Tax Implications

Hey hey! And welcome back to lesson 8 of The Minimal Investor.

If you read the subject of this lesson and went “ew”, or had a physical reaction, I’ll understand. Talking about taxes isn’t most people’s favorite thing in the world. I’ll be honest though – you don’t need to be a tax preparer or accountant to understand the basics of how taxes will affect your investments.

Depending on how complex your situation is, there are many things to take into account – far too many to cover in a single lesson. Instead, what we are going to cover is the groundwork for looking at your portfolio through a tax-focused lens. After that, you’ll have more areas to look into that are specific to you.

Lesson 8: Tax Implications

If you’re investing, then you’re probably starting to wonder about how the whole tax thing works for your funds. Luckily we’ve talked a lot about taxes before when we focused on the principles of tax-efficient fund placement. We’ll review then build on some of these concepts in this lesson.

Tax-Efficient Fund Placement Review
Finding Your Tax Rate
How much tax will I pay if I sell some funds for a long-term gain?
What about taxes on dividends?
How much tax will I pay if I sell some funds for a loss?
How do I file all of this at tax time?
How do taxes work when withdrawing from a 401k, IRA, or Roth IRA?
What if I don’t have enough in brokerage, but have a lot in a 401k and want to retire?

I’m pretty sure that’s the most questions in one lesson that I’ve ever written. Feel free to skip to the questions that are the most interesting to you.

Lesson 7 Review: Tax-Efficient Fund Placement Review

In Lesson 4, we talked about GoodSaver and BadSaver.

GoodSaver used their 401k for Bonds funds and their taxable account for stocks. When it was time to cash out, they paid very little tax on both.

GoodSaver	Stocks in Taxable	Bonds in Tax-Deferred	Total
Beginning Value	$50,000	$50,000	$100,000
Value after 30 Years	$820,490	$380,613	$1,201,103
Taxes due on withdrawal	$100,499	$95,153	$195,652
After-tax value	$719,991	$285,460	$1,005,451

BadSaver did the opposite, putting their stocks in a 401k and bonds in a brokerage account. They ended up paying more taxes from each account.

The things to note here from a tax standpoint:

BadSaver didn’t pay taxes on bonds in their taxable when they withdrew — instead, they paid taxes on the dividends EVERY year at their ordinary income tax rate.
BadSavers tax-deferred account rose a lot. Because of that, they were taxed at their ordinary income tax rate.
GoodSaver didn’t pay taxes on their bonds dividends every year — instead, they paid taxes at the ordinary income tax rate when they withdrew.
GoodSaver paid capital gains tax on their stock gains, which is much lower than the ordinary income tax rate.

That was a lot of terms — capital gains tax, ordinary income tax, dividend rates. Let’s look at these one by one:

2) Finding Your Ordinary Income Tax Rate

The term “Ordinary Income” refers to income you earn from wages. This is money from your job, or from a side business that’s distributed to you. You can offset some of this “ordinary income” at tax time by taking deductions like a mortgage interest tax deduction, 401k/IRA contributions, donations, or the child tax credit. If you don’t have kids or a mortgage, there aren’t many ways to offset this income.

The “Income Tax Rate” is determined by how much “Ordinary Income” you have. For example, let’s say you’re filing taxes as an individual and you earned $50,000. You can check out the Tax Brackets in 2020 and see that you’re in the 22% tax bracket. This doesn’t mean you pay 22% of $50,000 in taxes though – which would be $11,000 in taxes. Federal taxes are progressive – which means you pay more tax on the NEXT dollar as rates rise.

Let me say that again: there’s never a point where earning a $1 will cost you more than $1. Even at the highest tax bracket you’ll pay 37% – allowing you to keep $0.63 of every dollar you earn.

For our $50,000/yr solo filing person, you can find out the total amount of taxes paid by adding up the tax at each tax tier:

10% on the first $9,875 = $987.50
12% on $9,875 – $40,125 = $3,630.00
22% on $40,125 – $50,000 = $2,172.50

For a total paid of $6,790, which is about an “effective tax rate” of 13.58% ($6,790 / $50,000). The more money you make as ordinary income, the higher the rate you’ll pay in new money.

This example is for a person filing taxes as a single individual. If this were for a couple making $50,000 a year, they’d pay less – only $5,605.

What this doesn’t take into account are any deductions. If this person took the standard deduction ($12,400), their taxes would be based on an income of $12,400 less – $37,600. If they also put $5,000 into a 401(k), then their income would be based on $32,600! At $32,600 their total taxes paid would be $3,714.5 – an effective tax rate of 7.4%!

3) How much tax will I pay if I sell some funds for a gain?

Capital Gains Tax Rate

If you hold a fund in a brokerage (an after-tax account) then sell it for a gain, that gain is a “Capital Gain”. You won’t pay “Income Taxes” on it, but instead, pay “Capital Gains Taxes” on it. How much you pay in capital gains will depend on 2 things:

If you hold an investment less than a year you’ll pay taxes at the short-term capital gains tax rate. If you hold an investment longer than a year you’ll pay long term capital gains.
What tax bracket you’re in (from your ordinary income tax rate above).

NerdWallet has a really good table of these rates, but it takes a little explanation to understand them. Here are scenarios to help shed some light on this:

Case 1: Single filer, short-term capital gains in 25% income bracket
A single filer with an ordinary income of $40,000. Sold $15,000 in investments that were originally bought less than a year ago for $10,000. This brings their entire income for the year up to $55,000.

The keys here are the 25% income bracket (based on their ordinary income of $40,000), the $5,000 gains on their investment ($15,000 – $10,000), and that this is a short-term capital gain since they bought and sold this investment within a year. The year here is a year from when they bought and sold it – not a calendar year. If you buy on June 1, 2017, and sell on February 10, 2018, that’s still in the same year for you. You would pay short-term capital gains when you filed your 2018 taxes.

So how much would they pay in taxes on this sale? Well, they’d pay short-term capital gains taxes on $5,000 at the 25% tax bracket — which is 25% of the capital gains. That would mean paying taxes of $1,250, leaving them with $3,750.

This is not ideal for a few reasons:

They’re paying 25% tax when they could pay 15% (or even 0%!). If they had held the funds for a year they could have paid less in taxes.
They sold funds while also earning income. If they waited until they had lower income, they’d pay less in capital gains taxes.

Case 2: Long-term capital gains in 15% income bracket
Married, filing jointly, with ordinary income of $75,000. Sold $100,000 in investments that were initially bought for $50,000 over a year ago.

The keys here are married, $75,000 in ordinary income and $50,000 in long-term capital gains. These numbers are a lot bigger than the first example, so it’s easy to think that the tax would be magnitudes higher. Between their income and investments, this couple is living on $125,000 this year after all – a very high income to most.

If you look at the “Married, Filing Jointly” tab of the capital gains chart though and find the “long-term capital gains rate”, you’ll see that their capital gains rate is actually 0%! Does that mean they’ll pay $0 in taxes? Unfortunately no. The capital gains will be added to your “adjusted gross income” (AGI), and bump your tax bracket up to the 25% tax bracket (since their AGI is now $125,000). Because of that, they would pay 15% long-term capital gains tax on the $50,000 – $75,000.

Case 3: Paying no taxes
Married, filing jointly, no ordinary income, sold $125,000 in investments that were originally bought for $50,000 over a year ago.

The keys here are married, no ordinary income, and $75,000 in long-term capital gains. What’s really interesting about this situation is that by having $0 in income, they’re in the 0% long-term capital gains tax bracket. Their adjusted gross income (ordinary income + capital gains) is $75,000, which still puts them in a higher tax bracket for ordinary income — but 0% for capital gains. In this situation, they would pay $0 in taxes for the entire year!

This is the Minimal Investor way to go. Buy with the intention of holding on to a fund until you’re in a low-income bracket then sell it. This is the best-case scenario, and what I would personally try to shoot for. If your total income is under this amount, $40,000 (filing single) or $80,000 (filing jointly) you can get away with paying $0 in capital gains taxes.

With the standard deduction you can even raise this up to $52,400/$104,800. You could have $104,800 in long-term capital gains and pay exactly $0 in taxes. That sounds crazy, but it’s just math.

4) What about taxes on dividends?

Let’s move on to something slightly different – dividends taxes. If you’re invested in any mutual fund or ETF, it’ll likely distribute dividends which will either be added to your account as cash or reinvested. If these are in a tax-deferred or a tax-exempt account (401k, IRA or Roth IRA), then you don’t need to worry about dividends taxes – there aren’t any!

If your funds are in a brokerage account you will need to plan for taxes on dividends. Funds give off two types of dividends: qualified and unqualified. Throughout the year you won’t know which is which unless you’re reading the funds prospectus (which I’d recommend trying once to see, but it’s not needed).

Qualified dividends are taxed like long-term capital gains. Nonqualified dividends are taxed like short-term capital gains. Qualified dividends are MUCH better for tax reasons for the same reason long-term capital gains are MUCH better.

So how do you choose a fund that gives qualified dividends? Look for funds with a low “turnover”. Turnover is how much of that fund are sold each year. If a lot of the fund is sold each year, that means that you’ll get a lot of nonqualified dividends.

Vanguard provides some details on this throughout the year – which shows what percent of a funds dividends are qualified.

5) How much tax will I pay if I sell investments for a loss?

If an investment goes down in price and you sell it, you won’t need to pay any taxes on it. The tax is “capital gains” after all, so if there are no gains, there’s no tax.

You can even use the loss to balance out other gains you had during the year. For instance, if you had $2,000 in qualified dividends, but also sold a fund that had a $2,000 loss, then these would zero out and you won’t pay any taxes on the dividends at the end of the year.

There is even a term for this behavior – tax-loss harvesting. It refers to the process of selling funds that have lost value to offset other gains in your portfolio. If you do this smartly, it can help you reduce your taxes over the long-term. When the market is rising (as it has been lately) opportunities for this are fewer, so don’t stress out if the opportunity doesn’t present itself to balance – that just means all of your investments are going up!

If you do sell a fund, for this reason, you can’t just turn around and re-buy it. There is an IRS rule called a Wash-Sale that prevents this exact thing. A Wash-Sale is when you sell a fund, then re-buy it, or something “substantially identical” within 30 days. If you sell some shares of Apple you can’t rebuy more shares of Apple for 30 days. The same is true for index funds that track the same index – you can’t sell a Vanguard S&P 500 fund then rebuy a Fidelity S&P 500 fund.

Last year I sold all of my “Emerging Markets” funds at Vanguard (at a loss) and immediately re-bought the “Total International Stock Market” fund that we’ve talked about. At tax time, Vanguard sent me a notice that a portion of this transaction was classified as a “wash-sale” and that around 20% of the transaction was changed from being a sell/buy to just being a conversion. That meant I didn’t get the tax-loss harvesting benefit from 20% of that transaction. This is something to be aware of when selling funds – try to wait 30 days before buying a similar fund.

6) How do I file all of this at tax time?

Ok, so you have some funds – how do you file taxes on them? Do you need a CPA or someone to do this for you? These are all good questions. At the end of January or the beginning of February, most financial institutes will begin sending out a bunch of tax documents. There’s a 1099-Div for your dividends, a 1099-B for brokerage proceeds, a foreign tax paid sheet – just lots and lots of paperwork.

The first time I tried filing taxes with all of these I was completely overwhelmed and went to the closest widely popular tax-preparer I could find during my lunch hour. We spent much longer than the hour in there entering page after page of data manually. I was happy to have help getting it submitted. A few months later I got a letter from the IRS – my taxes were wrong! Apparently, we’d missed the back of a double-sided sheet, and now I owed slightly more in taxes (and I had to pay the tax-preparer to fix the mistake since I didn’t buy insurance from them).

This completely soured me to use them for my taxes. Instead, I started using Turbotax with the professional addon. They connect directly to your Vanguard account to pull in and process your transactions from there. Cutting out the manual process of typing everything is completely amazing. The peace of mind in knowing that everything is entered correctly and I didn’t miss a page or mistype something is worth it to me.

I filed my taxes with Turbotax for 15 years. The only time I got a message from the IRS was the one year I used a tax preparer. That being said, if you do your taxes and you end up owing thousands and you don’t understand why – it could pay to have a second opinion.

7) How do taxes work when withdrawing from a 401k, IRA or Roth IRA?

401k and IRA withdrawals after you are age 59.5 are taxed just like ordinary income. If you withdraw $40,000 you’d pay exactly the same tax as the ordinary income situation we looked at up top. The more you decide to withdraw from your 401 or IRA, the more taxes you’ll pay – just like with wages from a job.

For withdrawals from a Roth IRA after you are age 59.5 you’ll pay $0 taxes. This won’t affect your ordinary income or your AGI. This is money that’s completely off the books and doesn’t impact anything else you have going on.

This makes Roth IRAs amazingly useful in helping to control your tax bracket. For example, you can use withdrawals from a Roth IRA to still have higher income but stay in the 10%/15% tax bracket so that you pay 0% capital gains tax.

8) What if I want to retire early, but most of my money is in a 401(k)?

Let’s look into the future a bit. Let’s say you’re hoping to retire when you’re 40. You want to figure out how you’re going to make it work when you have a bunch of money in a 401k that you can’t access until you’re 59.5. What do you do?

Side note: There are a bunch of different strategies to access your 401(k) money early. One of the most flexible is called a “Roth IRA Ladder”.

The key to making this work involves two things:

Having at least 5 years of savings in non-ordinary income saved up.
Using a Roth IRA Conversion Ladder

The tl;dr of this process goes something like this (ages are arbitrary).

You retire at age 40, (on December 31, 2019) bringing your ordinary income to $0 for the year 2020. You were spending $30,000/yr and plan to continue.
In the year 2020, you convert $30,000 from your IRA to your Roth IRA. During this year you live off savings.
In the year 2021, you convert $30,000 from your IRA to your Roth IRA. During this year you live off savings.
In the year 2022, you convert $30,000 from your IRA to your Roth IRA. During this year you live off savings.
In the year 2023, you convert $30,000 from your IRA to your Roth IRA. During this year you live off savings.
In the year 2024, you convert $30,000 from your IRA to your Roth IRA. During this year you live off savings.
In the year 2025, you convert $30,000 from your IRA to your Roth IRA. During this year you live off the $30,000 from 2020 from your Roth.
In the year 2026, you convert $30,000 from your IRA to your Roth IRA. During this year you live off the $30,000 from 2021 from your Roth.

The idea is that what is converted from your 401k to your Roth needs to be there for 5 years before you can withdraw it. After that, you can withdraw it from your Roth before you are 59.5 without paying an early withdrawal penalty.

This is a very large topic, and I can’t do it full justice here, but check out the Minafi post on this topic, or other coverage by RootOfGood or The Mad Fientist’s post to learn more.

Lesson 8 In Review

Learn about the taxes that will affect your situation first. If you can wrap your head around the major taxable events for the rest of your life, you can start working to optimize them today. This can shave years off your working career by planning ahead. Here’s a recap of some of the general points:

Put Bonds in tax-deferred accounts, stocks in taxable (if you have to).
Understand what your tax bracket is – it’s useful in a bunch of calculations.
Plan to hold funds a while to pay the lower long-term capital gains rate.
Avoid short-term capital gains whenever you can.
Favor funds with low turnover whenever possible, since they usually have nonqualified dividends.
Wait until you’re in a low-income bracket to sell funds if you can.
Filing taxes is hard at first but gets easier.
Withdrawing from a 401k, IRA, or Roth IRA isn’t rocket science.

Whew, that was quite a lot. Taxes are a large subject, and this is only the tip of the iceberg. Luckily, these concepts will cover the vast majority of tax situations you’ll likely face in your life when it comes to investing.

Next Lesson

We’ll get into rebalancing, and how to keep your investment allocation matching your target allocation. From this lesson on taxes, you may already be thinking “but, if I sell to rebalance won’t I have to pay a bunch of taxes?” Well, you may be right! This is why rebalancing isn’t quite so easy. We’ll go into the minimal way to do this which requires the least work and pays the least taxes.