Who doesn’t love a long-winded discussion on taxes??? OK, I promise it is not that and I promise it is not everything you need to know, because that would fill a book or 2, but we’ll talk about some of the key concepts that we all should understand in order to maximize our total returns.
We work hard to grow our money through investing and the magic of compounding. We want to be sure that Uncle Sam takes as little of our hard-earned gains as possible.
Asset Location
This is not about how to hide your money in a numbered Swiss bank account. As much fun as that might be, this is simpler. Asset location is simply the process of making good decisions about which assets we should put in which types of accounts.
Let’s look at a couple of examples:
Dividend Stocks
I love dividend stocks. One of my favorites is a small Massachusetts insurer called Safety Insurance (SAFT). SAFT currently pays a 4.49% dividend.
SAFT has hugely underperformed the S&P 500 since my first purchase in 2010. SAFT has gained a lackluster 64% since then v. over 300% for the S&P 500. But in addition to that small stock price appreciation, every year it has paid me between 4% and 5% in dividends. In the years when CDs and Treasuries were paying less than 1%, this was a stellar return on a fairly stable asset.
I didn’t buy SAFT for stock price appreciation – that’s what I have Apple, Amazon and Netflix for. I bought it for the steady stream of income along with a potential for small capital appreciation over time. Knowing why we own a particular security is important. See more in the investment thesis post.
Back to SAFT and asset location. I have a taxable brokerage account, a traditional IRA, a Roth IRA and an HSA. In which account should I buy SAFT shares?
The answer is…somewhat complicated, but not so much.
My experience has been that anytime I make investment decisions primarily based on tax consequences, I am unhappy years later. Someday we’ll talk more about this, but for now, my advice is to make investing decisions based on investing principals (and a strong thesis) and be aware of tax implications and work to minimize taxes, but don’t let them be the primary deciding factor.
So the answer is:
- HSA
- Roth IRA
- Traditional IRA
- Brokerage account
Why?
If I buy SAFT in my taxable brokerage account, every year, I will receive a healthy dividend check. I will owe taxes on that check.
If I buy SAFT in my traditional IRA, I pay no taxes on the dividend I receive each year. I’m deferring tax. When I withdraw from the traditional IRA, I pay ordinary income taxes on the withdrawal amount, whether it is principal, capital gain or dividend. The idea of the traditional IRA is that I pay no taxes on the money I put in, or the income I earn from my investments, but I pay taxes at a hopefully lower rate, when it comes out.
If I buy SAFT in my Roth, I paid taxes on the money going in, so there are no taxes on the dividends or capital gains. Yay!! Same for the HSA, as long as the proceeds are used to pay medical expenses. The additional benefit of the HSA is the money going in is not taxed.
Growth Stocks
Growth companies are typically plowing all of their capital into growing. Thus the name. That typically means they don’t pay a dividend. The investment return we receive from a growth stock is in the form of capital appreciation. If we’ve chosen well, our stock is worth more when we sell it than when we bought it.
I have Amazon in my brokerage account. I bought some shares on 4/8/2010 at a price of $6.99 per share. They are up 2,543.29%. I have thousands of dollars in capital gains on this one purchase. Yay!! I have not paid a dime in taxes…yet. As soon as I sell these shares, I’ll pay capital gains taxes on all of the gain.
Tax Free Municipal Bonds
I love municipal bonds and municipal bond ETFs. They offer huge tax advantages. For most muni bonds, there is no federal tax, and there is no state tax if we buy munis issued by the state in which we live. Munis will typically have a lower yield than a similar taxable bond because of the tax free status.
Munis belong in a taxable brokerage account. We want the tax advantage of not having to pay taxes on the income that they generate each year. If we own them in a tax deferred account, we will end up paying ordinary income tax on the interest when we redeem.
One caveat. There are taxable munis. These typically offer a higher yield and they are taxable. Taxable munis are a good choice for a tax deferred account.
Summary
Assets that generate dividends or interest, are best suited for tax deferred accounts. This includes high yield stocks, REITs, taxable munis, high yield bonds and funds, treasuries, and CDs.
Growth assets like Apple, Amazon and Netflix, or a low-yield equity fund are better for our taxable brokerage account. These assets will typically not generate dividends that would be taxable in the current year. We will pay taxes in the future when we sell the assets, but hopefully this will be in retirement when we’re hopefully in a lower tax bracket. That’s a lot of hope. That’s all we really have when it comes to tax planning.
And tax free munis belong in a taxable account.
For a brief period I held some Master Limited Partnerships (MLPs). These are typically energy pipeline companies and there are special tax situations. After doing some research, I decided that the probability of my reporting my taxes incorrectly was higher than the probability that I’d make money on the MLP investment. I don’t invest in MLPs.
And finally, I don’t let tax planning govern my investment decision making. If I decide I’d like to buy SAFT, and the only available cash I have is in my taxable brokerage account, I would buy it. Sure I’ll pay taxes each year on the dividend, but I may end up better in the long-run.
Interest
We can typically hold CDs, treasuries and money market funds that will pay interest in our taxable brokerage account. Our broker will send us a consolidated 1099-INT for all interest payments.
Dividends
Some companies pay a dividend. See more here. If we own a company that pays a dividend, we will get payments (usually quarterly) that we can reinvest in additional shares of the company or we can take in cash.
Either way, the payment of that dividend is a taxable event. Our broker will be nice enough to consolidate all of our dividend payments into one 1099-Div that it will send us at the end of the year.
Exception: As we noted above, dividend taxes are deferred for any of the tax deferred accounts like an IRA, Roth or HSA. We will not get a 1099-Div for these accounts and we will not pay taxes until we take a distribution.
Qualified Dividends
Qualified dividends are dividends received from companies that we have held for a longer period of time. As a benefit for being a long-term investor, we are qualified to receive the capital gains (lower) tax rate on these dividends. How long is longer. Read here. I’m including the rule so you can have a quick laugh.
A dividend is considered qualified if the shareholder has held a stock for more than 60 days in the 121-day period that began 60 days before the ex-dividend date. The ex-dividend date is one market day before the dividend’s record date. The record date is when a shareholder must be on the company’s books to receive the dividend.
Whoever made this up had a sense of humor.
Ordinary Dividends
Ordinary dividends are dividends we’ve received from companies that we have not held as long. These do not receive the preferential capital gains tax rate. These dividends are taxed at the higher ordinary income tax rate.
Tax Forms
The good news is that our broker will calculate this and break all of this out for us in detail in our 1099-Div.
Capital Gains
A capital gain occurs when we sell an asset for a higher price than we paid.
Capital gains apply to lots of things, not just investments like stocks, bonds and funds. If we buy a classic car and it goes up in value, we’ll pay capital gains taxes when we sell it.
Fun note: on our brokerage website, the amount we paid will be referred to as the cost basis. If we have several purchases of the same stock on different days, our brokerage will track a separate cost basis for each purchase. The broker will need to know this in order to classify our capital gains/losses as short term v. long term, and to classify our dividends as ordinary or qualified.
Short Term Capital Gains
A short term capital gain occurs when we sell an asset that we’ve owned for a year or less. Short term capital gains are taxed at our ordinary income tax rate.
Long Term Capital Gains
Long term capital gains get a preferential tax treatment as an incentive for us to invest long-term. Long term capital gains are taxed at 0%, 15% or 20%, depending on our filing status and income level.
Capital Losses
Just as we can have a capital gain, when we sell an asset for a higher price than we paid, we can have a capital loss if we sell for a lower price than we paid. The same long-term/short-term classifications apply.
Wash Sales
We cannot sell a security to take a capital loss and then buy the same, or similar, security back within 30 days. This is to prevent investors from taking the loss, essentially keeping the security (by buying it back right away) and reducing taxes. The rule is a little more complicated, but be aware that jumping in and out like this could have tax implications.
Tax Considerations on Sales
When we decide to sell shares, our brokerage will typically use the FIFO (first in first out) method for choosing which shares to sell. So if we enter a sell order, and we don’t specify which shares to sell, our broker will sell the oldest lots. This is typically in our best interest as we’ll be selling shares with the longest holding period and will be more likely to have long-term gains (or losses).
We may however, have a situation where newer shares have a loss, while the older shares have a gain. We may want to use this short term loss to offset a short term gain we’ve taken. I always like to choose specific lots even if I’m going with the oldest. Never hurts to look.
Tax planning strategies could fill a book, a very dull book. For us, it’s important to know the basic tax implications outlined here, and to assess all share purchases to determine which ones to sell to minimize tax payment.
Tax Forms
Our broker will send us a 1099-B tax form showing all security sales. Sales will be designated either long-term or short-term, based on holding period.
Mutual Funds
Fund Dividends and Interest
As we all know, mutual funds are a basket of securities. The stocks in a mutual fund may pay dividends and the bonds will likely pay interest. Mutual Funds hold onto these payments for us and periodically distribute them to the fund shareholders.
Fund Capital Gains/Losses
Mutual funds also realize capital gains and losses. The fund managers are buying and selling securities regularly. Even passive funds buy and sell as they re-align to their respective index. These sales will generate capital gains or losses. The fund will hold on to these and pass them on to shareholders periodically.
Fund Sales
As a fund shareholder, we may at times sell our shares. This works the same as selling a stock. We could incur short term or long term gains or losses. One caveat is that some brokerages will use an average cost basis for shares purchased. Instead of tracking the cost of each purchase, the broker will still identify long v. short shares, but will apply an average cost across all purchases.
Fund Tax Forms
Funds will send us a 1099-Div and a 1099-B, just like we’d get for our individual stock holdings.
ReCap
Taxes stink!!
I love Roth accounts because we’ve paid taxes before we put our money in so we never have to worry about taxes again.
I love an HSA even more. The money goes in before taxes, it grows tax free and we can take it out without paying taxes as long as we use it for qualified health care expenses. I’m 61 and retired. Trust me, you’ll have enough qualified health expenses to drain this account.
That leaves us with our taxable brokerage account. We need to be very aware of capital gains and losses as well as dividends and interest income. Every year our broker will send us a 1099-Div, a 1099-INT, and a 1099-B to specify the dividends, interest, and cap gains that we must pay paxes on.
We also need to be careful of security sales. Capital gains are taxable, so if we’ve done a great job and our investment has grown, we may be making a sizable tax payment on our capital gains. Look closely before selling.
Anytime I’ve made a decision based on tax implications, I’ve regretted it down the road. Tax implications should be an input to all investing decisions, but not a deciding factor.
Have fun.