Welcome back to another week of our Investment Series.
So far we have covered a lot of ground on the core concepts of understanding what our investments do, what we need to consider over the long term, and what we can expect in terms of our experience as investors.
This week, we are going to cover one of the less enjoyed aspects of investing, taxes.
Taxes are making big headlines this year with even more proposed changes to how we save money, especially when looking at retirement.
Many of these changes are being proposed after it came to light that billionaire Peter Thiel (co-founder of PayPal) amassed a $5 Billion fortune inside of a Roth IRA, after contributing less than $2,000.
While we won’t cover the whole story in this blog, we will go deeper into Roth IRAs later this fall. Get signed up to learn more about the different types of accounts we have access to in our next series, which will be announced in a couple of weeks.
Taxes are a tricky subject, mostly because how they are determined are based on many moving pieces.
While we certainly don’t want to overpay on taxes, when we look back at the topics we have covered so far in this series, I want to start this post with the idea that our tax liability should not be the main driver in our investment choices for a couple of reasons.
- Why do we invest? We invest to grow our money, and outpace inflation. We will need this money to do something for us in the future. Just as an example, I personally wouldn’t delay a vacation goal if it meant paying a little more in tax this year. We will get more into this a little later on, but just for illustrative purposes, let’s stick with this for now.
- Types of investments and risk. Over the past few weeks, we have talked about how our risk tolerance can impact our ability to grow our money and also how if we are too far out of alignment, it may cause us unneeded stress as we stay invested. Waiting to rebalance solely due to taxes can create a ticking time bomb for investor heartbreak.
Again, I want to make clear that not overpaying in taxes is something we want to accomplish in all areas of our financial decision-making. However, in the highs and lows of our financial lives, we are probably not going to look back and say “I saved/paid a lot in taxes for that”.
When optimizing finances, saving taxes should be considered the cherry on top. Not paying more than your fair share is something we certainly want to accomplish. Any good thing can be taken to an extreme though, and putting off goals to save a few dollars on taxes may not be our best choice overall.
Having a clear financial plan can help make these opportunities easier to recognize, and avoid making costly tax mistakes that could have otherwise been avoided.
Before we get into anything too complicated, let’s establish the very basics of what we typically will need to be aware of when it comes to taxation and making investment choices.
Of course, you should consult with your tax or financial professional before making any decisions in regard to your own situation. This article is not investment or tax advice, is not a recommendation, and is solely for educational purposes.
Now that we have that out of the way, it is time to dig in!
Let’s stick with the example I mentioned earlier in this post. Perhaps we want to take a $2,000 vacation.
In this situation, let’s also say we invested $400 just over 3 years ago, and it grew to $1,700.
8 months ago, we invested an additional $200, and it grew to $300. We now need all $2,000 of the money in our account to take a vacation.
The chart below illustrates what we have done.
As you can see, there are a few different terms listed in the chart. Let’s do a quick breakdown so we can fully understand what that will mean for our taxes after making the sale of all of our investments.
Cost basis is just a fancy way of saying how much you paid for the investments that you currently hold. In our example, we paid $400 for the first set of investments, and $200 for the second set. Our total cost basis is $600, as outlined in the chart.
Anytime we sell our investments for more than we purchased them, we have gained value from the initial capital we invested. Hence the name, Capital Gain.
The Capital Gain we experience is simply the price we sold for, less the purchase price.
In this case, we have sold $2,000 worth of investments, which we purchased for $600. This means we have $1,400 ($2,000 – $600) of Capital Gains.
Now, you may notice that in the chart above, we have two different types of Capital Gains.
You may be asking, “What is the exact difference?”.
Again, jargon can make this a little more confusing than it needs to be (maybe by now in this series, it is obvious this is how a lot of the financial world operates) when taking care of our finances.
Long-Term Capital Gains are how any investment held for more than one year is treated when it comes to tax. Note that it is more than one year, not one year.
And yes, if you were to sell at the one-year mark exactly, that one day could cost you quite a bit.
In our example, we had $1,300 of Long-Term Capital Gains, since the first set of investments were purchased 3 years ago.
If you were to sell an investment after owning it for one year or less, you would instead be taxed according to the rules of a Short-Term Capital Gain.
This would be the $100 we gained from the $200 we invested 8 months ago in the example above.
The Short-Term Capital Gain will be taxed just as your normal income is, with it following the bracketed system we all know and “love”.
Our Long-Term Capital Gains will follow a different schedule but again are driven by how much income we have in a given year.
As we can see, most of us will not fall into the highest 20% rate when it comes to Long-Term Capital Gains. Paying the Short-Term Capital Gains rate could mean a lot of additional tax, and we try to avoid these unless it is absolutely necessary to sell an investment.
We will talk more about this come Spring when we cover taxes.
Now that we have the foundational information about how we are taxed when we sell our investments, let’s look at a real-world example of why taxes can’t be the sole driver of our investment decisions.
A couple of weeks back, we talked about risk and why it is important we maintain a level of risk we are able to tolerate over the long-term while investing.
Let’s use this example of this mutual fund that increased in value after we purchased it.
If this occurs over too long of a time, and are trying to avoid rebalancing to prevent taxes from being generated, the investments that have grown may cause our portfolio to become riskier than we originally wanted.
This can cause greater account fluctuations, and increase our level of investment-related stress.
We can see this in the graphic from a couple of weeks back showing different levels of stock to bond ratios, and how the accounts can move over time based on a higher concentration of stock.
If we now go back to our example of how much tax we will pay in a given situation, we have to remember that we are only subject to taxes on the gains when we sell an investment to rebalance.
(This is very different from how an IRA or other tax-deferred accounts work. Be sure to stay tuned to our blog in the coming months for information on how different types of accounts work when it comes to tax.)
With an investment loss or decline, our whole balance is subject to the decline.
If you paid an effective 15% tax rate on the $1,400 of gains, that is a total of $210 of tax we must set aside to pay the IRS come Tax Return time.
Of course, it gets more complicated than this as the amounts get higher and other pieces of our tax situation change. Having a well-rounded financial plan can help us manage when and how much tax we will ultimately realize.
If this sounds like a good plan to you, feel free to schedule a Free Initial 30-Minute Phone Call, by clicking the button below.
Understanding how much tax will be created (in this case, $210) can be a much easier pill to swallow if we can make that decision knowing our investments won’t be subject to any excess risk.
If we were to see a 15% account value decline due to our portfolio being more aggressive than it needed to, we would be out $300 instead of the $210 of tax.
In the case of our trip, we wanted to use the money now, and this additional $90 of loss became very real. We would have been better off paying the taxes than waiting.
Of course, rebalancing wouldn’t have helped save the entire loss of $200, but it may have been a wash paying taxes and not having to deal with the pain of seeing quite as large of a drop. This becomes especially true when we are dealing with larger sums of money.
The right answer for your situation will come down to why you are investing, and what those investments are trying to accomplish.
It always, always, always, should come down to why we are making a decision… not what is necessarily the best on-paper decision.
You might not be able to always have the lowest amount of tax paid, or the biggest refund while chatting amongst your co-workers, but if it allows for you to enjoy that vacation even a few months earlier, it will almost certainly be worth it.
Personal finance is personal after all. The only person you want to keep score with is yourself.
Play your own game.
Next week we are going to talk about the media, and how their messaging can disrupt our investment strategy more than tax savings or any factor we have talked about up to this point.
Until next time,