Basic Question on Investment Taxes

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Tim1477
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Basic Question on Investment Taxes

Post by Tim1477 » Fri Nov 22, 2019 6:58 am

Hi everyone,

I'm completely new to investing and will have an inheritance of around $700,000 that I will soon be investing almost entirely in mutual funds. I don't know how the taxes work on a situation like this, so my questions are:

1. Will I be taxed annually on these investments (or will it depend on the specific investment)?
2. If I will be taxed on the above, should I set aside some of that inheritance specifically to pay the taxes on it?

Thanks

Silk McCue
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Re: Basic Question on Investment Taxes

Post by Silk McCue » Fri Nov 22, 2019 7:17 am

You will not only be taxed on inherited assets that are sold at a gain based upon the increased value established on the date of your father's passing. That is known as the step up basis.

https://www.bogleheads.org/wiki/Step-up_in_basis

You will be taxed on the dividends and capital gains associated with these investments annually once you receive them. No need to set aside money on the inheritance itself but important to understand how your investments will be taxed. Please read this Wiki on Tax Efficient Fund Placement. It is very important to understand in advance how your investments will be taxed. No use in giving the government more than necessary nor earlier than required.

https://www.bogleheads.org/wiki/Tax-eff ... _placement

It is crucial that you take time to get educated on the Bogleheads investing approach. Broadly diverse low expense ratio investing. Prior posts have referenced resources to help you achieve that. If you haven't already I would suggest you spend some time starting here.

https://www.bogleheads.org/wiki/Getting_started

Cheers

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RickBoglehead
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Re: Basic Question on Investment Taxes

Post by RickBoglehead » Fri Nov 22, 2019 7:19 am

Tim1477 wrote:
Fri Nov 22, 2019 6:58 am
Hi everyone,

I'm completely new to investing and will have an inheritance of around $700,000 that I will soon be investing almost entirely in mutual funds. I don't know how the taxes work on a situation like this, so my questions are:

1. Will I be taxed annually on these investments (or will it depend on the specific investment)?
2. If I will be taxed on the above, should I set aside some of that inheritance specifically to pay the taxes on it?

Thanks
Have you read the Wiki?

1) Assuming you are not inheriting retirement accounts, you will be taxed annual on the interest, dividends, and capital gains that this $700,000 generates each year. When you sell any shares, you will be taxed on the capital gains, short or long term, on the selling price minus the cost at date of death.

2) Not relevant.

You should invest the $700,000 in something like Vanguard Prime Money Market until you understand the proper investments for you.
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Chadnudj
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Re: Basic Question on Investment Taxes

Post by Chadnudj » Fri Nov 22, 2019 7:21 am

1. You will be taxed annually on the dividends the mutual funds pay out (plus any realized capital gains of the mutual funds). Generally speaking, with $700k in a S&P500 type mutual fund, you'd likely see around $14k in dividends paid out annually. But we don't know what mutual funds you have, so we can't really give you a precise number.

Those ordinary dividends are taxed as ordinary income -- so, depending on your tax bracket, you'll pay taxes on that $14k at your highest bracket. So if you're in the 24% bracket, you'd owe $3,360 on $14k in dividend income.

2. You could set aside some of the inheritance specifically to pay the taxes on it, I suppose. Or you could increase the withholding on your paycheck so that (over the course of the year) an extra $3,360 is taken out in income taxes. Or, whenever your mutual funds pay dividends over the year, you could be sure to keep aside $3,360 in cash, and then take the rest and do whatever you please with it (I'd recommend reinvesting it).

goblue100
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Re: Basic Question on Investment Taxes

Post by goblue100 » Fri Nov 22, 2019 7:22 am

Tim1477 wrote:
Fri Nov 22, 2019 6:58 am
Hi everyone,

I'm completely new to investing and will have an inheritance of around $700,000 that I will soon be investing almost entirely in mutual funds. I don't know how the taxes work on a situation like this, so my questions are:

1. Will I be taxed annually on these investments (or will it depend on the specific investment)?
2. If I will be taxed on the above, should I set aside some of that inheritance specifically to pay the taxes on it?

Thanks
1. Taxes cam be complicated. Is the money in a tax deferred account now(IRA, 401k)? If so, then it is important that you receive the inheritance in a certain way so that you can continue to defer the taxes. If the money is not in a tex deferred vehicle now, then you will owe taxes annually on the dividends and capitol gains that the mutual funds generate.
2. I would not think you need to set money aside, you can always withdraw money as needed to pay taxes if the money is not tax deferred.
Financial planners are savers. They want us to be 95 percent confident we can finance a 30-year retirement even though there is an 82 percent probability of being dead by then. - Scott Burns

Topic Author
Tim1477
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Re: Basic Question on Investment Taxes

Post by Tim1477 » Fri Nov 22, 2019 7:38 am

Thanks for the replies, everyone. I should clarify a point--

I'm in my last year of medical school now, earning zero income, so I have no investment accounts set up at this time. Next year, as a resident, I will be earning a modest salary. That is why I'm worried about the taxes on my investments. If they are substantial (relative to a ~55k/year income) I am worried about using my paycheck to pay those taxes. Thanks again for the great replies

livesoft
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Re: Basic Question on Investment Taxes

Post by livesoft » Fri Nov 22, 2019 7:46 am

It is time to learn about taxes if you haven't already been filing your own tax returns.

You did not state whether this inheritance was from an IRA, taxable account, trust account, life insurance proceeds, or whatever. That knowledge may change the tax situation. Furthermore, if from a taxable account that gets a stepped up basis, the money has been earning taxable dividends and/or interest even while it has been just sitting there, so you will have to include that income on your tax return.

The IRS has a publication on investment taxes: https://www.irs.gov/pub/irs-pdf/p550.pdf

You can always pay the IRS your taxes directly. Look up Direct Pay at irs.gov.
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rkhusky
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Re: Basic Question on Investment Taxes

Post by rkhusky » Fri Nov 22, 2019 7:55 am

If you put the $700K in Vanguard's Prime Money Market, it is currently paying about 1.75% interest. That works out to $12,250 added to your income. Your salary of $55K/yr puts you in the 22% tax bracket if single, 12% tax bracket if married. The added interest won't change your tax bracket. So, an additional $2700 in tax if single, or $1500 in tax if married.

If you put the $700K in Vanguard's Total Stock Market, it is currently paying about 1.84% in dividends, of which about 95% are qualified dividends. That works out to $12,900 in dividends, of which about $12,250 will be qualified and about $650 non-qualified. If single, the qualified dividends would be taxed at 15% and the non-qualified would be taxed at 22%. If married, the qualified dividends would be taxed at 0% and the non-qualified taxed at 12%. So, an additional $2000 in tax if single, or $80 in tax if married.

The above assumes that this is in a taxable account, not a 401k or IRA.

You can interpolate between the two for a combo of PMM and TSM.

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RickBoglehead
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Re: Basic Question on Investment Taxes

Post by RickBoglehead » Fri Nov 22, 2019 8:03 am

You can easily sell some of the $700,000 in investments to pay any taxes...
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livesoft
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Re: Basic Question on Investment Taxes

Post by livesoft » Fri Nov 22, 2019 8:18 am

rkhusky wrote:
Fri Nov 22, 2019 7:55 am
If you put the $700K in Vanguard's Prime Money Market, it is currently paying about 1.75% interest. That works out to $12,250 added to your income. Your salary of $55K/yr puts you in the 22% tax bracket if single, 12% tax bracket if married. The added interest won't change your tax bracket. So, an additional $2700 in tax if single, or $1500 in tax if married.
Salary of $55K - non-taxed health insurance premiums - standard deduction + Interest might not reach the 22% tax bracket for a single person.

My point is that one should learn about taxes now when life is easy in medical school.
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rkhusky
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Re: Basic Question on Investment Taxes

Post by rkhusky » Fri Nov 22, 2019 8:26 am

livesoft wrote:
Fri Nov 22, 2019 8:18 am
rkhusky wrote:
Fri Nov 22, 2019 7:55 am
If you put the $700K in Vanguard's Prime Money Market, it is currently paying about 1.75% interest. That works out to $12,250 added to your income. Your salary of $55K/yr puts you in the 22% tax bracket if single, 12% tax bracket if married. The added interest won't change your tax bracket. So, an additional $2700 in tax if single, or $1500 in tax if married.
Salary of $55K - non-taxed health insurance premiums - standard deduction + Interest might not reach the 22% tax bracket for a single person.

My point is that one should learn about taxes now when life is easy in medical school.
True. Not only health insurance, but 401k contributions, could drop OP down into 12% bracket. And some of the interest/dividends could span the 12%/22% brackets. But at least he's got some numbers to play with.

livesoft
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Re: Basic Question on Investment Taxes

Post by livesoft » Fri Nov 22, 2019 8:50 am

^Presumably the OP will be contributing to a Roth 401(k) or Roth 403(b) and/or Roth IRA when he has some earned income to do so. They can live off of withdrawals from a taxable investment account and make their tax rate go to zero if they want to. None of this is rocket surgery for someone in medical school, but they do need to open their eyes.
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22twain
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Re: Basic Question on Investment Taxes

Post by 22twain » Fri Nov 22, 2019 9:44 am

RickBoglehead wrote:
Fri Nov 22, 2019 7:19 am
1) Assuming you are not inheriting retirement accounts, you will be taxed annual on the interest, dividends, and capital gains that this $700,000 generates each year. When you sell any shares, you will be taxed on the capital gains, short or long term, on the selling price minus the cost at date of death.
Just to make clear: this refers to two kinds of "capital gains."

When you sell shares of stock, mutual funds, or ETFs, you incur tax on the increase in value of those shares ("realized capital gains"), as described in the second sentence above. You don't incur tax on the increase in value of the shares that you don't sell ("unrealized capital gains").

Mutual funds and ETFs also realize capital gains (and losses) from selling shares of the stocks that they hold. They are required to pass the net capital gain on to you, and usually do it annually in December. These are "capital gains distributions" and you incur tax on them in the year that you receive them. These are the capital gains mentioned in the first sentence above.
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Tim1477
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Re: Basic Question on Investment Taxes

Post by Tim1477 » Fri Nov 22, 2019 10:46 am

livesoft wrote:
Fri Nov 22, 2019 8:50 am
^Presumably the OP will be contributing to a Roth 401(k) or Roth 403(b) and/or Roth IRA when he has some earned income to do so. They can live off of withdrawals from a taxable investment account and make their tax rate go to zero if they want to. None of this is rocket surgery for someone in medical school, but they do need to open their eyes.
To clarify my understanding, are you saying when I start working as a resident: Max my contributions to my 401(k) and IRA, and then withdrawal money from a taxable investment account (for example a Vanguard Joint Investment Account) for living expenses? Wouldn't my tax rate still be from my earned salary + realized capital gains from the investment account? If you could explain how I could make my tax rate go to zero I'd appreciate it. I apologize if this is a basic question, I'm trying to understand all of this as much as I can as I'm completely new to the world of investing and taxes.

livesoft
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Re: Basic Question on Investment Taxes

Post by livesoft » Fri Nov 22, 2019 10:52 am

Money contributed to a tax-deductible 401(k) and tax-deductible IRA is tax deductible and not included in income on your tax return.

As a resident, you may wish to actually pay taxes though to get investments into Roth 401(k) and Roth IRA because your tax rate as a resident may be lower than your future tax rates.

Finally, the tax rate for lowish income investors for realized long-term capital gains and so-called qualified ordinary dividends is currently 0%. That's lower than the tax rate on interest income, non-qualified ordinary dividends, and realized short-term capital gains.
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fyre4ce
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Re: Basic Question on Investment Taxes

Post by fyre4ce » Fri Nov 22, 2019 11:10 am

Tim1477 wrote:
Fri Nov 22, 2019 10:46 am
livesoft wrote:
Fri Nov 22, 2019 8:50 am
^Presumably the OP will be contributing to a Roth 401(k) or Roth 403(b) and/or Roth IRA when he has some earned income to do so. They can live off of withdrawals from a taxable investment account and make their tax rate go to zero if they want to. None of this is rocket surgery for someone in medical school, but they do need to open their eyes.
To clarify my understanding, are you saying when I start working as a resident: Max my contributions to my 401(k) and IRA, and then withdrawal money from a taxable investment account (for example a Vanguard Joint Investment Account) for living expenses? Wouldn't my tax rate still be from my earned salary + realized capital gains from the investment account? If you could explain how I could make my tax rate go to zero I'd appreciate it. I apologize if this is a basic question, I'm trying to understand all of this as much as I can as I'm completely new to the world of investing and taxes.
Your goal should not necessarily to get your tax rate to 0. Your goal should be to have as much money left over after taxes, over your lifetime, as possible.

In your situation, I would recommend maxing contributions to a Roth IRA ($6,000) and a Roth 401k ($19k 2019, $19.5k 2020). If you have to sell some investments to do it, so be it. But that would still leave you with ~$30k of income, minus taxes, to live off, which you might be able to do if you live frugally (another BH principle).

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