[Editor's comment: This is a republished post from Physician on FIRE, a member of The White Coat Investor Network. The original post ran here, but if you missed it the first time, it’s new to you!]
Most of us start making our first investments in tax-sheltered accounts. These accounts, which include traditional and Roth IRAs, 401(k) and similar employer-based retirement accounts, allow your investments to grow tax-free.
There are advantages to a “taxable” account, despite that ugly word. You can access the money at any time without penalty. Your investment choices are not limited as they are in an employer’s retirement account. You can engage in tax loss harvesting to lower your taxable income by $3,000 a year.
But we hate taxes. Remember the Boston tea party? Me neither, but I remember learning about it.
How about when Ms. Stroud delivered this cynical, but more or less accurate line to the graduating seniors of the Lee High class of ’76:
“Okay guys, one more thing, this summer when you’re being inundated with all this American bicentennial Fourth Of July brouhaha, don’t forget what you’re celebrating, and that’s the fact that a bunch of slave-owning, aristocratic, white males didn’t want to pay their taxes.”
Fortunately for me, you, and the aristocrats, a taxable account doesn’t have to be subjected to a heavy tax burden. If you earn anything close to a physician’s salary, a taxable account will be subject to “tax drag.” We will discuss exactly what that means, and what we can do to minimize it.
What is tax drag?
Simply stated, tax drag is the amount that your returns in a taxable account are decreased by taxes. It is commonly given as a percentage of the portfolio.
How is tax drag calculated?
You must calculate your taxes paid on short and long term capital gains, and on ordinary and qualified dividends. Divide that number by the sum of your taxable investments, and you’ve got your tax drag. Wouldn’t it be nice if someone built a calculator for this?
Short-term capital gains and ordinary dividends are taxed at your marginal tax rate. At a physician’s salary, this is probably in the range of 30% to 50%. Long-term capital gains and qualified dividends are taxed at a lower capital gains rate of 15% for most, or 20% for those in the highest federal tax bracket. On top of the 15% or 20% is state income tax for most, and a 3.8% surtax (known as the NIIT) for individuals with a modified adjusted gross income (MAGI) over $200,000 and couples with a MAGI over $250,000. Your rate can be as low as zero if your AGI is low enough (i.e. in early retirement), but will most likely owe somewhere between 15% and 35% while working.Some “real life” examples
I’d like to introduce three hypothetical characters, each with a healthy one million dollar taxable portfolio. We’ll examine how tax drag can be affected by different investing strategies, incomes, and states of residence.
Joel
Joel is a retired family practitioner living in Alaska. A native of New York City who moved north to eliminate his student loans, he relishes in the fresh air and mountain scenery abundant in our nation’s 49th state.
Joel invests in passive index funds and his portfolio sees very little turnover. In retirement, he and his wife Maggie keep their taxable income low enough to remain in the 15% tax bracket, avoiding all taxes on qualified dividends and long-term capital gains. Joel keeps the international portion of his asset allocation in his taxable account to take advantage of the tax credit.
Pete
Pete is a retired engineer turned successful blogger living in Colorado. Like Joel, he avoids actively managed funds in his taxable account. He did take some long-term capital gains this year when he sold a fund which held a large stake in a mining company that was found to have polluted the Colorado River. Some of those gains were offset by automatic tax loss harvesting in his Betterment account.
Pete doesn’t receive a foreign tax credit, as he has no international exposure. No, Pete. A road trip to Canada does not count as international exposure, at least not for this exercise.
Vince
Vince is a Hollywood actor living in [where else?] Hollywood, California. Vince sees more income in one year than Joel & Pete have earned in their lifetimes. He also spends money like it’s going out of style. To keep from going broke, Vinny asks his business manager Eric to handle a million dollar taxable portfolio for him.
Eric knows more about tossing pizzas than tax-efficient investing. He buys and sells “hot stocks” based on tips from Hollywood insiders. He got lucky this year, as novices sometimes do, and ended the year ahead while generating $50,000 in short-term capital gains.
Investing mainly in growth stocks in the tech industry, Eric unwittingly avoids receiving much dividend income, another good thing he does with the portfolio in spite of his naivety.
Care for a drag?
Adding up the total taxes paid on investment income, and dividing by the portfolio’s value, we can come up with a tax drag for each of the three taxpayers.
Looking at the tax drag on these million dollar accounts, we see a wide range from just under zero for Joel to 3% for Vince. Pete has a reasonable tax drag of 0.7%. Vince’s 3% may not sound like much, but it represents a >50% tax of nearly $30,000 on $57,000 in capital gains and dividends. Have you seen what a 3% reduction in returns can do over the long haul? It can cost you millions.
What can be done to minimize tax drag?
- Choose funds with dividends that are mostly or all qualified (examples from my portfolio include VTSAX (total stock index) and VFIAX (S&P 500 index).
- Research funds @ Morningstar.com.
- Place international funds in a taxable account.
- Avoid actively managed funds in a taxable account.
- Minimize turnover. Buy-and-hold as opposed to buy-and-sell.
- Live in a state with low or no state income tax.
- Earn less (retire early), but don’t let the tax tail wag the dog.
The Excel file used in this sheet is available to use online or as a download with the other PoF calculators on the calculators page. Subscribe to download.
Do you have a taxable account? Do you know your tax drag? What strategies do you take to minimize it?
Also, to the extent that you hold a portion of your fixed-income allocation in your taxable account consider muni-bond funds if you are in a high marginal tax bracket.
Absolutely. WCI says bonds go in taxable (munis only), but I keep mine in a 401(k).
Best to avoid target date funds in taxable for the same reason.
Cheers!
-PoF
As rates go up, eventually bonds in taxable won’t be the right move anymore even for people for whom it is the right move now.
I keep my bond in taxable now too. Have 80% munis. To WCIs comment above,
“As rates go up, eventually bonds in taxable won’t be the right move anymore even for people for whom it is the right
move now.”
I don’t think that hold true for municipal bonds. Those should be in taxable. I wouldn’t normally mention this because I’d assume WCI was talking non-munis but the comment BMAC started with a discussion on Municipals in taxable.
Sure. If you’re going to hold bonds in taxable, then make them munis. My point is that at a certain rate, you will likely be better off with taxable bonds in a tax-protected account and stocks in taxable. At 1-2%, you’re probably better off with munis in taxable. At 10%, you’re probably better off with taxable bonds in tax-protected.
Makes sense. As the Mini-Treasuries spread changes the “muni in taxable” for high brackets doesn’t always make sense.
No, while that’s true, I”m referring to a separate issue. It’s discussed here:
https://www.whitecoatinvestor.com/asset-location-bonds-go-in-taxable/
Would you say just a bit more about the foreign tax credit? Here it I sound as though it is a net benefit, but I understood it to simply offset taxes that were paid to foreign sovereigns. Also, does the mutual fund calculate it for you?
You are correct in that it offsets taxes paid to foreign governments by the brokerage on your behalf. You will indirectly pay those taxes regardless of where you hold your international allocation, but you only get the benefit fo the foreign tax credit if you hold the international asset in a taxable account.
The brokerage will calculate it for you. From Vanguard:
“Vanguard prepares IRS Form 1099-DIV that lists, among other things, the portion of taxes paid to foreign countries by Vanguard funds that elect to pass through those taxes to shareholders. The amount of foreign tax paid that is attributable to a shareholder may then be used to offset the shareholder’s U.S. tax liability. If more detailed information on such funds is needed, use the worksheets listed below to assist with the preparation of IRS Form 1116 (available at the IRS website).”
Best,
-PoF
Very helpful, thanks. Turns out not to be much of a driver for me, and I suspect others. That is, two thirds of my investments are in employers 403b and 457 accounts. I use Vanguard target Retirement funds, which have a healthy dose of international equities. I might instead select individual funds in both taxable and tax deferred so I could put the international in taxable only, which would also modestly reduce my fees. But then I would have to give up on the convenience of the target retirement funds, and converting my taxable from total stock market to international would generate a hefty capital gain.
I wouldn’t sell anything in taxable to rebalance. Just start buying international in taxable and make a slow transition. As the international allocation grows in taxable, you can exchange to US stock in the tax-defeerred accounts (assuming you exchange to individual funds). It’s a little work, but pretty easy to do. And none of this stuff will make or break your plan. It’s just optimizing.
Best,
-PoF
What is the tax drag for VBR, the vanguard small value fund. I understand there is a lot more turnover in this fund then the total market fund…
Morningstar calculates it at 0.5 to 0.6 in recent years. VTI is generally 0.4 to 0.5. So not a huge difference between the two. I don’t know exactly how they calculate it, but you can compare different funds by clicking on the “Tax” tab when researching a fund. No membership required.
Cheers!
-PoF
Surprisingly, not too much higher. But yea, slightly less tax efficient.
thats not too bad at all… I believe both of you avoid small value in your taxable account. is this because of the increased tax drag or is there another reason to avoid that?
I just have better stuff to put in there. Remember my portfolio is still mostly tax-protected. Not much has to go into taxable. Real estate goes there for simplicity for me, I’ve got a few muni bonds there, and then TSM and TISM.
Thoughts on VTSAX vs VTIAX in a taxable account? As noted in the post, most dividends from VTSAX are qualified. While VTIAX generates a foreign tax credit, a smaller portion of the dividends are qualified. Has anyone crunched the numbers?
It will depend a little bit on the state you live in (dividends and cap gains are generally subject to state income tax, where one exists) and your federal income tax and capital gains brackets.
I own both in my taxable portfolio (https://www.physicianonfire.com/the-pof-portfolio/), and I plan to develop the “international goes in taxable” into a full post. When I get to it, I’ll do a more detailed analysis with some baseline assumptions.
Cheers!
-PoF
Always important to remember when people say “international (or whatever) goes in taxable” that it only goes in taxable if something has to go in taxable. You don’t skip out on retirement accounts for it.
Also, I’m not entirely convinced that the foreign tax credit makes up for the additional tax drag from the higher yield on international stocks.
In my opinion, the foreign tax credit is overrated. Even if you have a six figure amount in VTIAX, your foreign tax credit will only amount to a few hundred dollars. That’s certainly better than a punch in the face, but not very significant. I also learned this year that the foreign tax credit is “non-refundable”, meaning that if you get money back from your tax return, the foreign tax credit does not add to your refund. This is in contrast to a “refundable” tax credit (such as the Earned Income Tax Credit).
I think you mean the foreign tax credit is non refundable in the sense that on your tax RETURN when you file if you owe zero in federal income taxes it will not come back as a transfer payment from the government like the earned income credit. The foreign tax credit indeed is refundable in the sense it increases you refund if you have one, and you pay at least as much income tax aa the value of the credit.
That’s “tax language.” There are refundable credits (like the Earned Income Credit) and non-refundable credits (like the foreign tax credit.) You explained well the difference.
I don’t think you understand what refundable means. You only don’t get it if you don’t owe at least that much in tax, and that’s very unlikely for a doc.
There is a difference between what is owed/paid and what is withheld/refunded.
I may be misunderstanding what refundable means. However, when I entered my foreign tax credit (~$200) into Turbotax it did not increase my tax refund. In other words, it did not change my total tax owed for the year. When I prepared my taxes for 2016, I owed money at the end of the year and the foreign tax credit reduced my amount owed. Perhaps this is a glitch in the Turbotax software?
That’s interesting. Sounds like there is an error somewhere. Better go back over it. Try looking in “forms mode” to see what is going on.
I checked the actual tax forms and the foreign tax credit seems to be accounted for correctly. I still can’t explain why my real-time tax refund (as calculated by TurboTax) did not change after I entered the foreign tax credit. I suppose this illustrates the disadvantage of using TurboTax rather than preparing the forms yourself. Thank you for clarifying the definition of a refundable vs. nonrefundable tax credit.
I can’t either.
That’s exactly the comparison that needs to be made. I’ve got both in taxable right now (and in tax-protected.) Doubt it really matters much honestly.
It’s a real problem for traders. For buy and hold types, not so much (as your examples illustrate).
Personally, I think this is one factor that makes investing in individual stocks more attractive in taxable accounts. By investing in companies that pay no dividends, the tax drag is zero.
And even if they pay a small dividend, the tax drag may be less then even a low cost funds fees.
The best of both worlds would be a diversified fund that only owns non-dividend paying stocks. But I’ve yet to find one of those.
I actually looked into starting such an ETF!
Yes, but at that point you’re allowing the tax tail to wag the investment dog by adding uncompensated risk to the portfolio.
I have a bit of BRKB (Berkshire Hathaway) in taxable. It’s my only individual stock.
A low or no dividend ETF could be popular. As WCI said, it could be the tax tail wagging the dog, but if the fees are low enough, it could be worthwhile. There are tax-managed funds, but they’re not all that different tax-wise from total market or S&P 500 funds.
Best,
-PoF
I am with PoF, I also have BRK-B as my only single stock taxable holding.
Semi-related question, on a subject of taxes: have either of you thought of up-gifting (i.e. gifting shares to your parents or in-laws, who then pass it back to you with their estate and a new basis)? Yeah, a bit morbid, but less so than viaticals, which were already discussed here.
Oooh, interesting tactic. I like it.
Hi,
I work as an independent contractor and also as an employed physician. Hence, in 2017 I received both a W2 and a 1099 Misc.
I have an individual 401 k plan for my 1099 Misc income and an employer sponsored 401K plan for my W2. I have a few questions.
1. The maximum elective deferral for 2017 was $18000 (under 50 years old). Does that mean my elective deferral contribution to individual 401k and to employer sponsored 401k plan should add up to $18000? E.g if I had contributed $10000 to the employer sponsored 401k then I can only contributed up to $8000 to my individual 401k?
2. The maximum I can contribute (elective deferral plus employer non elective contributions) to my individual 401k is 20% of my 1099 Misc income or $54000, whichever is smaller, right?
Thank you
1. Yes.
2. No. The maximum of your employer contribution is 20% of net 1099 income or $54K, whichever is smaller. If you are putting in employee contributions too, then it is the smaller of your employee contribution plus 20% of net 1099 income or $54K.
Thank you for your prompt reply. I paid estimated taxes (Self employment taxes) for 2017. To derive net income from 1099 income do I deduct 50% of total estimated taxes I paid in 2017 and any business expenses like travel, renewal of licensing, etc.? I am a sole proprietor and hence, do not have any employee.
Thank you
Net income is income minus expenses including half the payroll taxes actual paid (not estimated.)
On 1099 Misc income I pay estimated taxes quarterly and its not until next year when I file taxes that I get to know what I actually had to pay. Am I missing anything? in such a situation how to I nail down the exact amount of payroll taxes for 2017 before filing for taxes?
You can’t know what your payroll taxes are until you know your income and calculate your payroll taxes from it.
I know my 1099 income for 2017. do you have any example that would help me calculate my payroll taxes (social security taxes plus Medicare taxes) for 2017? or any form you recommend?
For Medicare, multiply the income by 2.9%. For SS, multiply the first $127,200 by 12.4%. Remember half of it is deductible. You can use Schedule SE to calculate it, just like the IRS does.
example: if my 1099 misc income is $100k
medicare tax = $2900 , SS tax is $12400. Hence, my total payroll taxes would be $15300.
I can deduct $7650 (along with my other business expenses like home office expense, travel, food, etc.) from $100k to derive my net income. Finally 20% of this net income can be contributed in my individual 401k account as employer contribution. Please correct me if I am getting anything wrong.
Appreciate all your valuable comments!
Looks right to me.
Thank you !!
I have another situation now: I had to repay part of my W2 income (sign on bonus that was received in 2016) in 2017. I had to return more than what I received (post tax) due to exceeding some Medicare tax cap.
HR advised that I file 1040 Schedule A for the returned income. Do you have any recommendation on that? Or any resource that I can access to file for it correctly?
You mean 1040X? Sure, if you screwed up your 1040, file a 1040X and fix it.
Thank you. Your valuable comments have helped me to get rid of a CPA (who messed up my taxes real bad that I had to redo) and file taxes myself for the last few years. Appreciate it greatly!