Taxable account

From Bogleheads
Jump to: navigation, search

A taxable account is an account for which the default IRS tax rules apply. Generally, investors are required to pay taxes on interest, dividends, and capital gains earned within a taxable account in the year they are earned. Taxable accounts include checking accounts, savings accounts, money market accounts, and brokerage accounts.

Taxable accounts are distinguished from tax-advantaged accounts, which have special tax rules. Examples of tax-advantaged accounts are 401(k)s, IRAs, 403(b)s, Health Savings Accounts (HSAs), and 529 plans. However, unlike tax-advantaged accounts, taxable accounts do not have restrictions on contributions or withdrawals.

Taxable account basics

The tax rules for taxable investments are as follows:

  • Taxable investments are made with after-tax money
  • Interest, dividends, and capital gains generated by taxable investments are taxed as income in the year they are earned, either as ordinary income (for interest, non-qualified dividends, and short-term capital gains), or at a reduced rate for long-term capital gains and qualified dividends
  • When the investment is sold, the difference between the sale price and the cost basis is taxed as either short-term (if held for <=1 year) or long-term (if held for >1 year) capital gains.
  • Taxable accounts have no contribution or income limitations, and no withdrawal restrictions

Appropriate uses for taxable accounts include:

  • Saving for goals on a shorter time horizon than permitted by retirement accounts, including emergency funds, or saving for a car, house down payment, or other purchases
  • Saving for retirement when the amount being saved is above the contribution limits for available tax-advantaged retirement accounts
  • Investing in investments not available inside tax-advantaged accounts

Details

Earnings from a taxable account are taxed as income in the year they are earned. This section discusses the tax treatment of specific kinds of earnings from a taxable account. Regardless of the type of earnings, all taxable account earnings are treated as investment income, and so have the following tax treatments:

  • Earnings do not result in payroll taxes (Social Security Tax, Medicare Tax, or the Additional Medicare Tax)
  • Earnings may be subject to the Net Investment Income Tax

Interest

Interest, for example, earned from a savings account or money market, is taxable as ordinary income in the year it is received. Interest receives no preferential tax treatment. Interest payments are usually reported to investors on IRS Form 1099-INT.

Bond interest/coupons

Bond interest (coupons) are generally treated as interest, although certain types of government-issued bonds pay interest that is exempt from certain taxes:

  • Corporate bond interest is fully taxable
  • Federal government bond interest (Treasury notes, I-Bonds, TIPS, etc.) is taxable by the federal government, but typically exempt from state income tax
  • Municipal bond (issued by state and local governments) interest is typically exempt from both federal taxes, and state taxes in the state that issued the bonds, although exceptions exist, so consult your specific state's tax rules

Dividends

Dividends are payments made from a business to its shareholders (owners). Holding shares of stock in a taxable account means you will receive dividends when the stock pays out dividends. Dividends that meet the requirements for qualified dividends are subject to long-term capital gains tax rates, which are lower than for ordinary income. Dividends that do not meet these requirements are called non-qualified dividends, and are taxed at ordinary income rates. Dividends are reported to investors on IRS Form 1099-DIV.

Capital gains and losses

When an investment is sold for more than its cost basis (typically, what you paid for it; sometimes the IRS requires adjustments to this number), the profit on the investment becomes taxable income in the year the investment was sold. Generally, if the investment was held for more than one year, the gains are taxed at reduced long-term capital gains tax rates. If the investment was held for one year or less, the gain is taxed as ordinary income. Taxes are only assessed on the gains; the cost basis (typically the amount of the original investment) is returned to the investor tax-free when the investment is sold.

When an investment is sold for less than its cost basis (at a loss), the losses are generally tax-deductible. If the investment was held for more than a year, the loss will first offset long-term capital gains on other investment sales, then offset short-term gains, and up to $3,000 of remaining losses can offset earned income. Losses beyond the $3,000 limit are carried over to future years and can be used to offset future income. This is called capital loss carryover. Typically, gains and losses from the sale of investments are reported to investors on IRS Form 1099-B.

Distributions

When owning a mutual fund inside a taxable account, any interest, dividends, and capital gains earned inside the mutual fund are generally passed to the fund owners. This is why a mutual fund owner may see capital gains reported on a 1099-DIV at the end of the year, even if they did not sell any shares of the mutual fund.

Step-up in basis

One feature of taxable accounts is that the cost basis of investments "steps up" to equal the value of the security when inherited after the owner's death. For example, if your uncle owned shares of a stock worth $100,000 with a basis of $20,000 (what he originally paid for it, plus any reinvested dividends), and bequeaths these securities to you when he dies, your basis becomes $100,000 on the day you inherit the stock. If you sell the stock immediately for $100,000, you receive the full value and are required to pay no tax. Conversely, if your uncle sold the stock the day before he died, he would be required to pay capital gains tax on the $80,000 gain.

It is possible to gift taxable investments while you're still alive. In this case, the recipient "inherits" the same basis as you had for purposes of gains, so receiving a gift of investments with unrealized capital gains will cause you to incur capital gains tax in order to liquidate the investments. If the recipient sells for a loss, the basis is the lower of your basis or the fair market value at the time of the gift. (This rule prevents you from giving property with a loss to a relative who would get a larger tax benefit from the loss than you would.)

Foreign tax credit

Main article: Foreign tax credit

International investments sometimes have to pay taxes in foreign countries, and when they do, these taxes are indicated on tax forms such as Form 1099-DIV. Subject to some limitations, the IRS allows taxpayers to take either a credit or deduction for foreign taxes, avoiding double taxation; the credit is usually the better choice.

Taxable account investing strategy

In Traditional and Roth accounts, investment performance is solely a function of the overall return. Investing in a taxable account is considerably more complex, due to the more complex tax rules, additional dimension of yield (returns that are paid out from the investment as opposed to retained as an increase in value), and tracking of the basis. Tax efficiency describes the concept of minimizing taxes over one's entire portfolio by optimizing around tax laws. This section describes various strategies that are useful for minimizing taxes and maximizing returns when investing in taxable accounts.

Tax-efficient funds and fund placement

An investor should prefer minimal yield on taxable investments, for a given level of return. Lower yield improves investment performance in three ways:

  • Taxes that would be paid on dividends and capital gains are retained in the investment and provide compounding growth
  • Retaining growth as price appreciation, as opposed to yield, gives the investor control over when this gain is realized. For example, appreciated investments can be sold off in low-income years to reduce the tax burden. Taxes on yield must be paid in the year they are earned, even if tax rates are high.
  • Investments held for longer than one year receive preferential tax treatment as long-term capital gains, whereas yield may be taxed at higher ordinary income tax rates.

The inherent tax efficiency of passive stock funds, such as index funds, gives them an enormous advantage over actively-managed stock funds inside a taxable account. Passive funds, by their nature, buy and hold a set of stocks, and trades within the fund are rare (for example, to track the index as the market capitalization of the constituent stocks fluctuates). This means that the mutual fund generates far less capital gains than an active fund, and any capital gains tend to be long-term. If any of the stocks pay dividends, those dividends are unavoidably passed to the mutual fund owners, but the dividends are far more likely to meet the holding period requirement for qualified dividends and receive preferential tax treatment.

Exchange-traded funds tend to be more tax-efficient than mutual funds (see also: ETFs vs mutual funds), although passive funds are already more tax-efficient than active funds, so the difference is smaller. Vanguard is a special case; both their ETFs and mutual funds have the same tax efficiency.

Several investment companies, including Vanguard, offer tax-managed funds for taxable account investing, which are designed to maximize tax efficiency at the cost of slightly higher expenses. Compared to low-expense non-tax-managed passive funds that are already very efficient, the difference is small. For investors with very high marginal tax rates, tax-managed funds can offer an advantage in after-tax performance. However for investors in lower brackets, the lower expenses of the normal funds will likely outweigh the tax efficiency and result in lower overall performance.

Bonds and bond mutual funds are inherently tax in-efficient investments, because much of their return is in the form of interest, which is taxed as ordinary income in the year it is earned. Tax efficiency considerations would tend to locate bonds inside tax-advantaged accounts. However, bonds tend to be lower-return assets in most portfolios, and by locating those assets inside tax-advantaged accounts, future tax-advantaged space is reduced. See Tax-efficient fund placement for a discussion on where to hold bond-based investments.

Tax-free investments

Certain investments, such as municipal bonds, are tax-exempt at the federal or state level, or both. When considering investments in a taxable account, the after-tax return is what matters. Investors with high marginal tax rates can see significant benefits in after-tax returns by selecting tax-free investments.

However, tax-free investments tend to deliver lower returns, so investors in lower tax brackets may see higher after-tax returns with fully taxable investments such as corporate bonds, despite the higher tax cost. Also for this reason, tax-free investments are usually not appropriate for tax-deferred or tax-free accounts such as 401(k)s and IRAs.

While returns from tax-free investments are not directly taxed, they are taken into account when phasing in taxation of Social Security benefits, and so can have substantial tax consequences for certain investors.

Tax loss harvesting

Main article: Tax loss harvesting

Tax loss harvesting is the process of selling investments that have lost value relative to their basis, for the purpose of reducing taxes. Selling investments at a loss reduces overall taxes through two mechanisms:

  • By deducting the loss now and receiving a tax deduction from the IRS, you effectively receive an interest-free loan from the government. The taxes saved can be invested and will generate future returns. The ability to deduct up to $3,000 of losses from earned income per year amplifies this effect.
  • Long-term capital gains tax rates are lower than ordinary income tax rates. If the investment is donated to charity or left to heirs upon death, capital gains taxes will never be paid.

Harvesting losses is a strategy that improves long-term performance in most cases, so most investors should harvest their losses as soon as they occur. In rare cases, harvesting losses is not recommended, such as when future tax rates are known to be much higher than today, or when the losses would offset gains that would be taxed at 0%.

Deducting harvested losses is subject to the wash sale rule, whereby losses are not deductible if you buy a "substantially identical" security within 30 days of the sale. "Substantially identical" is not perfectly defined by the IRS, but likely includes different mutual funds that track the same index, and different share classes of the same mutual fund (including ETFs vs mutual funds). It does not include mutual funds that track different sets of stocks, such as the Vanguard Total Stock Market Index Fund (VTSAX) and the Vanguard S&P 500 Index Fund (VFAIX), even though the two funds might have very high market correlation.

Tax gain harvesting

Main article: Tax gain harvesting

Generally, retaining gains within an investment results in higher long-term performance, due to the compounding of the taxes that would otherwise be paid, and also the possibility for future donation to charity or step-up in basis at death. Therefore, tax gain harvesting is a much less common strategy. However, harvesting gains can make sense in certain circumstances, usually when the investor is confident their tax rates will be higher in the future, and they know they will want to sell the investment. Harvesting gains at a rate of 0% is usually a good idea, as long as the additional taxable income doesn't cause unwanted tax consequences. There is no wash sale rule for tax gain harvesting.

Low-basis investments

Dealing with investments with a low cost basis (large unrealized capital gains) is a common issue for investors. The more unrealized capital gains within the investment, the bigger the disincentive for the investor to sell. One common situation is when an investor learns more about the Bogleheads investment philosophy and decides they no longer want to hold individual stocks in their taxable account, and yet these stocks have large unrealized gains. For any low-basis investment, there are three options on how to dispose of it:

  • Liquidate it and pay the tax cost
  • Continue to hold it, and plan to either sell it at a future time when the taxes may be lower, or leave it as part of one's estate
  • Donate it to a charity, avoiding the tax cost for both you and the charity and allowing you to deduct the full value of the investment

The best strategy for each individual investor depends on a variety of factors, such as current and expected tax rates, need for cash, plans for charitable giving, the investor's age and health, performance and risk level of the investment in question, and how well or poorly the investment fits into their investing plan. See also: Paying a tax cost to switch funds

Low-basis investments also present challenges for rebalancing. Trading within a taxable account generates additional tax drag and lowers long-term performance, so is best avoided when possible. One strategy for rebalancing is to perform trades within tax-advantaged accounts, such as 401(k)s and IRAs. Whether Traditional or Roth, tax-advantaged accounts allow trading of investments without tax consequences. Rebalancing can usually be achieved without selling low-basis investments by a combination of new investments and trading within tax-advantaged accounts. For more substantial investment restructuring, the benefits of selling low-basis investments would have to be weighed against the tax cost, using the various factors described above.

Tax lots

Main article: Cost basis methods

Buying shares of a security at different times, and reinvesting dividends, will result in different tax lots of shares with different cost bases. There are several common accounting methods for handling multiple tax lots:

  • First-in-first-out (FIFO) method: Oldest shares are always sold first
  • Specific identification of shares: The brokerage identifies each tax lot of shares with its own cost basis
  • Average cost method: The IRS allows investors to treat a security using an average cost method, whereby each sale uses the average cost basis of all tax lots. Once an investor uses the average cost method, it must be used for all future transactions of that security, until completely liquidated.

There is no single best cost basis method. Specific identification of shares allows for the most control, but can result in a high number of tax lots if dividends are automatically reinvested.

Depending on each investor's goals, it may be advantageous to sell older or lower-basis investments first, in order to receive preferential tax rates for long-term capital gains. Or, it may be best to sell more recently-purchased higher-basis shares, to minimize realized capital gains and preserve lower-basis shares.

Some brokerages offer more complex cost basis methods that seek to optimize around tax laws. These tools may streamline trading, but make sure you understand the procedure before you use them, to make sure you are getting the methods that work best for your situation.

Performance

Because the tax rules for taxable accounts are more complex than for retirement accounts, so is calculating the performance. The following is a derivation of the formulas that can be used to calculate future taxable account values, given a rate of return and other parameters.

This analysis assumes that all dividends are reinvested and all taxes are paid from the dividends. While reinvesting dividends is not always desirable, it allows for direct comparison to the performance of tax-advantaged accounts.

Evaluating the performance of investments that have dividends periodically removed from the value, or that have dividend taxes paid from external sources, is more difficult than the method presented here, and would require discounted cash flow analysis. Variables are defined as follows:

For simplicity and clarity, this derivation will assume continuous compounding, but the formula may be modified for period compounding as desired. Continuous compounding formulas use exponentials of base e 2.71828. The value of the investment at any future time t can be written as follows:

Calculating the basis at any time t requires integration. The rate of change of the basis at any time t is equal to the value at t, multiplied by the yield, multiplied by (1 - ). The product of is the rate of loss to dividend taxes, and the remainder is added to the cost basis:

Integrating this formula from 0 to t and setting gives:

Finally, the after-tax value after the investment is sold is given by:

For periodic (eg. annual) compounding instead of continuous compounding, may be substituted for . When analyzing a periodic compounding investment, make sure the period on the rates of growth matches the compounding period. For example, a monthly compounding investment with an annual rate of return of 8% and a yield of 2% would have a periodic return of ~0.667% (8% / 12) and a periodic yield of ~0.167% (2% / 12). Time should also have the units of number of compounding periods, eg. number of months. Summary:

Periodic (eg. Annual) Compounding Continuous Compounding

Example

You invest $10,000 in a mutual fund in a taxable account and plan to sell it after 25 years. Your federal tax rates are 24% on ordinary income and 15% on qualified dividends on long-term capital gains. In addition, your state charges a 9.3% tax on all forms of income, and you don't itemize your state income taxes on your federal return.

You plan to move to a tax-free state and will pay a 15% long-term capital gains tax rate when the investment is sold. The mutual fund has an expected return of 9% and a yield of 2%, compounding annually. The yield is comprised of 90% long-term capital gains (paid within the fund and passed to you) and qualified dividends, and 10% short-term capital gains and non-qualified dividends.

What is your expected after-tax value when the mutual fund is sold? Your effective tax rates are:

Your future balance is:

Your future basis is:

After the fund is sold, your after-tax value will be:

Comparison to Traditional and Roth accounts

In almost all cases, the taxes will be lower for investments inside Traditional and Roth retirement accounts (401(k)'s, IRAs, etc.) then for taxable accounts. A Roth retirement account has the same performance as a taxable account with no dividend and capital gains tax, and so its performance will always be equal to or higher than a taxable account.

Under the same conditions as the above example, an investment in a Roth account would be worth $86,230.81 ($10,000 * (1 + 9%)^25), about 26% more than the same investment in a taxable account. A Traditional retirement account is similar to a Roth, except that taxes are paid when the funds are withdrawn rather than when they are invested as after-tax income.

For these reasons, almost all investors should contribute retirement savings to Traditional and Roth accounts first, and use taxable accounts only if the amount they wish to invest exceeds the contribution limits. They should also check less widely known retirement account options, such as catch-up contributions, the Backdoor Roth IRA, and the Spousal IRA, before saving retirement funds in a taxable account.

When using a taxable account for retirement savings, the use of low-cost tax-efficient investments is critical for achieving good long-term performance.

Comparison to non-deductible IRAs and variable annuities

Non-deductible Traditional IRAs and variable annuities have a similar tax structure: contributions are after-tax, growth is tax-deferred, and withdrawal of growth is taxed as ordinary income.

For tax efficient investments, taxable accounts tend to outperform these accounts. The future value of the same investment in the above example inside a non-deductible IRA or variable annuity would be $86,230.81 ($10,000 * (1 + 9%)^25) before taxes, and $67,935.41 ($86,230.81 - ($86,230.81 - $10,000) * 24%) after taxes.

For tax in-efficient investments, non-deductible IRAs and variable annuities may have a significant advantage over a taxable account.

Consider the above example, but with an investment that returns 6% that is all fully taxable yield. The future taxable balance is:

The future taxable basis will be:

This makes sense; because the growth is entirely due to yield, the future value and future basis are equal. This also means there is no capital gains due, so the future value is after-tax. The future value of a non-deductible IRA or variable annuity is:

After taxes, the value will be:

However, investors in variable annuities should weigh fees and liquidity issues against the tax advantages. Variable annuities typically have fees of 0.5-1%+ per year, and when subtracting these fees from the returns, the annuity performance isn't nearly as good.

In the above example, the annuity would slightly outperform the taxable account with a fee of 0.5%, but under-perform with a fee of 1%. Annuities also typically have surrender fees for early withdrawal, and the IRS also assesses an early withdrawal penalty for withdrawals before age 59.5.

Non-deductible Traditional IRAs also have early withdrawal penalties and contribution limits, although low-fee IRAs are much easier to find. However, due to the Backdoor Roth IRA, which is strictly better than a non-deductible IRA, no investor should have a need to invest in a non-deductible IRA.

See also

External links