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hello everybody Welcome to episode 53 of
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the best interest podcast my name is
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Jesse Kramer today we're going to talk
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all about taxes now it was just tax
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season we're not necessarily talking
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about how to file taxes we're not
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talking about income taxes we're going
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to talk about this intersection this
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very very important intersection of
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taxes and investing so I've got a few
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different articles that I'm going to
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pull some important information from all
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those articles will end up in the show
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notes so if you want to read those
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articles
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and especially if you want to consult
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some of the charts in those articles
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check out the show notes check out those
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links read those articles before we get
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started I am trying to be more
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intentional with growing the best
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interest podcast it's been going really
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well so far this year and one thing that
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really helps growing the podcast and
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attracting potential listeners helping
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them decide if they want to listen to
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the show is the show's ratings and
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reviews so if you've listened to the
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show before if you're listening right
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now and you enjoy this episode I'm
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hoping that you could leave a rating and
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a review if you have the time on Spotify
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you can only leave a rating if you use
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apple podcasts you can leave a rating
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and a review either one works thank you
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in advance if you choose to do that and
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thank you for listening to the best
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interest podcast welcome to the best
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interest podcast where we believe
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Benjamin Franklin's advice that an
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investment in knowledge pays the best
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interest both in finances and in your
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life every episode teaches you personal
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finance and investing in simple terms
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now here's your host Jesse
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Kramer So today we're going to tackle
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the topic of taxes from a few different
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angles mixing in a few different
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thoughts three things are certain in
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life death taxes and a couple weekly
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articles from the best interest this one
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this idea addresses death and taxes
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we're going to talk about the most
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common mistake in understanding taxes
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our current federal tax brackets how tax
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brackets work a common myth about
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getting a raise at work and how you can
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save thousands off your tax bill every
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year and we'll answer these questions
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using some easy charts which I know you
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won't be able to see but if you refer to
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the link in the show notes you can see
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them and some easy math so let's go on
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let's start with the opposite of how tax
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brackets work let's say we have a person
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Ben Ben is a side Hustler he builds some
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kites he writes almanacs he designs
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bifocals and he makes $100,000 per year
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Ben looks at the federal tax brackets
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which you can just Google online and he
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says Ah based on my $100,000 salary I
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fall in the 24% income tax bracket
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therefore my tax burden must be 24% of
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$100,000 or $24,000 in taxes the math is
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pretty easy there 24% times 100,000
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leads to 24,000 in taxes but Ben is
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wrong that is not how tax brackets work
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and he's off by thousands and thousands
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of dollars the federal tax brackets are
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a progressive system the chart below the
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table here in the in the article
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visually shows you exactly what that
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means it means your early dollars are
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taxed less and your later dollars are
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taxed progressively more and now how
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much more that answer is given by the
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federal tax brackets for recent years
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they've stayed relatively stable the
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federal tax brackets might change in
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future years but roughly speaking here
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your first $10,000 are taxed at 10% the
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next $30,000 you earn are taxed at 12%
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the next
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$45,000 you earn are taxed at 22% I
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won't keep going from there but you can
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see as you earn more dollars your
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marginal dollars eventually start
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getting taxed at higher and higher rates
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but the earlier dollars they're still
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taxed at the original lower 10 12 22%
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rates now once you see this visually
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once you see this graphically you'll see
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how the portion of Ben's
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$100,000 that's actually taxed at 24% is
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pretty small only about
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$15,000 of his income are taxed at 24%
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$10,000 is taxed at 10% 30,000 at 12%
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45,000 at 22% and so in summary the
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important summary is that Ben his
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federal tax burden ends up being about
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$18
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,000 significantly less about $6,000
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less than what Ben originally assumed
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was
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$224,000 in fact I'm even leaving out
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something important what I'm talking
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about here is that that's the standard
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deduction you might not know this but
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everybody right now you can either
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itemize your deductions or you can
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choose to accept a standard deduction
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and what that means is that the first
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block of your income is literally exempt
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from federal taxes right right now the
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standard deduction for a single filer I
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believe is about
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$112,500 and for married couples it's
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about
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$25,000 so if your itemized deductions
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are more than 125 or as a couple your
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itemized deductions are more than
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$25,000 then it makes sense for you to
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itemize and deduct as much money as you
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can from your taxes but even if you
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don't have any itemized deductions you
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still get that standard deduction and
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the first 12 or $25,000 of your income
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is literally tax-free
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so the progressive tax system with a
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standard deduction is significantly
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different than what many people assume
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the tax system looks like and it's
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important that you understand that
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because one of the most common
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misconceptions or I shouldn't it's it's
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a very common it's probably not the most
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common but it's a very common often
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repeated personal finance myth is that
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accepting a raise could actually
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decrease your take-home pay and the
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reason why this this myth persists is
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that people think well I was in the 22%
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bracket and that little $2,000 raise
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pushed me into the 24% bracket and they
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mistakenly think that that bump in taxes
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applies to all their income which we've
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just gone over that's that's not how it
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works that the bump in taxes only
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applies to the the most recent income it
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only applies to the the very tippy top
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income so accepting a raise cannot hurt
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your income tax burden now how did this
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here in the first place well based on
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what we've learned today we we
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understand
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[Music]
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that all right let's now switch over and
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talk about how taxes affect investing if
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you aren't familiar there's this
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important acronym that isn't used that
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often but many investors think about the
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individual portions of This Acronym and
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This Acronym is is just a way to
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remember the important factors when you
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are thinking about investing the acronym
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is RR TT LL U okay is it rudoo is it
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raloo Rudy I'm not sure RR TT LL U and
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individually those letters stand for
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risk return timeline taxes liquidity
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legal concerns and then unique
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situations okay I won't spend a ton of
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time going over each one of them but
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real quick risk how much risk can you as
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an investor tolerate and what kind of
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risk is associated with the investment
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fairly straightforward we talk about it
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a lot on the best interest and then
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return of course what's the expected
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Return of the investment or what return
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is required to meet your goals remember
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from a financial planning point of view
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you should think about your goals first
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and then understand what return you need
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to get there that's the kind of stuff I
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do at work all day risk and reward we
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talk about that a lot timeline another
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thing we talk about a lot how much time
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do you have to get to your future goals
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how old are you can you make short-term
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sacrifices for long-term gains those are
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some timeline questions to ask we're
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going to come back to dive into the tax
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a little bit deeper that's why we're
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here today but first the other letters
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liquidity do you have enough liquid cash
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to cover your near-term expenses do you
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have an emergency fund can you afford to
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invest in some ill liquid ways can you
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lock up some of your money for the long
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term legal do you have any particular
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legal constraints that might prevent you
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from investing in certain things a lot
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of us see this there might be
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contribution limits for certain types of
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investing accounts like a 401k or an IRA
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there might be withdrawal mandates on
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certain types of accounts especially for
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older people right required minimum
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distributions that kind of stuff unique
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situations that's kind of a catchall
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some people maybe they have a moral or
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ethical constraint against a particular
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investment they don't want to invest in
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tobacco or alcohol or Firearms companies
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they're worried about ES SG
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environmental sustainability and
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governance objectives maybe they have
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inside knowledge of a particular
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corporation they're in the C suite and
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therefore they can't invest there so
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those are some of the unique stuff maybe
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that last one's a legal thing but either
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way let's go back to taxes the second T
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in this rrt llu framework talks about
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tax situations do you have any unique
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tax situations as an investor what tax
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bracket are you in how will that tax
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bracket change over time based on your
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expected income what are some of the
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potential tax implications of your
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different investment choices many of us
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asks these questions and then execute
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some tax efficient strategy via accounts
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like a 401k IRAs 403bs hsas Etc and we
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can go a step further and for taxable
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accounts consider interest dividends and
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capital gains we're definitely going to
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dive into the capital gains in a little
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bit and then finally we can ask
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questions about Estate Planning and
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inheritance how will various Investments
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affect the future estate of the investor
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and any beneficiaries children grandkids
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Charities those kind of things they
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might wish to leave money
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to so let's dive a little bit deeper on
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this tax and investing topic what kind
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of return can you expect from the
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American Stock Market most sources would
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say 10% per year nominally on average
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account for inflation the real return
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ends up around 6 and half or 7% of
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course we know that actual returns are
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disturbingly different than average
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returns that's something I write about a
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lot on the best interest it's something
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that a lot of good investing
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professionals will tell you while the
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average might be 10% per year you're
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rarely going to hit that average you're
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usually either way over or way under and
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that's why it's important to be a
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long-term investor in order to capture
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that average but let's talk about the
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tax side of things there are three types
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of tax treatments in American Investment
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accounts tax-free accounts have no
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long-term tax burden typically that's
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because income taxes have already been
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paid before the investment deposits Roth
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accounts are one example of that tax
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deferred accounts are as the name
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implies a way to defer taxes to the
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Future traditional 401K accounts are one
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example you pay no income tax today
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invest in a 401k and pay income taxes
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upon your future 401K withdrawals
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finally we have taxable accounts that's
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the third leg of the retirement stool
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they provide none of the tax benefits
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outlined above before but they're
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significantly more time flexible most
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tax-free and tax deferred accounts have
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age restrictions associated with their
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use but not so with taxable accounts as
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for the taxes themselves the money going
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into taxable accounts has already
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suffered income tax and the funds in the
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account will be subjected to both
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dividend taxes throughout the life of
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that tax bill account and then
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eventually capital gains tax ta when you
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withdraw from that account so with these
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extra taxes the dividend taxes and the
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capital gains taxes in taxable accounts
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how are investment returns affected how
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much do the 10% Pere nominal returns
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decrease after we account for taxes to
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answer this question I downloaded the
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dividend tax rate capital gains tax rate
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over the last 100 years as well as
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Robert Schiller's very highly cited and
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well-respected S&P 500 data set I ended
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up zooming in on the data from 1950
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until today that's a good post World War
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II date providing 72 years of data and I
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divided the period into 700 plus rolling
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10-year periods you know an example
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would be March of 1954 to February of
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1964 that's one period I looked at each
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10-year period as a modern investor
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might do as an opportunity to dollar
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cost average into the market buying an
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even $100 of the S&P 500 every month
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and for each period I asked what's the
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nominal tax-free stock market return
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then if we include dividend taxes every
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month as various Dividends are paid and
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we include capital gains taxes as a lump
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sum at the end of the 10-year period how
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much did the returns decrease and then
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finally I asked how did inflation
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decrease the spending power of those
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returns over the 10year period so on
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average each of these 10year periods saw
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a total compounded return of
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170% or 10.4% per year that does not
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include taxes nor inflation that's
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pretty close to what we expect about 10%
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per year a tax deferred account like a
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traditional 401K would see the same
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returns except for a big bite of income
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taxes upon final withdrawal if someone
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was paying a 22% federal income tax
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their 170% Total return would decrease
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to
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133% which makes more sense when we
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annualize it you go from 10.4% per year
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down to 8.8% per year some of you though
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will max out your 401K and your IRA and
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then the next smartest option is a
00:14:12
simple taxable Brokerage in that case
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dividend taxes will trim profits every
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month and capital gains taxes will cause
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a big haircut upon final
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withdrawal on average each 10-year
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period in that case saw an annual rate
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of return of 7 . 2% per year versus the
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original
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10.4% in other words taxes decrease
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stock returns basically by 41% overall
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from 10.4% down to
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7.2% in this article I've plotted out
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those returns over 10 years both in
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total returns and also
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annualized but we still need to adjust
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for inflation to see real returns real
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returns in other words measure how much
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did my actual spending power change it
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accounts for inflation and taxes the
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average real return of this data in the
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completely tax-free account the first
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account is 6.8% per year in the
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traditional 401K that has no taxes until
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the end then we pay income tax the
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average real return was 5.2% per year
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and then the average real return in a
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taxable account was
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3.6% per year so that 3. 6% per year
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rate of return that's that's better than
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a kick in the pants right that's that's
00:15:33
better than zero but 3.6% annualized is
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a far cry from that pre-tax
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pre-inflation Assumption of 10% per year
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it's pretty easy to plan a retirement if
00:15:44
your real spending power increases by
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10% yearly but it's much harder to do
00:15:49
that at 3.6% per year so what's the
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point of all this the point is that most
00:15:55
retirement calculators especially the
00:15:56
quick and easy ones on the internet do
00:15:58
not appropriately account for that tax
00:16:01
drag as such they estimate that
00:16:03
investors will increase their spending
00:16:05
Power by six or 7% per year that's the
00:16:09
nominal 10% minus 3.5% for inflation but
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as we seen today that's incomplete your
00:16:15
Roth and your 401k assets will grow in a
00:16:18
tax advantaged manner totally true but
00:16:20
for many of us a significant chunk of
00:16:22
our stock portfolios that are in our
00:16:25
taxable accounts will only see real
00:16:27
growth of 3 to 4% per year assuming that
00:16:31
future growth will mimic the past which
00:16:33
of course is no guarantee some of you
00:16:35
might be thinking well Jesse tax rates
00:16:37
have changed over time and that's
00:16:39
completely correct as previously stated
00:16:41
taxes took an average 41% bite out of
00:16:44
investment profits Over The observed
00:16:45
10-year period since 1950 but recent tax
00:16:48
rates have relaxed with many recent
00:16:50
periods seeing only only a 25 to 35%
00:16:54
reduction now I'd argue that's still a
00:16:56
significant drag what does the future
00:16:58
hold for taxes well taxes are currently
00:17:01
historically low so don't be surprised
00:17:03
if future taxes go up from here and post
00:17:07
tax investment returns go down now
00:17:10
finally some of you might see this and
00:17:12
say well the ideal zero tax account
00:17:15
which is essentially like a Roth account
00:17:17
returned 6.8% per year and the
00:17:20
traditional accounts returned 5.2% per
00:17:23
year so does that mean that Roth
00:17:25
accounts are simply better well we have
00:17:28
to recall that traditional accounts have
00:17:30
terrific tax benefits upfront before any
00:17:32
of the analysis that I've talked about
00:17:34
today if I had identical income tax
00:17:37
rates today and at retirement then the
00:17:39
benefit of traditional accounts and Roth
00:17:41
accounts would be exactly the same
00:17:43
that's just the
00:17:44
math Roth dollars do have a higher
00:17:47
long-term return only because they've
00:17:50
already had their tax haircut up front
00:17:53
traditional dollars are equal but
00:17:55
opposite there's no tax up front but
00:17:57
their future taxation affects the
00:17:59
investment returns and finally some of
00:18:01
you might be asking should I avoid
00:18:03
investing in taxable accounts altogether
00:18:06
now the way I approach it is that a
00:18:08
positive real return like our 3.6% per
00:18:11
year is way better than nothing the
00:18:14
dollars in your bank account over the
00:18:15
last year or so have suffered a negative
00:18:18
real return that's a loss in purchasing
00:18:20
power so compared to that I would take
00:18:22
3.6% any day you know the point of this
00:18:25
section of the podcast is not to
00:18:27
discourage you from investing in a
00:18:28
taxable account rather the point is to
00:18:31
correct a common and overly optimistic
00:18:33
assumption about investing returns if
00:18:35
you want a Shand metric to plan your
00:18:37
future I'd recommend using these
00:18:39
historical averages but round it down
00:18:41
since I'm investing for long periods in
00:18:43
a diversified stock portfolio I use 6%
00:18:46
real return per year for Roth accounts a
00:18:49
5% real return per year for traditional
00:18:51
accounts and a 3% real return per year
00:18:54
for taxable accounts and that's for the
00:18:55
stock portion of the portfolio now I do
00:18:58
want to dive deeper into the Roth versus
00:19:00
traditional debate because it's a very
00:19:03
hot debate I'd say it's not necessarily
00:19:05
contentious but the question comes up
00:19:06
all the time when I'm reading online
00:19:08
should I invest in Roth should I invest
00:19:10
in traditional accounts now I would go
00:19:13
deep on this topic here the thing is I
00:19:16
need quite a bit of visual aids to
00:19:18
support what I'm saying the shorthand
00:19:20
answer is and I kind of already went
00:19:21
over it a minute ago it all depends on
00:19:23
tax rates current tax rates versus
00:19:25
future tax rates with Roth accounts you
00:19:27
get tax taxed up front but you never get
00:19:29
taxed again so if you think that current
00:19:32
tax rates are lower than the future then
00:19:34
you'd rather pay taxes now which makes a
00:19:37
Roth more beneficial if you think tax
00:19:39
rates might go down in the future or
00:19:41
your personal tax rates might go down in
00:19:43
the future then a traditional account
00:19:45
makes more sense so it depends on not
00:19:47
only the federal tax rates and how you
00:19:49
think they might change but also how
00:19:51
your personal income is going to change
00:19:52
over time how will your income fit into
00:19:55
those tax brackets personally I try to
00:19:58
max out my traditional 401K as best I
00:20:02
can and I also try to max out my Roth
00:20:05
IRA as best I can I have a mix of both
00:20:07
so no matter what kind of tax situation
00:20:09
is thrown at me in retirement I can try
00:20:12
to take advantage of what's going on by
00:20:14
either paying some taxes when the tax
00:20:16
rates are low out of my traditional
00:20:18
account or not paying any taxes when tax
00:20:21
rates are high out of my Roth account if
00:20:24
you want to see how this all works if
00:20:27
you want to see some charts that
00:20:28
supports the detail if you want to see
00:20:29
some graphs and even a few mathematical
00:20:32
examples check out the show notes
00:20:34
there's a link to an article and the
00:20:35
article is called Roth is better than
00:20:38
traditional it's a blog post good posts
00:20:41
good reading lots of good info there I
00:20:43
highly recommend you check it
00:20:48
out how can a quick math error plus some
00:20:51
faulty logic cost someone
00:20:55
$120,000 this was a a link or a story
00:20:59
from October 2021 that I saw on the
00:21:01
bogleheads Forum on Reddit someone was
00:21:03
asking for investing help the quick
00:21:05
highlights of this person's situation is
00:21:08
they had a 401k that offered a 2% match
00:21:11
now 2% Is Not Great compared to the
00:21:13
industry standard of 4 or 5% but still
00:21:15
2% it's free money assuming they
00:21:18
contribute to their 401K the 401K has
00:21:20
funds or investing vehicles with a 1%
00:21:23
expense ratio 1% fees now that's really
00:21:26
high if all you're getting is an
00:21:28
investment product right if you're going
00:21:30
to pay 1% you expect much more than just
00:21:32
an investment product and that
00:21:34
combination of poor employer matching
00:21:37
and high fees made the person writing
00:21:41
this post asking these questions it made
00:21:42
them want to say well screw it screw the
00:21:44
401K I'd rather just invest in a taxable
00:21:47
account but they hadn't done the math to
00:21:50
back up that gut instinct so let's
00:21:54
highlight some important points about
00:21:56
their question and what's going on here
00:21:58
now open questions about money lead to
00:22:00
important lessons and this is a great
00:22:02
question for this person to ask but we
00:22:04
can learn two quick lessons from the Bad
00:22:06
and the Ugly aspects of this
00:22:08
question first we have to separate what
00:22:11
feels bad from what is bad it might feel
00:22:14
bad to pay a higher expense ratio than
00:22:16
what's standard or typical and it might
00:22:18
feel bad to have a low employer match
00:22:20
but the math of the problem is a fact
00:22:23
and that math holds true irrespective of
00:22:25
any feelings Charlie ER tells a story
00:22:28
from when birkshire hathway bought BNSF
00:22:31
railroad some of Burkshire Hathway's
00:22:33
shareholders felt that they were only
00:22:35
getting a good deal while the BNSF
00:22:37
shareholders were getting a great deal
00:22:39
on the transaction and those
00:22:41
shareholders wanted berkshire's
00:22:42
leadership meaning Warren Buffett and
00:22:44
Charlie Munger to negotiate a better
00:22:45
deal and Charlie Munger wisely pointed
00:22:49
out if you're getting a good deal why
00:22:51
the hell do you care what the other guy
00:22:53
is getting his point there being that
00:22:55
Envy Envy is a potent drug
00:22:58
now going back to the second lesson from
00:23:00
this this person's question about their
00:23:02
401K they mentioned that they hadn't
00:23:04
done the calculations for the long term
00:23:07
but they're pretty sure that they were
00:23:08
getting a bad deal and right there time
00:23:11
out that's a dangerous statement in
00:23:13
personal finance if you don't know the
00:23:15
calculations that is okay and you should
00:23:17
ask for help and the internet is an
00:23:19
amazing resource but to be pretty sure
00:23:22
about a mathematical outcome without
00:23:24
doing any math that is not a wise thing
00:23:27
to do so to get a real answer you've got
00:23:29
to do real math so that's what I did and
00:23:32
we're going to talk about it now so
00:23:33
remember this curious redditor believed
00:23:35
that their 401K would surely do worse
00:23:37
than a taxable account and I I'll give
00:23:39
them the benefit of the doubt I used
00:23:41
conservative assumptions for my
00:23:43
hypothetical 401K investor and then I
00:23:45
used comparatively kind assumptions for
00:23:48
my hypothetical taxable investor I
00:23:50
wanted to be extra gracious to this
00:23:52
redditor's Theory could his gut instinct
00:23:54
be correct the assumptions in the math
00:23:57
can all be found in a a Google
00:23:58
spreadsheet that I'll I'll link here in
00:24:00
the show notes we have both investors
00:24:03
contributing the same amount the 401K
00:24:05
investor receives a 2% company match but
00:24:07
ends up paying a 1% expense ratio the
00:24:09
taxable investor pays income tax upfront
00:24:12
receives no matching funds but also pays
00:24:14
no expense ratio no fees both investors
00:24:17
see the same investment performance
00:24:19
before fees both investors pay taxes
00:24:22
upon withdrawal we're going to say
00:24:23
that's 30 years in the future though I
00:24:25
assume a 22% income tax rate for the
00:24:28
401K investor and only a 10% capital
00:24:31
gains rate for the taxable
00:24:34
investor now even with my harsh
00:24:37
assumptions right even though I'm being
00:24:39
conservative with a 401k investor and
00:24:41
liberal with the taxable investor the
00:24:44
401K in this case outperforms the
00:24:46
taxable investor by
00:24:48
$120,000 or about 12% over a 30-year
00:24:52
period that's a huge amount the 2%
00:24:55
company match and the tax deferred
00:24:57
nature of the 401K are extremely
00:25:00
significant and outweigh the fact that
00:25:02
there's this 1% fee involved not to rub
00:25:05
salt in the wound but recall that this
00:25:07
person was fairly certain that their
00:25:09
taxable account was the smarter choice
00:25:11
so the lesson here is to always question
00:25:14
your assumptions especially if math can
00:25:16
help you I guarantee you know someone
00:25:19
who could build a spreadsheet like this
00:25:20
in 15 minutes or less you can call me if
00:25:23
you want help with that it's not that
00:25:25
much time but there's a large amount of
00:25:26
money to be gained
00:25:28
[Music]
00:25:41
now finally we're going to do a deep
00:25:42
dive into capital gains taxes a reader
00:25:45
recently wrote into me and said Jesse
00:25:47
after a tough tax season for me can you
00:25:49
offer any advice on capital gains tax
00:25:51
planning should I set up a tax
00:25:53
withholding on my taxable accounts what
00:25:56
general framework should people use use
00:25:57
and that's a question from Jennifer
00:25:59
Jennifer is a reader of the blog thank
00:26:01
you Jennifer that's a great question so
00:26:03
let's devote some time to the basics of
00:26:05
capital gains taxes capital gain occurs
00:26:07
when you sell an asset for more than you
00:26:09
bought it for it's like profit right
00:26:11
it's a synonym for profit a capital loss
00:26:13
occurs when you sell an asset for less
00:26:15
than you bought it for capital gains or
00:26:18
Capital losses become realized upon such
00:26:20
a sale until that sale the gain or loss
00:26:22
is considered unrealized sometimes those
00:26:25
are called paper gains or paper losses
00:26:27
when they're unrealized while realized
00:26:30
capital gains are taxed that's the point
00:26:32
of what we're going to talk about here
00:26:33
never forget that capital gains are
00:26:35
evidence that something good has
00:26:37
happened right you've turned a profit
00:26:39
how are capital gains calculated and
00:26:41
what accounting methods are used this is
00:26:43
kind of important in their most simple
00:26:44
form obviously capital gains are
00:26:46
synonymous with profit but there are
00:26:48
three different accounting methods that
00:26:49
can be used to calculate capital gains
00:26:52
the first one is called First in first
00:26:54
out and it assumes that you're selling
00:26:56
your oldest shares first if you bought
00:26:59
shares over a number of years and then
00:27:01
you decide to sell some of those shares
00:27:03
this year the gain or the profit is used
00:27:07
assuming that you are selling your
00:27:08
oldest shares the second method is
00:27:11
called specific share identification as
00:27:14
the name implies it involves identifying
00:27:16
exactly which Shares are being sold at
00:27:19
any given time now to keep taxes low
00:27:22
this is probably the method that I would
00:27:23
use because you would sell whichever
00:27:25
shares would result in the lowest
00:27:27
capital gain but since you're
00:27:29
identifying specific shares you need to
00:27:31
ensure that you're keeping excellent
00:27:32
records of everything the last method is
00:27:35
called the average basis method to use
00:27:38
that method you would average the cost
00:27:40
basis or you would average the purchase
00:27:42
price of all of your shares over the
00:27:45
number of years that you've bought them
00:27:46
and you would get the average price per
00:27:48
share and then you'd use that average
00:27:50
price to calculate the capital gains on
00:27:53
a current sale once that method is used
00:27:56
then all remaining unsold shares get
00:27:59
reconstituted at that cost
00:28:02
basis so now how are capital gains taxed
00:28:05
capital gains are subject to tax in
00:28:07
taxable accounts there are no capital
00:28:10
gains in 401ks in IRAs in hsas or in any
00:28:15
other qualified or tax advantaged
00:28:17
investing accounts there are no capital
00:28:19
gains in tax advantaged qualified
00:28:22
investing accounts only in taxable
00:28:25
accounts the first major consideration
00:28:26
in determining capital gains tax is the
00:28:28
duration of holding the asset if you
00:28:30
held an asset for less than a year
00:28:32
before selling it it generates a
00:28:33
short-term capital gain or loss if you
00:28:36
held it for more than a year it
00:28:38
generates a long-term capital gain or
00:28:39
loss short-term capital gains are taxed
00:28:42
as normal income for many Americans that
00:28:44
equates to a 12 to 24% tax rate
00:28:48
long-term capital gains are taxed
00:28:50
anywhere from 0 to
00:28:52
23.8% depending on the Investor's total
00:28:55
income we'll we'll dive into that a
00:28:57
little a little bit later now
00:28:58
importantly Capital losses offset
00:29:01
capital gains going even further Capital
00:29:03
losses can offset some of your normal
00:29:06
income up to $3,000 per year and excess
00:29:09
Capital losses can carry forward into
00:29:11
future tax years that's why the concept
00:29:14
of tax loss harvesting is important to
00:29:16
consider when thinking about capital
00:29:18
gains which assets are subject to
00:29:21
capital gains most common assets are
00:29:24
stocks bonds some real estate Vehicles
00:29:26
can be subject to capital gains and
00:29:29
other reasonable capital gains assets
00:29:31
include Gems and Jewelry digital assets
00:29:34
household furnitur gold silver other
00:29:37
medals coin collection stamp collections
00:29:40
there's quite a list but for most of us
00:29:42
the most common capital gains will run
00:29:44
into in our life are stocks bonds real
00:29:48
estate now how are long-term capital
00:29:51
gain taxes calculated this is an
00:29:53
important concept that is very often
00:29:56
misunderstood in personal finance
00:29:58
circles and it's often it's it's
00:30:00
misunderstood on on the wrong side
00:30:02
usually people think that they can get
00:30:04
away with paying less tax than they
00:30:06
actually can so long-term capital gains
00:30:09
are taxed based on a tax filer's taxable
00:30:13
income not just based on their capital
00:30:15
gains alone as a reminder taxable income
00:30:19
includes many sources including wages
00:30:22
salary commissions bonuses unearned
00:30:24
income such as canceled debts or
00:30:26
government B benefits and then it
00:30:28
includes the capital gains themselves as
00:30:30
well as investment dividends and
00:30:32
interest all of those things combine to
00:30:35
create your taxable income and then your
00:30:38
capital gains tax bracket is based on
00:30:41
that taxable income so I'll just go
00:30:44
through there there's a table here in
00:30:45
the article in the show notes and I'm
00:30:47
not going to go through Section by
00:30:49
section of the table to read you the
00:30:50
entire long-term capital games tax rates
00:30:53
but long story short you can be taxed at
00:30:55
0% for the first 44 $4,000 15% from
00:31:00
44,000 up to
00:31:02
$500,000 and then 20% over
00:31:05
$500,000 now for a single filer what
00:31:08
that means if your total taxable income
00:31:12
Falls below 44,6 25 then you'll owe
00:31:16
nothing on any capital gains that is the
00:31:19
where the confusion comes in because
00:31:21
many people see that and they mistakenly
00:31:23
think that their first
00:31:25
44625 in cap capital gains is not taxed
00:31:29
which would be great well that's only
00:31:31
true if someone has no other taxable
00:31:33
income right because it looks at the
00:31:35
total taxable income if your total
00:31:37
taxable income is under 44,000 then none
00:31:40
of your capital gains are taxed there's
00:31:42
a really nice chart in the article in
00:31:45
the show notes that graphically shows
00:31:47
this showing some normal income some
00:31:50
deductions how your total income tax
00:31:53
works then how the capital gains are
00:31:54
stacked on top of that and then which
00:31:57
portion of the capital gains are taxed
00:32:00
so next when are capital gains taxes due
00:32:02
normal income tax is withheld from your
00:32:04
paycheck to make estimated tax payments
00:32:06
throughout the year now capital gains
00:32:08
are a bit different nevertheless you
00:32:10
should consider making capital gains tax
00:32:12
payments on a quarterly basis using
00:32:14
estimated tax payments in other words
00:32:17
you should not wait until the end of the
00:32:19
year to make a large lump some capital
00:32:21
gains tax payment instead you should
00:32:24
make estimated tax payments and and
00:32:26
there are some rules here about making
00:32:28
estimated tax payments you should
00:32:30
definitely make estimated quarterly tax
00:32:31
payments if you think that you'll owe a
00:32:34
capital gains tax of at least
00:32:36
$1,000 and your current year's tax
00:32:39
withholding is less than 90% of what you
00:32:42
owe for the year or less than 100% of
00:32:45
what you owed last year that's a little
00:32:47
bit confusing at least the way that
00:32:49
Andor logic and and some of the wording
00:32:52
there so a little example might clear
00:32:54
things up and this example and these
00:32:56
numbers are written out in the article
00:32:58
if you want to consult them there so
00:33:01
let's say last year John and Jamie
00:33:03
earned
00:33:04
$160,000 and they paid
00:33:07
20736 in federal taxes so income was 160
00:33:11
their federal taxes was approximately
00:33:14
$21,000 now this year their combined
00:33:16
salary is $170,000 and they're on Pace
00:33:18
to pay a federal withholding of
00:33:21
essentially
00:33:23
$23,000 but in February John and Jamie
00:33:26
decide to sell assets for a $50,000
00:33:28
long-term capital gain these capital
00:33:31
gains all happen to fall in the 15%
00:33:33
bracket based on their total taxable
00:33:37
income and that means that they're
00:33:38
incurring a tax burden a capital gains
00:33:41
tax burden of
00:33:42
$7500 the question is should John and
00:33:45
Jamie make estimated quarterly tax
00:33:47
payments so let's go back to those two
00:33:48
rules above are they going to owe
00:33:50
capital gains of at least $1,000 the
00:33:53
answer there is yes they're going to owe
00:33:54
7500 but then the second question is
00:33:57
is their current year withholding less
00:34:00
than 100% of what they owed last year
00:34:02
well the answer to that is no because
00:34:04
their current year withholding is on
00:34:05
Pace for
00:34:06
$23,000 and last year they owed $21,000
00:34:09
so they're definitely withholding enough
00:34:11
out of their normal taxable income
00:34:13
however is their current year
00:34:15
withholding less than 90% of what
00:34:17
they'll owe this year and the answer
00:34:19
there is yes because this year they're
00:34:21
going to owe 23,000 plus 7500 but
00:34:25
they're only withholding the 23,00 part
00:34:27
they're only withholding about 75% of
00:34:30
what they're going to owe which is under
00:34:31
the 90% threshold therefore the federal
00:34:35
government is going to say to them you
00:34:37
need to make up for that you need to
00:34:39
make some quarterly estimated tax
00:34:40
payments so that we the government are
00:34:43
going to receive at least 90% of what
00:34:45
you owe us throughout the year those
00:34:48
quarterly tax payments are due on April
00:34:50
15th June 15th September 15th and
00:34:52
January 15th that's boring logistical
00:34:54
stuff that you can Google okay next
00:34:57
topic can you set up a withholding for
00:35:00
capital gains this is one of Jennifer's
00:35:02
original questions above withholding is
00:35:04
a concept that comes from the income tax
00:35:06
world when a final tax bill is
00:35:08
predictable based on income the capital
00:35:11
gains world is not so clear the reason
00:35:14
why is because we have to ask questions
00:35:16
like well will there be more capital
00:35:17
gains later this year will there be
00:35:19
Capital losses to offset the capital
00:35:21
gains will you even owe capital gains
00:35:24
taxes or will you fall into the 0%
00:35:26
capital gains bracket for all those
00:35:28
reasons it's hard to set up a fixed
00:35:30
percentage withholding for capital gains
00:35:32
purposes instead many investors elect to
00:35:35
create a a DIY withholding account to
00:35:38
ensure that they maintain enough cash to
00:35:41
fully cover their capital gains tax
00:35:43
burden on a quarterly basis essentially
00:35:45
what it means is if you're the people we
00:35:47
talked about before John and Jamie you
00:35:49
sold assets for $50,000 in long-term
00:35:51
capital gains and you know that you owe
00:35:53
that $7500 you should set aside $7,500
00:35:56
in cash in your bank account to act as a
00:35:59
a personal withholding from which you're
00:36:01
going to make your your estimated
00:36:03
quarterly tax payments there's something
00:36:06
important to talk about here called the
00:36:07
net investment income tax the nii tax
00:36:11
the nii tax is relatively recent and it
00:36:14
effectively States or it effectively
00:36:16
acts I should say as an additional
00:36:18
capital gains tax at a 3.8% rate the nii
00:36:22
tax applies to investment income so only
00:36:25
investment income
00:36:27
above $200,000 if you're filing singly
00:36:30
or above $250,000 if you're filing
00:36:33
jointly and so what it really means is
00:36:35
that it applies to some of the 15%
00:36:39
capital gains bracket and it applies to
00:36:41
all of the 20% capital gains bracket in
00:36:45
other words there are effectively four
00:36:47
capital gains brackets it's not 0 15 and
00:36:49
20 it's zero and 15 but then part of the
00:36:54
15% bracket is affected by nii and
00:36:56
becomes for all intents and purposes an
00:36:59
18.8% capital gains tax and then all of
00:37:02
the 20% bracket is affected by nii so it
00:37:05
becomes a
00:37:06
23.8% capital gains tax
00:37:09
bracket let's get to some good stuff how
00:37:12
should you avoid or minimize capital
00:37:15
gains taxes I'm going to keep these tips
00:37:17
brief we can always go into more detail
00:37:19
reach out to me if you want more ideas
00:37:21
number one take advantage of tax
00:37:23
deferred investing accounts number two
00:37:25
invest for the long-term avoid
00:37:27
short-term capital gains tax rates
00:37:29
number three try to offset capital gains
00:37:31
with capital losses number four utilize
00:37:34
tax loss harvesting and carryover losses
00:37:36
to Future years number five utilize tax
00:37:39
gain harvesting in lowincome years
00:37:42
number six use the best accounting
00:37:44
methods for your situation from the
00:37:46
accounting methods we talked about
00:37:47
before number seven wait to die
00:37:50
seriously we'll we'll get into that one
00:37:52
later number eight asset location place
00:37:55
your high tax investments in qualified
00:37:58
accounts and place your low tax
00:38:00
investments in taxable accounts number
00:38:02
nine use high gains assets for your
00:38:05
donations the charity that you donate to
00:38:08
gets full value you pay no capital gains
00:38:10
taxes and you get a tax deduction and
00:38:13
number 10 you can use high gains assets
00:38:16
as loan collateral now I've never done
00:38:18
this and I'm not necessarily sure I
00:38:20
would recommend it but if you're looking
00:38:22
to avoid capital gains taxes you can
00:38:24
reach out to your brokerage firm many
00:38:26
firms offer loans against shares so you
00:38:30
can get a loan giving you some cash
00:38:32
liquidity that you need without selling
00:38:35
the underlying shares now let's go back
00:38:37
to number seven about waiting to Die the
00:38:39
question is well what if someone dies
00:38:41
who pays the capital gains taxes if
00:38:43
someone dies with a lot of unrealized
00:38:45
capital gains under current tax law if
00:38:48
you die and you leave High gains assets
00:38:51
to your heirs no capital gains tax will
00:38:54
be paid on the transfer nothing is paid
00:38:57
by your estate and nothing is paid by
00:38:59
your heirs now not only that but your
00:39:01
heirs they receed the assets on a
00:39:03
stepped up basis now what that means is
00:39:06
let's say you bought Apple in the year
00:39:08
2000 when it was less than $1 per share
00:39:11
and today it's
00:39:12
$166 per share if you sold it today that
00:39:16
$165 gain per share is subject to
00:39:19
capital gains but if you die today your
00:39:23
heirs will inherit those Apple shares at
00:39:25
A6 $6 cost basis if they sold the shares
00:39:29
tomorrow let's say it's the same price
00:39:31
tomorrow the IRS would look at that and
00:39:33
say you received the shares at 166 you
00:39:37
sold the shares at 166 there is no
00:39:39
capital gain and therefore no tax for
00:39:43
that reason capital gains tax planning
00:39:45
is especially important in retirement or
00:39:47
in older years it's especially important
00:39:50
for any assets that you plan on handing
00:39:52
down to your heirs or simply it's
00:39:54
important if you think you have enough
00:39:56
asset assets that you don't need to sell
00:39:58
and incur any capital gains you can just
00:40:00
wait to die and absolve yourself of any
00:40:03
unrealized capital gains taxes granted
00:40:07
that area of the tax code is hotly
00:40:09
debated and it's in legislative
00:40:11
crosshairs in general capital gains
00:40:14
taxes right a a tax on Capital they're
00:40:17
significantly lower than income taxes
00:40:19
which are a tax on labor and for a few
00:40:22
different reasons many people don't
00:40:24
really think that makes sense and think
00:40:27
that it's quite the loophole to allow
00:40:30
people to die and absolve themselves of
00:40:32
capital gains taxes kind of interesting
00:40:35
stuff okay everyone that is the episode
00:40:38
that is all I've got today on taxes I
00:40:41
hope it helped and if you have any
00:40:42
questions feel free to reach out thank
00:40:44
you again for
00:40:45
[Music]
00:40:47
listening thanks for tuning in to this
00:40:49
episode of the best interest podcast if
00:40:52
you have a question for Jesse to answer
00:40:54
on a future episode send him an email at
00:40:56
Jesse bestin interest. blog again that's
00:41:00
Jesse bestter interest. blog did you
00:41:03
enjoy the show subscribe rate and review
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helps others find the show and invest in
00:41:10
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00:41:12
appreciate it we'll catch you on the
00:41:14
next episode of the best interest
00:41:16
[Music]
00:41:19
podcast the best interest podcast is a
00:41:21
personal podcast me for education and
00:41:24
entertainment it should not be taken as
00:41:26
Financial advice and is not prescriptive
00:41:28
of your financial
00:41:30
situation