When I was rotting away in the five-sided well of souls, wondering what I had done to break my streak of good Air Force assignments and plotting how to never set foot in the Pentagon again, I also struggled with managing my investments.
It’s a common issue. Taxes are fact and investing is opinion, but it seems that the nexus of the two is just confusion. I started to have a nagging suspicion that my investing mistakes might have zeros behind them—and not just after the decimal point.
I had plenty of opinions about investing and I knew a few facts about taxes, but how to find the “L over D max” (optimum point of lift and drag on an airplane) of taxes on my investments escaped me to say the least.
A Quick Re-Blue
I’ve written before about using the mnemonic “4-I-4-T” as an order of operations for investing retirement money.
4 = 401(k) or TSP
I = IRA
4 = 401(k) or TSP
T = Taxable Account
The idea is that, for dollars that you’ll need when you jettison a paycheck, the most efficient investing order is to investing your employer’s plan (e.g., 401(k) or TSP) up to the match, then fund your IRAs, then put more dollars into the 401(k) or TSP, and only if you still have retirement dollars to invest—put them in a taxable account.
The 401(k)/TSP has great advantages:
Tax-free distributions in retirement (Roth)
Tax-free contributions (Traditional)
High annual contribution limits
Excellent bankruptcy and creditor protection
Ability to buy/sell underlying investments without taxable events
401(k)’s and the TSP can have disadvantages too:
Typically limited investment choices
Potentially high investment costs
Potentially restrictive rules on accessing funds
IRAs are next in the pecking order and feature
Traditional or Roth treatment based on income
Ability for a non-working spouse to contribute
Maximum investment options
Low investment costs (depending on the investment and brokerage)
Favorable distribution order (Roth)
Ability to buy/sell underlying investments without taxable events
IRA disadvantages include:
Relatively low limits ($6,000/$7,000) under/over age 50 in 2022
Income and employer plan-based limits on tax deductions (Traditional)
Income limits for contributions (Roth)
5-year waiting period to withdraw earnings and conversions (Roth)
Potentially restrictive rules on distributions
There’s plenty of complexity about TSP/401(k)/IRAs, so it’s always best to talk to your installation’s Personal Financial Counselor or your financial planner before launching your money on a mission.
If a family has retirement investing dollars to deploy after maxing out their TSP/401(k) and IRAs, then it’s time to use a taxable account.
If I Don’t Like Taxes, Why have a Taxable Account?
If you’ve already loaded up your TSP/401(k) and IRAs to the annual limits, pretty much every other option is “taxable.” Really, this just means that there’s no preferential tax treatment when compared to employer plans and IRAs.
You’ll hear the terms “Qualified” and “Non-Qualified” in the investment world from time to time. When it comes to investment accounts, “Qualified” just means that the account is qualified to receive preferential tax treatment—e.g., it’s an IRA or TSP. “Non-Qualified” means that it doesn’t receive the type of preferential tax-treatment that IRAs and the TSP get.
All dollars will eventually get taxed, but a taxable account is exposed to taxation in three ways.
Prior to investing in the taxable account, someone earned the dollars and Tax Uncle taxed them.
Each year as the investments earn returns, Tax Uncle taxes the returns.
When you sell investments in your taxable account, Tax Uncle taxes any gains.
Despite carrying an unfortunate name, taxable accounts actually have some great advantages and may even be a more tax-efficient way to invest than some Qualified accounts.
No limits on contributions or distributions
Nearly unlimited investment choices
Potentially low investment costs
Potentially low annual tax cost
Potentially favorable tax rates compared to earned income
Stepped-up basis at death
Potential tax deduction for charitable donations
Tax-loss harvesting can lower one’s tax bill
Tax-gain harvesting can lower one’s eventual tax bill
Disadvantages of taxable accounts include:
May not be able to sell assets without causing taxable events
Difficult to rebalance without causing taxable events
Difficult to re-shape when investment thesis changes… without causing taxable events
Types of Taxation on Taxable Accounts
While there is more to the discussion, at the end of the day taxable accounts usually get taxed at one of two rates:
Your top marginal income tax rate (e.g., 22% or 24%)
A favorable long-term capital gains rate (e.g., 15% or 20%)
Clearly, the long-term capital gains (LTCG) rate is preferable and for lower income years, it can be 0%!
The most crucial factor in investment taxes is the type of investment, so let’s look at tax characteristics of the most common types of investments:
Stocks can pay dividends which can be taxed in two ways depending on whether they are “qualified” or “ordinary.” In this context, it primarily means that you owned the stock for certain number of days prior to the dividend payment. If you don’t own the stock long enough, you’ll pay tax at the “ordinary” rate—your marginal income tax rate. But, if you meet the requirements for the holding period, you’ll generally pay the more favorable LTCG rate.
The sale of stocks can create capital gains which can also be taxed in two ways. If you own the stock for at least a year and a day, then any gains are taxed at the lower LTCG rate. But if you own the stock for a year or less, then you’ll pay the short-term capital gains (STCG) rates which is your top marginal income tax rate.
The moral of the story for most investors is to avoid selling at a gain if you haven’t held the stock for at least a year and a day.
Bonds usually pay interest which is always taxed at your marginal income tax bracket (e.g., 22% or 24%). The sale of a bond can create a capital gain that can be taxed at either the STCG or LTCG rate depending on the holding period.
The key feature of bonds is the interest they pay which is taxed at the highest rates. Thus, it’s most common to avoid holding bonds in taxable accounts.
Municipal Bonds generally receive favorable tax treatment. The federal government doesn’t levy income tax on the interest from municipal bonds, but states may. Holding municipal bonds in a taxable account can be more efficient, but if the bond is sold for a gain LTCG or STCG tax rates apply.
Mutual Funds and Exchange-Traded Funds (ETF) hold stocks and or bonds. As such, they’re taxed the same, although the qualified dividend rules are slightly different. With mutual funds and ETFs, you’re along for the ride. A fund manager buys and sells the underlying stocks and bonds and you get no say on the timing.
Thus, mutual funds and ETFs can create a mix of gains at both ordinary and long-term rates and generally you won’t know what your tax liability might be until you receive your annual 1099-DIV or 1099-B in February of the following year.
REITs (Real Estate Investment Trusts) are essentially taxed like a mutual fund that holds bonds. Dividends are taxed at the higher ordinary income rates, but sales of REIT shares are taxed as either long-term or short-term capital gains. Just like bonds and bond funds, REITs are better held in an IRA/401(k)/TSP.
Crypto Assets are currently treated largely like stocks. Crypto assets do not pay dividends, so owners only need to be concerned with the holding period—longer than a year versus a year or less. That said, using crypto assets to purchase other assets creates a capital gain.
If you use $100K of PugCoin to buy a Tesla, you’ll pay at least $15K of tax just to execute the transaction. Not so much with $100K of Benjamins.
Other Investment Taxes
So far, we’ve looked at the following taxes on your taxable investment account:
Qualified Dividends—usually taxed at 15% or 20%
Ordinary Dividends—taxed at your marginal income tax rate, e.g., 22% or 24%
Long-term Capital Gains—usually taxed at 15% or 20%
Short-term Capital Gains– taxed at your marginal income tax rate, e.g., 22% or 24%
Unfortunately, there are additional taxes you may have to worry about.
NIIT (Net Investment Income Tax) is a 3.8% surcharge paid on investment income (dividends and gains) or earned income above $200K (single) or $250K (married filing joint) in order to fund healthcare. NIIT is supposed to be a tax on high earners, but since the income thresholds are not indexed to inflation, it’s a tax that effectively goes up every year.
IRMAA (Income-Related Monthly Adjustment Amount) is often called a shadow tax. This is the increase in what Medicare recipients (those over age 65) pay each month when their income, including from investments, is over certain thresholds.
Putting the Pieces Together
You’re forgiven if at this point, you don’t feel like have it all solved quite yet, but now that we have the building blocks laid out, let’s talk about how to minimize your investment tax bill.
4-I-4-T—By using tax-favored accounts first, you’re at least deferring taxation on potentially decades of earnings. Investment location—the type of account used is every bit as important and the investment choice (e.g., a stock or bond).
Buy-and-Hold—The longer you hold onto an investment without selling all or part of it, the lower your tax bill may be. This is because short-term capital gains rates are high for most investors and ordinary dividends rates also come from short holding periods.
If you hold a taxable investment until death, your heirs receive a step-up in basis to current fair market value, effectively erasing a lifetime of capital gains.
Bonds and REITS should usually be in an IRA/401(k)/TSP to avoid paying higher taxes on their interest/dividends each year. If they’re in a Roth account, you’ll likely skip taxation on their returns altogether.
Sell Surgically—If you’ve purchase shares of stocks or funds in various lots over the years, each lot has a different amount of gain. Selling shares with the highest basis results in the lowest gain. Selling shares based on average cost can be leaving the tax man a tip.
Measure Twice…Invest Once—If you don’t currently have a taxable account, don’t just buy the hot meme stock of the day or the companies you know. Build a plan that simultaneously chooses the investments and tax characteristics that suit you best. You’ll be on that horse a long time so make sure it’s comfortable.
Don’t let the tax tail wag the investment dog—While all of the wisdom here is important, you’re investing to fund future goals. When it’s time to sell in order to fund the goal, don’t fret too much about the tax bill. Do what you can to signature-manage the tax man over the years, but choose the best investments for your needs and sell them when you need to in order to live your best life.
Cleared to Rejoin
All investment accounts are taxable depending on the conditions, but you need to be very intentional about your taxable brokerage account. Once you’ve built a sizeable balance in your taxable account, you may have few options to avoid Aunt IRS. If you have a taxable brokerage account already, talk to your financial planner about how to optimize your tax bill this year and in the future. If you’re thinking about starting a taxable account, your financial planner can help you avoid a lifetime of tipping the tax man with intentional investment choices.