - 2013 Update
I have updated the Cash Game Tax Planning Calculator for the new year, containing some brand-new potential negative tax effects which will impact certain amateur poker players.
If you haven't used the Cash Game Tax Planning Calculator before and you're a US poker player, especially if you're only playing part-time and don't file your taxes as a professional, now is the perfect time to start. The purpose of this spreadsheet is to calculate a player's after-tax expected value based on their intended poker play for the year. This is important to do in advance, as a few different negative tax effects can easily turn a winning player into a losing player. You'll also probably want to check out the older posts on the Cash Game Tax Planning Calculator, as I'll only discuss the 2013 changes here.
The new spreadsheet is freely available here, with continued thanks to pokerfuse.com for hosting:
(You may have to give permission for macros to run. There's nothing malicious or objectionable.)
Runtime and efficiency
Note that this version of the sheet takes about 3-4 minutes per row for the default recommended loop size of N=1,000,000 when you hit the Calculate button. It's not frozen or broken! If you'd like to test it out to make sure it's working before you embark on a longer run, set N=100 in cell K6 for faster calculation, but keep in mind that the results will likely have significant error for N<1,000,000. Excel is really not an ideal platform for these calculations, but I find that it's not too much trouble to run them overnight. This certainly isn't commercial-grade software, it's merely something I've built for myself that I'm making freely available for the benefit of the poker community. (i.e. bear with it and thanks for your patience!) New tax considerations for 2013
The recent fiscal cliff compromise included a few ways to penalize high-income tax payers... but, as with many pieces of the tax code which attempt to assess income, these income thresholds look at Adjusted Gross Income rather than net income. AGI is a before-deductions figure which includes "phantom income" for amateur poker players resulting from the sum of all losing sessions they play throughout the year. Amateurs report the sum of their winning sessions as income and deduct the sum of their losing sessions (to the extent of their winnings) later as an itemized deduction.
Net taxable income is generally what ends up affecting the tax a player owes, but AGI is overinflated along the way, and that's what these three new rules consider. Thus these new effects will be triggered by many amateur players whose actual incomes are not high at all. (If you need a refresher on poker tax basics, check out the 2+2 tax sticky.)
New inputs & instructions
To account for these new tax considerations, there are 4 new inputs in the 2013 version, all of which are located in the Tax Rates tab at the bottom of the sheet. All other inputs are the same as the previous version, and everything else about the sheet, its backend, and its runtime should essentially be familiar.
2013 new trouble case #1: High-Volume Amateur
Each of these new effects will only unduly impact amateur players, due to the AGI inflation from their phantom poker winnings; high-income professional players will be paying higher taxes as well, but only when their legitimate winnings exceed the income thresholds. With that in mind, we first look at the case of an amateur player with high phantom poker winnings and thus significant overinflation of AGI.
Consider a high-volume amateur poker player, perhaps a full-time student playing poker on the side as his primary source of income. He has $80k net worth, non-poker income of $3k per year, all of which is from investments, and $3k in non-poker itemized deductions (state taxes paid last year, perhaps). Let's say that he plays in certain poker games such that he has an hourly rate of $40 and a standard deviation of $1,800 per hour, and that he typically plays for 2 hours per session. I'm envisioning a solid winner at multitabling small/mid stakes online here, which is not currently relevant to very many American taxpayers, but I've chosen a higher-variance and higher-volume profile to highlight the potential impact of the new rules.
This player will certainly put in enough volume to avoid the classic negative tax effects of the risk of a losing year or the risk of being unable to deduct losses due to not hitting the standard deduction, so we don't worry about that in the graph. However, once his number of sessions increases to about 250 for the year, his expected AGI from the sum of his winning sessions starts to hit the threshold and the effects of the investment surtax and exemption/deduction phaseout start to cut into his profits, leveling off at a maximum effective loss of $2,500 when these are all fully phased out.
The new tax rules won't turn this high-volume amateur from a winning player into a losing player, but they will take a rather high percentage of his average after-tax profit at certain volume levels.
2013 new trouble case #2: Wealthy Amateur
Some low-volume amateur players will already be at or above the income thresholds from their non-poker income, in which case even a single poker session will produce phantom income that will cut directly into the new tax rules. These players are in much worse shape than those in the first case.
Consider a upper-middle-class person with a successful career outside of poker who enjoys occasionally playing poker for fun, but still cares about winning, or at least not losing money in her poker career. Let's say she has $1M net worth, and non-poker income of $250k per year, $20k of which is from investments, and $15k in non-poker itemized deductions. For simplicity, let's say that her choice of game and her winrate profile is the same as that of the high-volume amateur, except that the wealthy amateur fits in far fewer of these 2-hour sessions each year.
The impact on expected after-tax winnings is dramatic. In 2012, she would have had to play about 40 sessions per year to break even (due primarily to the classic negative tax effect of having a losing year). In 2013, she now must play three times as much volume to break even after-tax, and her earnings are increasingly divergent from what they would have been in 2012. The gap between the earnings lines would continue to grow until all investment earnings were met with the 3.8% surtax and all deductions and exemptions were phased out to their maximum.
Any amateur poker player whose income is at, over, or near the thresholds for the new tax rules will have to be very careful. Depending on their winrate profile and the amount of investment income and deductions they expect to have, many will be forced out of the game.
A brief note on a third potential trouble case (it could happen to you)
Many amateur poker players will not fall into either of the above two cases. However, if such a player happens to run well enough during the first portion of 2013, perhaps by spiking a big tournament score, such that the likelihood of hitting the thresholds goes on to become significant, they will suddenly find themselves impacted by these effects.
The spreadsheet is designed to be used on an ongoing basis after every session is played, or at least after any big wins or losses. As another example, a large early realized loss will mitigate the negative tax effect of having losses which, along with other deductions don't exceed the itemized deduction, which will benefit the profitability of future sessions during the year. Running this calculator often will make sure you always know the costs of these new negative tax effects as well as the ones that have always been around.
Everybody's situation will be different, particularly under these new rules, since they are sensitive to the particular amounts of investment income and non-poker itemized deductions you expect to have. If you're a responsible player, you should check out the calculator and to use it to compute the after-tax expectations for your individual situation. Here's hoping that you'll still be +EV after-tax, but if not, it's better to determine that now rather than putting in your year of play and getting hit with an excessive tax bill at the end.
As usual, I am eager to hear your feedback, suggestions, questions, bug reports, etc.
I'm also working on coding a version of the calculator in [R], mostly for my own edification as I learn the language and for my own use. It won't be as pretty or user-friendly, and I am not planning to ever be able to compile it into something palatable to the general public, but it will be faster and more flexible if you're comfortable with code. Feel free to email me if you want to mess around with it.
See also:
Cash Game Tax Planning Calculator - Instructions (2012)
Examples, charts, and general results
If you haven't used the Cash Game Tax Planning Calculator before and you're a US poker player, especially if you're only playing part-time and don't file your taxes as a professional, now is the perfect time to start. The purpose of this spreadsheet is to calculate a player's after-tax expected value based on their intended poker play for the year. This is important to do in advance, as a few different negative tax effects can easily turn a winning player into a losing player. You'll also probably want to check out the older posts on the Cash Game Tax Planning Calculator, as I'll only discuss the 2013 changes here.
The new spreadsheet is freely available here, with continued thanks to pokerfuse.com for hosting:
(You may have to give permission for macros to run. There's nothing malicious or objectionable.)
Runtime and efficiency
Note that this version of the sheet takes about 3-4 minutes per row for the default recommended loop size of N=1,000,000 when you hit the Calculate button. It's not frozen or broken! If you'd like to test it out to make sure it's working before you embark on a longer run, set N=100 in cell K6 for faster calculation, but keep in mind that the results will likely have significant error for N<1,000,000. Excel is really not an ideal platform for these calculations, but I find that it's not too much trouble to run them overnight. This certainly isn't commercial-grade software, it's merely something I've built for myself that I'm making freely available for the benefit of the poker community. (i.e. bear with it and thanks for your patience!) New tax considerations for 2013
The recent fiscal cliff compromise included a few ways to penalize high-income tax payers... but, as with many pieces of the tax code which attempt to assess income, these income thresholds look at Adjusted Gross Income rather than net income. AGI is a before-deductions figure which includes "phantom income" for amateur poker players resulting from the sum of all losing sessions they play throughout the year. Amateurs report the sum of their winning sessions as income and deduct the sum of their losing sessions (to the extent of their winnings) later as an itemized deduction.
Net taxable income is generally what ends up affecting the tax a player owes, but AGI is overinflated along the way, and that's what these three new rules consider. Thus these new effects will be triggered by many amateur players whose actual incomes are not high at all. (If you need a refresher on poker tax basics, check out the 2+2 tax sticky.)
- Phaseout of itemized deductions for "high-income taxpayers"
The first new rule triggers for taxpayers whose AGI exceeds $250k for single taxpayers, $275k for heads of household, and $300k for those who are married and filing jointly. Once this threshold is exceeded, most itemized deductions are reduced ("phased out") by 3% of the amount of the excess of AGI to the threshold, up to a maximum phaseout of 80% of these deductions. Luckily, the deductions which are phased out do not include the gambling loss deduction, which would have resulted in a very costly direct surtax on gross amateur poker earnings, but essentially all other common types of itemized deductions are included. Further discussion and links can be found in this thread.
This will create a negative tax effect on those amateur poker players whose phantom poker income pushes them over the $250k threshold. Professional players (who have no phantom income) and all other Americans should be mindful of this new threshold as well, but they get the privilege of having their AGI reasonably approximate their true income. Naturally, the biggest impact here will be on those with many non-poker itemized deductions. - Phaseout of personal exemption for "high-income taxpayers"
Similarly, using the same thresholds as the above effect, a taxpayer's personal exemptions are reduced by 2% for every $2,500 of AGI in excess of the threshold. This, again, impacts all amateur poker players with high gross winnings, and will hit the hardest on those with dependents who would take multiple personal exemptions.
Personal exemptions were not considered at all in the 2012 build of this spreadsheet, but are accounted for in the new version to allow for this effect to be captured. - 3.8% surtax on investment income for "high-income taxpayers"
The final noteworthy change is a 3.8% surtax to fund Obamacare, applied to the excess of AGI over a certain threshold, but not exceeding the amount of one's investment income. For this rule, the threshold is $200k for single taxpayers, $250k for those who are married and filing jointly, and $125k for those who are married and filing separately.
Poker winnings, be they amateur or professional, are not considered investment income, so this effect will only matter on players who happen to have significant income from traditional investments, but it hits very hard for those who do.
New inputs & instructions
To account for these new tax considerations, there are 4 new inputs in the 2013 version, all of which are located in the Tax Rates tab at the bottom of the sheet. All other inputs are the same as the previous version, and everything else about the sheet, its backend, and its runtime should essentially be familiar.
- Personal Exemption — The total amount of your personal exemptions. For 2013, this is $3,800 for a single person with no dependents. If you have dependents such that you take more than one exemption, this should be changed to $3,800 times the number of total exemptions you take.
- Portion of salary which is investment income — The approximate amount of investment income you expect to have this year. Note that your Annual Salary figure on the main tab should also include this amount in its total, as the Annual Salary figure is intended to include all non-poker sources of income. This new field simply requests the portion of that total non-poker income which comes from investments so that the effect of the new investment surtax can be computed.
- Phaseout Threshold — The threshold for the phaseout of itemized deductions and personal exemptions as described above. Set this equal to $250k if you are single, $275k for head of household, and $300k for married filing jointly.
- Investment Tax Phaseout Threshold — The threshold for the phaseout of itemized deductions and personal exemptions as described above. $200k for single taxpayers, $250k for those who are married and filing jointly, and $125k for those who are married and filing separately.
2013 new trouble case #1: High-Volume Amateur
Each of these new effects will only unduly impact amateur players, due to the AGI inflation from their phantom poker winnings; high-income professional players will be paying higher taxes as well, but only when their legitimate winnings exceed the income thresholds. With that in mind, we first look at the case of an amateur player with high phantom poker winnings and thus significant overinflation of AGI.
Consider a high-volume amateur poker player, perhaps a full-time student playing poker on the side as his primary source of income. He has $80k net worth, non-poker income of $3k per year, all of which is from investments, and $3k in non-poker itemized deductions (state taxes paid last year, perhaps). Let's say that he plays in certain poker games such that he has an hourly rate of $40 and a standard deviation of $1,800 per hour, and that he typically plays for 2 hours per session. I'm envisioning a solid winner at multitabling small/mid stakes online here, which is not currently relevant to very many American taxpayers, but I've chosen a higher-variance and higher-volume profile to highlight the potential impact of the new rules.
This player will certainly put in enough volume to avoid the classic negative tax effects of the risk of a losing year or the risk of being unable to deduct losses due to not hitting the standard deduction, so we don't worry about that in the graph. However, once his number of sessions increases to about 250 for the year, his expected AGI from the sum of his winning sessions starts to hit the threshold and the effects of the investment surtax and exemption/deduction phaseout start to cut into his profits, leveling off at a maximum effective loss of $2,500 when these are all fully phased out.
The new tax rules won't turn this high-volume amateur from a winning player into a losing player, but they will take a rather high percentage of his average after-tax profit at certain volume levels.
2013 new trouble case #2: Wealthy Amateur
Some low-volume amateur players will already be at or above the income thresholds from their non-poker income, in which case even a single poker session will produce phantom income that will cut directly into the new tax rules. These players are in much worse shape than those in the first case.
Consider a upper-middle-class person with a successful career outside of poker who enjoys occasionally playing poker for fun, but still cares about winning, or at least not losing money in her poker career. Let's say she has $1M net worth, and non-poker income of $250k per year, $20k of which is from investments, and $15k in non-poker itemized deductions. For simplicity, let's say that her choice of game and her winrate profile is the same as that of the high-volume amateur, except that the wealthy amateur fits in far fewer of these 2-hour sessions each year.
The impact on expected after-tax winnings is dramatic. In 2012, she would have had to play about 40 sessions per year to break even (due primarily to the classic negative tax effect of having a losing year). In 2013, she now must play three times as much volume to break even after-tax, and her earnings are increasingly divergent from what they would have been in 2012. The gap between the earnings lines would continue to grow until all investment earnings were met with the 3.8% surtax and all deductions and exemptions were phased out to their maximum.
Any amateur poker player whose income is at, over, or near the thresholds for the new tax rules will have to be very careful. Depending on their winrate profile and the amount of investment income and deductions they expect to have, many will be forced out of the game.
A brief note on a third potential trouble case (it could happen to you)
Many amateur poker players will not fall into either of the above two cases. However, if such a player happens to run well enough during the first portion of 2013, perhaps by spiking a big tournament score, such that the likelihood of hitting the thresholds goes on to become significant, they will suddenly find themselves impacted by these effects.
The spreadsheet is designed to be used on an ongoing basis after every session is played, or at least after any big wins or losses. As another example, a large early realized loss will mitigate the negative tax effect of having losses which, along with other deductions don't exceed the itemized deduction, which will benefit the profitability of future sessions during the year. Running this calculator often will make sure you always know the costs of these new negative tax effects as well as the ones that have always been around.
Everybody's situation will be different, particularly under these new rules, since they are sensitive to the particular amounts of investment income and non-poker itemized deductions you expect to have. If you're a responsible player, you should check out the calculator and to use it to compute the after-tax expectations for your individual situation. Here's hoping that you'll still be +EV after-tax, but if not, it's better to determine that now rather than putting in your year of play and getting hit with an excessive tax bill at the end.
As usual, I am eager to hear your feedback, suggestions, questions, bug reports, etc.
I'm also working on coding a version of the calculator in [R], mostly for my own edification as I learn the language and for my own use. It won't be as pretty or user-friendly, and I am not planning to ever be able to compile it into something palatable to the general public, but it will be faster and more flexible if you're comfortable with code. Feel free to email me if you want to mess around with it.
See also:
Cash Game Tax Planning Calculator - Instructions (2012)
Examples, charts, and general results
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:
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:
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:
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:
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:
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.
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:
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.
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.
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
Continued in Part 2: Examples, charts, and general results
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:
- 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.
- 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.
- 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.
- 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.
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.
Continued in Part 2: Examples, charts, and general results
Saturday, November 19, 2011
Pokerfuse article: "Where and When Should You Buy 'Bubble Insurance'?"
I wrote another piece for pokerfuse, an analysis of "bubble insurance" offerings with a bit of light math, more in line with what I usually write about here.
Check it out here: Where and When Should You Buy “Bubble Insurance”?
Check it out here: Where and When Should You Buy “Bubble Insurance”?
Saturday, June 18, 2011
Update/correction to risky site model: Casualty losses and tax effects
This is not the kind of stuff that I want to be spending my time writing about, but I discovered a serious enough practical change to one of my old analyses that I felt it was important to inform you all of it.
In my model for bankroll management and game selection in risky sites, I made the following assumption, which I thought was a reasonable guess as to the tax implications of losing access to poker funds:
It turns out that this is indeed not exactly true. In fact, being able to deduct this money against poker winnings is probably not possible in many cases.
The default classification for such a loss would be as a casualty loss. Even though a player may have been "gambling" on the chance that the site would return his funds, this must be considered a casualty loss rather than a gambling loss, which brings about some serious restrictions in many cases. The effects on the affected player's bottom line are significant.
Tax effects of stolen funds for those who file as professionals
Professional poker players can take such a casualty loss related to his poker business without any limitations. So, if you file as a pro, you can ignore all of this.
...but for amateur players...
Amateur players most likely have to take the loss of poker site funds as a casualty loss, which is a deduction that is strictly limited. A casualty loss can only be deducted to the extent that it exceeds 10% of adjusted gross income (AGI) — and, remember, while an amateur player still ends up getting to use his net (positive) gambling winnings for his bottom-line taxes, the AGI is a figure which is calculated after all winning sessions are added, but before losing sessions are deducted.
Example
Bob, a formerly-winning recreational small-stakes player, decides to deposit $500 on a current risky U.S.-facing poker site. Though he knows he will not make much money, he enjoys playing and wants to keep his poker skills in practice. He averages $3/hr in risky site funds by playing on the site, and after playing for several months, he has run his balance up from $500 to $1,500. The site then has its funds seized, declares bankruptcy, or otherwise absconds with the money. Bob was never able to cash out successfully.
The results:
Implications for the model
I modified the old model by making the losses due to unretrievable funds occur after taxes, rather than before.
To keep the charts simple, I considered only the 50NL case this time. See the old article for the other assumptions.
We see that, as one might expect, the effects of this tax correction do not change much based on the per-day probability of site closure (i.e. the average lifetime of the site). If the site is likely to die at some point, the hit of this tax situation will be about the same whenever it happens, at least when cashouts are liquid enough along the way.
Much more important is the liquidity of the site, which will dictate the probability of funds being lost forever when the site disappears. After all, these funds being lost is what causes this fun little tax situation to occur.
Once the probability of losing funds becomes reasonably high, the utility gained by playing drops off quite a bit. Remember, playing and winning will go on to cost money if the site ends up not paying. Even in the extreme case where there is no probability of the site ever allowing a cashout, the "money" won on that site would still be considered gambling winnings for a player who knowingly put money onto the site for the purposes of practicing his game. What a mess.
Overall, I would think that any reasonable estimate of the safety of current risky sites is going to involve more than enough risk to really cut into the expected utility of playing. So, if nothing else, this provides another strong incentive to choose even lower stakes than one otherwise might. The less funds that are at risk, and the less likely a player is to win money and go on to get it stolen from him, the less the effects of these negative tax implications will be.
Other bad news
Americans who don't file as professionals and who currently have funds stuck on Full Tilt Poker (or, more likely, the other, less-reputable sites) will also suffer negative tax effects if those funds end up not being returned to the players. Unless their online bankrolls were more than 10% of their total income for the year (plus the phantom session-by-session income in the AGI), recreational players will get no deductions at all if their money is absconded with.
Strangely, in the event that the funds aren't returned, winning recreational players would have been much better off somehow losing their entire bankrolls prior to April 15.
In particular, if Full Tilt Poker goes on to end up not returning U.S. funds, then of the alleged $150 million in American funds that are stuck there, I would guess that at least $50 million of them will be completely non-deductible, even though much of that sum represents taxable poker winnings.
Possible exceptions
It's possible that, at least in the case of money put on post-Black Friday sites knowing that there would be a chance of not being able to get money out, there might be a way to argue that the losses should be gambling losses rather than casualty losses.
The key factor here is the notion of constructive receipt, which is the rule which causes poker income to be taxable when it is earned rather than when it is cashed out. The underlying principle is that, as soon as a taxpayer is able to undergo actions to have the money in their hand, that income is immediately taxable.
In the case of a poker site that disappears with player funds, one might argue that the player did not actually have the ability to ever receive the money and thus that constructive receipt does not apply. If this approach were deemed to be valid, there would be no taxable income.
It is likely important that the funds weren't accessible at the time they were won, rather than just at some later date when the site closed or when a cashout was attempted. For a hypothetical site which has never processed withdrawals, this would be true. For U.S.-facing sites which are currently not processing U.S. withdrawals, perhaps this is true, though the mere possibility of you being able to successfully withdraw in the time after the money was won might be enough to invalidate this. For pre-Black Friday sites, it's definitely less true, as though it certainly had been difficult to withdraw funds prior to Black Friday, people were able to do it with some degree of regularity. It's hard to guess where this line would be drawn.
Also, it is difficult to find a way to reconcile this sort of accounting rule with the necessary session-by-session accounting, which implicitly assumes constructive receipt.
I find the tax effect described in this article to be quite absurd, even in the context of the other IRS rules that produce various unfair tax situations for poker players. Despite this, there might not be any reasonable way around it. Filing one's taxes as if these losses were gambling losses instead of casualty losses may not be considered appropriate by the IRS, which has a history of interpreting rules for anything related to "gambling" as harshly as they are able to. Fighting to clarify the nature of these losses may be costly.
Thanks to taxdood, Russ Fox, and PokerXanadu for helping me understand this tax situation.
In my model for bankroll management and game selection in risky sites, I made the following assumption, which I thought was a reasonable guess as to the tax implications of losing access to poker funds:
...For simplicity, we'll assume that any money lost due to site-specific risks [sites closing down or withdrawals being seized] is treated the same as a poker loss and directly deductible against poker winnings, though I believe this is not exactly true.
It turns out that this is indeed not exactly true. In fact, being able to deduct this money against poker winnings is probably not possible in many cases.
The default classification for such a loss would be as a casualty loss. Even though a player may have been "gambling" on the chance that the site would return his funds, this must be considered a casualty loss rather than a gambling loss, which brings about some serious restrictions in many cases. The effects on the affected player's bottom line are significant.
Tax effects of stolen funds for those who file as professionals
Professional poker players can take such a casualty loss related to his poker business without any limitations. So, if you file as a pro, you can ignore all of this.
The original approach is still accurate for anyone filing as a professional on their taxes.
...but for amateur players...
Amateur players most likely have to take the loss of poker site funds as a casualty loss, which is a deduction that is strictly limited. A casualty loss can only be deducted to the extent that it exceeds 10% of adjusted gross income (AGI) — and, remember, while an amateur player still ends up getting to use his net (positive) gambling winnings for his bottom-line taxes, the AGI is a figure which is calculated after all winning sessions are added, but before losing sessions are deducted.
Amateur players can only take a casualty loss if it exceeds 10% of their AGI, an amount which will always be artificially inflated above actual income due to session-by-session accounting that amateurs must use.
In almost all practical cases, this will mean that losses due to the risks of the current online poker environment will not be deductible at all unless you file as a professional.
Example
Bob, a formerly-winning recreational small-stakes player, decides to deposit $500 on a current risky U.S.-facing poker site. Though he knows he will not make much money, he enjoys playing and wants to keep his poker skills in practice. He averages $3/hr in risky site funds by playing on the site, and after playing for several months, he has run his balance up from $500 to $1,500. The site then has its funds seized, declares bankruptcy, or otherwise absconds with the money. Bob was never able to cash out successfully.
The results:
- If Bob's AGI for the year is above $15,000, he cannot deduct any of the $1,500 that he lost. This is almost certainly the case, even if Bob does not suffer from undue AGI inflation from his poker sessions.
- However, Bob still earned $1,000 in gambling winnings from his play on the site, even though he never got his money.
- Notice that, given that the site ended up disappearing, Bob would have been better off if he lost money on the site. Winning has increased his taxable income, despite not providing any actual money or deductions to Bob.
Implications for the model
I modified the old model by making the losses due to unretrievable funds occur after taxes, rather than before.
To keep the charts simple, I considered only the 50NL case this time. See the old article for the other assumptions.
We see that, as one might expect, the effects of this tax correction do not change much based on the per-day probability of site closure (i.e. the average lifetime of the site). If the site is likely to die at some point, the hit of this tax situation will be about the same whenever it happens, at least when cashouts are liquid enough along the way.
Much more important is the liquidity of the site, which will dictate the probability of funds being lost forever when the site disappears. After all, these funds being lost is what causes this fun little tax situation to occur.
Once the probability of losing funds becomes reasonably high, the utility gained by playing drops off quite a bit. Remember, playing and winning will go on to cost money if the site ends up not paying. Even in the extreme case where there is no probability of the site ever allowing a cashout, the "money" won on that site would still be considered gambling winnings for a player who knowingly put money onto the site for the purposes of practicing his game. What a mess.
Overall, I would think that any reasonable estimate of the safety of current risky sites is going to involve more than enough risk to really cut into the expected utility of playing. So, if nothing else, this provides another strong incentive to choose even lower stakes than one otherwise might. The less funds that are at risk, and the less likely a player is to win money and go on to get it stolen from him, the less the effects of these negative tax implications will be.
Other bad news
Americans who don't file as professionals and who currently have funds stuck on Full Tilt Poker (or, more likely, the other, less-reputable sites) will also suffer negative tax effects if those funds end up not being returned to the players. Unless their online bankrolls were more than 10% of their total income for the year (plus the phantom session-by-session income in the AGI), recreational players will get no deductions at all if their money is absconded with.
Strangely, in the event that the funds aren't returned, winning recreational players would have been much better off somehow losing their entire bankrolls prior to April 15.
In particular, if Full Tilt Poker goes on to end up not returning U.S. funds, then of the alleged $150 million in American funds that are stuck there, I would guess that at least $50 million of them will be completely non-deductible, even though much of that sum represents taxable poker winnings.
Possible exceptions
It's possible that, at least in the case of money put on post-Black Friday sites knowing that there would be a chance of not being able to get money out, there might be a way to argue that the losses should be gambling losses rather than casualty losses.
The key factor here is the notion of constructive receipt, which is the rule which causes poker income to be taxable when it is earned rather than when it is cashed out. The underlying principle is that, as soon as a taxpayer is able to undergo actions to have the money in their hand, that income is immediately taxable.
In the case of a poker site that disappears with player funds, one might argue that the player did not actually have the ability to ever receive the money and thus that constructive receipt does not apply. If this approach were deemed to be valid, there would be no taxable income.
It is likely important that the funds weren't accessible at the time they were won, rather than just at some later date when the site closed or when a cashout was attempted. For a hypothetical site which has never processed withdrawals, this would be true. For U.S.-facing sites which are currently not processing U.S. withdrawals, perhaps this is true, though the mere possibility of you being able to successfully withdraw in the time after the money was won might be enough to invalidate this. For pre-Black Friday sites, it's definitely less true, as though it certainly had been difficult to withdraw funds prior to Black Friday, people were able to do it with some degree of regularity. It's hard to guess where this line would be drawn.
Also, it is difficult to find a way to reconcile this sort of accounting rule with the necessary session-by-session accounting, which implicitly assumes constructive receipt.
I find the tax effect described in this article to be quite absurd, even in the context of the other IRS rules that produce various unfair tax situations for poker players. Despite this, there might not be any reasonable way around it. Filing one's taxes as if these losses were gambling losses instead of casualty losses may not be considered appropriate by the IRS, which has a history of interpreting rules for anything related to "gambling" as harshly as they are able to. Fighting to clarify the nature of these losses may be costly.
Thanks to taxdood, Russ Fox, and PokerXanadu for helping me understand this tax situation.
Wednesday, June 8, 2011
WSOP Utility Analysis revisited, part 2: How many shares should a WSOP Main Event player sell off?
Last time, we looked at the relationship between a player's expected utility in the 2010 World Series of Poker Main Event and his skill advantage over the field. Under a particular proposed shape of finish probability distribution, we found that a raw ROI of about 86% (i.e. an average cash of $18,600) was necessary for a player with a typical income, risk aversion, and tax obligation to simply break even in terms of expected utility. Even in a juicy WSOP Main Event field, this is a pretty lofty goal for most, and many near-average players will be forced out of participating on their own dime unless they are willing to effectively pay for the privilege.
Fortunately, backing and staking agreements are common for large-field poker tournaments. Much as the stock market investor would never put a large portion of his capital into a single investment unless it were extraordinarily profitable, the poker player (who "invests in himself" in his poker career) will often benefit from diversifying away some of his risk by hedging his tournament results out to others. If these mediocre winning players players are able to find other parties to put up part of their entry fee in exchange for part of their prize, they will be able to yield a positive expected utility in the event, not only for themselves, but also for their investors.
Shares sold at face value
For the purposes of this analysis, we assume that only option of staking/backing available to the player is to sell off X% of his prize in exchange for X% of the cost of entry (selling shares at 1-to-1, with no markup). The result for the player of such a contract will be the same as if the entire tournament were scaled down by X%. A player can sell off 90% of himself to effectively make the WSOP Main Event a $1,000 buyin tournament for him, with prizes which are exactly proportional to those of the true main event.
For the time being, we are ignoring some other popular forms of staking and backing (listed in the order of likelihood that I might add them to the model in the future):
Given this opportunity to rescale the stakes of the tournament, assuming that there is an investor willing to buy any amount of shares that the player would offer, how much should the player look to sell off?
Optimizing share-selling for the typical player
Our typical, risk-averse player ($80k net worth, $50k income with at least $10k from poker, risk aversion of 0.8) will realize the following expected utilities based on his skill advantage and the percent of himself he chooses to retain:
Here, the different colored lines represent different several different levels of skill edge, expressed in terms of raw ROI. The horizontal axis shows the percentage of his own action that the player takes; the amount he sells off is equal to 100% minus this number.
In red — For the player of precisely average skill, who has a raw ROI of -6% (due to rake), we see that, regardless of the number of shares he sells, he cannot realize a profitable opportunity in this event. Since he's a break-even player and is risk-averse and experiences tax effects that are negative on average, he's going to lose utility by playing any poker tournament, regardless of how small he makes the stakes.
In orange — When he was forced to take all of his own action, we recall that the small winner (raw ROI of 50%) was forced out of being able to profit from his small skill advantage at all. We showed that the minimum ROI required for a positive expected utility is 86%, and the chart verifies that if this 50% ROI player were to take all of his own action, he would be losing money after taxes and risk aversion. By selling shares, we see that he can realize a small positive expected utility ($121 in certainty equivalent) by playing for about 12% of his own action. The ability to hedge against the entry fee has allowed the skilled, risk-averse player to realize a profitable opportunity where he otherwise could not.
In yellow — This solid winning player (raw ROI of 100%) is a strong enough player that he will realize a positive expected utility even if he takes all of his own action, as we can see by the yellow curve being completely above the x-axis. However, we see that this player will realize an even higher expected utility by selling off some of his action than by paying his own way entirely. He'll improve his certainty equivalent payoff from $532 to $805 by selling off roughly half of his action.
In green — A bigger winner (raw ROI of 150%) turns out to do best by playing for all 100% of his own action. The investment has become so profitable that even a risk-averse individual does best by taking it all on and not hedging it out to others.
In blue — This big winner (raw ROI of 200%) has similar results to the green player above.
Other cases: different risk/tax profiles
If we keep the player's relative risk aversion fixed at ρ=0.8 but increase his wealth from $80k to $500k and his annual income from $50k to $100k, he becomes more able to handle his own risk:
The breakeven player is, of course, still unable to profit, and it turns out the 50% ROI player still benefits slightly from selling off some of his action, but overall, the additional risk tolerance incentivizes this player to hold onto all or most of his own action.
Alternatively, instead of adjusting wealth, we can reduce the player's relative risk aversion from ρ=0.8 to ρ=0.5, representing an individual who is more willing to take on risk (at least for the special occasion of the WSOP Main Event, perhaps):
The nature of the effects is similar. It is worthy to note that the orange curve (raw ROI of 50%) is similar to that of the original analysis for the more risk-averse player, suggesting that a small winner with an average wealth should still be selling off most of his action regardless of his personal preferences for risk. On the other hand, it looks like the yellow curve (raw ROI of 100%) has become roughly the point where the player will prefer to take 100% of his own action for this particular level of risk aversion, so players with significant skill edges should be more inclined to take all of their own action if they have a higher tolerance for risk.
Optimal hedging percentages
Thanks to the complexity of the utility function and the sheer number of different payoffs, there is no simple way to express a formula for the curves we've found above. In order to calculate the optimal hedging percentages (i.e. the percentages of action to take which correspond to the maximum points of these curves), we proceed numerically.
Here, we disregard the ρ=0.5 case treated directly above and consider only the first two cases: the original "typical player" (in yellow below) and the "wealthy player" (in green below):
(Ignore the jaggedness of these curves; the negligible inconsistencies are a consequence of the numerical error of Excel's goal seek solver.)
Rather than only considering five different specific values, this chart looks at every possible value of raw ROI and provides a more comprehensive practical resource.
As we've seen earlier, a player with an ROI less than 0% does best by playing for 0% of his own action, i.e. not playing at all, unless some misinformed or charitable investor were to give him a full stake. For players with positive ROI, we see that there is always some positive percentage of his own action that produces a better profit than not playing at all.
The optimal percentage of his own action that the player should take seems to increase in a convex way; as the player increases his skill edge over the field, the optimal percentage that he should keep increases faster at higher values of ROI. For both the typical player and the wealthy player, there is a "ceiling" level of minimum ROI at which the player should take all of his own action. We see that this is about 136% for the typical player and about 66% for the wealthy player.
Conclusions and comments
These charts should provide a useful guideline for real-world staking and backing decisions for large-field tournaments. Some practical notes:
This is a model that should be of tremendous practical value to all tournament players, so if there is enough interest, I might clean up my spreadsheet and make it publicly available in the future.
Fortunately, backing and staking agreements are common for large-field poker tournaments. Much as the stock market investor would never put a large portion of his capital into a single investment unless it were extraordinarily profitable, the poker player (who "invests in himself" in his poker career) will often benefit from diversifying away some of his risk by hedging his tournament results out to others. If these mediocre winning players players are able to find other parties to put up part of their entry fee in exchange for part of their prize, they will be able to yield a positive expected utility in the event, not only for themselves, but also for their investors.
Shares sold at face value
For the purposes of this analysis, we assume that only option of staking/backing available to the player is to sell off X% of his prize in exchange for X% of the cost of entry (selling shares at 1-to-1, with no markup). The result for the player of such a contract will be the same as if the entire tournament were scaled down by X%. A player can sell off 90% of himself to effectively make the WSOP Main Event a $1,000 buyin tournament for him, with prizes which are exactly proportional to those of the true main event.
For the time being, we are ignoring some other popular forms of staking and backing (listed in the order of likelihood that I might add them to the model in the future):
- Selling shares at a price other than 100% of face value — If a player with a significant skill edge wanted to sell pieces of his action, in reality, he sould expect to get much better than 1-to-1 from his investors, since he's the one doing the work. The investors would still be left with a very profitable, fast, hands-free investment. Conversely, a -EV player might still be able to gain some expected utility by selling pieces of himself at a discount.
- Direct backing — One popular form of contract is for the investor to provide all of the player's entry fee in exchange for a payoff equal to a fixed percentage of the player's profit in the event that he cashes. This is a freeroll for the player and will thus always yield him a positive expected utility, and it can still provide the investor with a positive expected utility as well if the player is sufficiently skilled. It is reasonable to expect that this sort of deal may be more favorable than selling shares at face value if the player is very skilled, but also very risk-averse relative to the stakes of the event.
- Long-term, ongoing backing agreements — Some players have professional backers with whom they enter into long-term deals. The investor pays all of the player's buyins for a series of tournaments in exchange for a percentage of the player's profits, but if the player is already at a net negative from previous tournaments, he must repay that amount to the backer in full before being able to realize any profits from the contract. These agreements have several variables and would be complicated to analyze, and players under such agreements may not have the opportunity to consider other hedging options anyway, since they are often locked into their contracts until they expire.
Given this opportunity to rescale the stakes of the tournament, assuming that there is an investor willing to buy any amount of shares that the player would offer, how much should the player look to sell off?
Optimizing share-selling for the typical player
Our typical, risk-averse player ($80k net worth, $50k income with at least $10k from poker, risk aversion of 0.8) will realize the following expected utilities based on his skill advantage and the percent of himself he chooses to retain:
Here, the different colored lines represent different several different levels of skill edge, expressed in terms of raw ROI. The horizontal axis shows the percentage of his own action that the player takes; the amount he sells off is equal to 100% minus this number.
In red — For the player of precisely average skill, who has a raw ROI of -6% (due to rake), we see that, regardless of the number of shares he sells, he cannot realize a profitable opportunity in this event. Since he's a break-even player and is risk-averse and experiences tax effects that are negative on average, he's going to lose utility by playing any poker tournament, regardless of how small he makes the stakes.
In orange — When he was forced to take all of his own action, we recall that the small winner (raw ROI of 50%) was forced out of being able to profit from his small skill advantage at all. We showed that the minimum ROI required for a positive expected utility is 86%, and the chart verifies that if this 50% ROI player were to take all of his own action, he would be losing money after taxes and risk aversion. By selling shares, we see that he can realize a small positive expected utility ($121 in certainty equivalent) by playing for about 12% of his own action. The ability to hedge against the entry fee has allowed the skilled, risk-averse player to realize a profitable opportunity where he otherwise could not.
In yellow — This solid winning player (raw ROI of 100%) is a strong enough player that he will realize a positive expected utility even if he takes all of his own action, as we can see by the yellow curve being completely above the x-axis. However, we see that this player will realize an even higher expected utility by selling off some of his action than by paying his own way entirely. He'll improve his certainty equivalent payoff from $532 to $805 by selling off roughly half of his action.
In green — A bigger winner (raw ROI of 150%) turns out to do best by playing for all 100% of his own action. The investment has become so profitable that even a risk-averse individual does best by taking it all on and not hedging it out to others.
In blue — This big winner (raw ROI of 200%) has similar results to the green player above.
Other cases: different risk/tax profiles
If we keep the player's relative risk aversion fixed at ρ=0.8 but increase his wealth from $80k to $500k and his annual income from $50k to $100k, he becomes more able to handle his own risk:
The breakeven player is, of course, still unable to profit, and it turns out the 50% ROI player still benefits slightly from selling off some of his action, but overall, the additional risk tolerance incentivizes this player to hold onto all or most of his own action.
Alternatively, instead of adjusting wealth, we can reduce the player's relative risk aversion from ρ=0.8 to ρ=0.5, representing an individual who is more willing to take on risk (at least for the special occasion of the WSOP Main Event, perhaps):
The nature of the effects is similar. It is worthy to note that the orange curve (raw ROI of 50%) is similar to that of the original analysis for the more risk-averse player, suggesting that a small winner with an average wealth should still be selling off most of his action regardless of his personal preferences for risk. On the other hand, it looks like the yellow curve (raw ROI of 100%) has become roughly the point where the player will prefer to take 100% of his own action for this particular level of risk aversion, so players with significant skill edges should be more inclined to take all of their own action if they have a higher tolerance for risk.
Optimal hedging percentages
Thanks to the complexity of the utility function and the sheer number of different payoffs, there is no simple way to express a formula for the curves we've found above. In order to calculate the optimal hedging percentages (i.e. the percentages of action to take which correspond to the maximum points of these curves), we proceed numerically.
Here, we disregard the ρ=0.5 case treated directly above and consider only the first two cases: the original "typical player" (in yellow below) and the "wealthy player" (in green below):
(Ignore the jaggedness of these curves; the negligible inconsistencies are a consequence of the numerical error of Excel's goal seek solver.)
Rather than only considering five different specific values, this chart looks at every possible value of raw ROI and provides a more comprehensive practical resource.
As we've seen earlier, a player with an ROI less than 0% does best by playing for 0% of his own action, i.e. not playing at all, unless some misinformed or charitable investor were to give him a full stake. For players with positive ROI, we see that there is always some positive percentage of his own action that produces a better profit than not playing at all.
The optimal percentage of his own action that the player should take seems to increase in a convex way; as the player increases his skill edge over the field, the optimal percentage that he should keep increases faster at higher values of ROI. For both the typical player and the wealthy player, there is a "ceiling" level of minimum ROI at which the player should take all of his own action. We see that this is about 136% for the typical player and about 66% for the wealthy player.
Conclusions and comments
These charts should provide a useful guideline for real-world staking and backing decisions for large-field tournaments. Some practical notes:
- This analysis was done for the 2010 WSOP Main Event. Most other tournaments (likely including the 2011 WSOP Main Event) have much smaller fields, and, accordingly, have less skewed payoffs and have less extreme utility annihilation effects. So, for a $10k tournament with a smaller field, the optimal percentage of one's own action to keep will increase, and the guidelines in this post can be used as a lower bound to this.
- Similarly, for tournaments with buyins less than $10k, the optimal percentage of one's own action to keep will increase, and for tournaments with buyins greater than $10k, the optimal percentage of one's own action to keep will decrease. In these cases, the guidelines in this post can be used as an upper/lower bound.
- Note that every aspect of this analysis holds just as true for the person making the investment as it does for the person doing the playing. If a player and his investor(s) all have roughly the same wealth and utility, then each of them will be doing best by taking on the recommended optimal percentage of the player's action as recommended by this model. For example, when the player has a 100% ROI and wants to maximize the total utility among himself and his investor, the parties will both roughly optimize their expected utility by the player keeping 50% of his action while one investor takes the other 50%. In the case of the 50% ROI player, he would take about 12% of his own action while selling off equal pieces of about 12% each to 7 different outside investors.
- In reality, players can't know their exact ROI in any given tournament. The best that players can do is form something resembling a maximum likelihood estimate based on their assessment of their own ability, the expected field strength of the tournament, and the tournament struture. This could be modeled as a random variable with some uncertainty (likely Gaussian) about the point estimate. That is, if your best guess of your ROI is 50%, a more accurate implementation would involve your ROI being an unknown random variable with mean 50% and some nonzero standard deviation. Close inspection of the first chart shows that the distance between the ROI curves seems to get smaller as ROI gets higher, which means that, in the face of an uncertain ROI, it's best to "round down" a little for the purposes of plugging a fixed ROI into this model. For example, if you estimate your ROI is about 50% but have a lot of uncertainty about this estimate, you will probably get a slightly more accurate result by using something like 45% in these guidelines.
This is a model that should be of tremendous practical value to all tournament players, so if there is enough interest, I might clean up my spreadsheet and make it publicly available in the future.
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