How To Not Let Taxes Drag You Down
Paying more in taxes as you make more money is an essential yet cringe-worthy fact of life as an American today. If you learned there was a way to pay less in taxes and still make the money you’re making, would you implement it? Do you keep your RSUs invested in your company's stock because you don’t really know what to do with it? Do you invest the money outside of your retirement accounts just like you invest the money in your retirement accounts? If your answer is yes, you’re going to want to keep reading.
We meet a lot of people working in tech who have let their equity compensation sit untouched in their account. And they’re not alone. In fact, according to a 2018 survey conducted by Charles Schwab of 1,000 equity compensation participants, just 24 percent of workers have exercised employee stock options or sold shares that are part of their equity compensation. Participants cited fear of making a mistake, fear of selling at the wrong time and being afraid of potential tax implications as the main barriers to making a decision.
At Mana FLD, we are committed to preventing fear from overriding sound investment decisions.
The other ill-fitting investment practice is investing taxable dollars in tax-inefficient mutual funds. In fact, there’s a whopping $8.5 Trillion of taxable investments invested in open-end mutual funds. Unfortunately, investing in open-end mutual funds lends itself to a bigger tax bill come tax time (more on this later).
BEFORE WE BEGIN...
It's important first to know the lingo. These terms can seem relatively complicated, but we'll boil it down to a few essential concepts:
Taxable Accounts also known as ‘brokerage accounts’ or ‘taxable brokerage accounts’. Taxable accounts are investment accounts in which you invest your cash-money into securities like stocks, bonds, mutual funds and exchange-traded funds. Taxable accounts house your assets that are not earmarked for your retirement. What’s the big difference? Taxable accounts are taxed annually while qualified retirement accounts are not. Brokerage accounts, another name for taxable accounts, can generate taxable events when you buy and sell securities as well as when the securities you hold (stocks, bonds, REITs) generate dividends or interest payments. Alternatively, qualified retirement accounts - like IRAs and 401ks - are only taxed either when you when you withdraw funds from your account - which is why they’re referred to as ‘tax deferred accounts’. If you’re trying to reduce your annual tax bill, it is critical to invest your taxable account with consideration for your yearly tax bill.
Restricted Stock Units or RSUs both time-based and performance-based - are the most common form of stock compensation across the technology industry today. If you're granted RSUs, you get to own them without putting any money down (unlike when you are exercising options). Think of RSUs as a cash bonus, with similar tax implications.
Mutual Funds are investment vehicles made up of a pool of money collected from many investors and invested in a basket of securities. The mutual fund’s mandate is set in its’ prospectus - for example, there are mutual funds meant to only produce income for their investors while others attempt to produce capital appreciation. Mutual funds are all managed by a professional money manager.
Exchange-Traded Funds or ETFs are investment vehicles made of a collection of securities - like stocks and/or bonds - that track an underlying index, like the S&P 500. ETFs can invest in all different kinds of indices. It’s called an exchange-traded fund because an ETF is a marketable security which means that they have an associated price and can be bought or sold throughout the trading day on an exchange.
LET’S START TALKING ABOUT TAX-EFFICIENT INVESTING
So how do you invest the money that’s sitting outside of your retirement accounts to maximize your returns and tax efficiency while minimizing costs?
It starts with your goals. For instance, consider assigning a job description for each of your buckets of money. Ask yourself, “what will this bucket pay for in the future? How much does it need to earn and in what span of time does it have to earn it?” After this, you could begin the process of investing your money with the desired outcome of reaching the funding required to make your newly identified goals a reality. Remember, the longer your money is invested in the market, the more you can count on the power of mean reversion and compound interest to get you to your goals.
Once your investment goals have been outlined, it’s time to make moves.
If you have RSUs and have read this recent blog post, then you know we encourage cashing them out as soon as they vest. If the proceeds aren’t going to fund something in the immediate future (like next year’s tax bill) they could be transferred to a taxable brokerage account where the funds could be invested and left to grow for several years or even decades. The fact is, getting to your big goals - like a future home down payment, starting your own business, or potential income replacement - is much easier when you put the miracle of compound interest to work by investing your money in the markets.
So, can you invest your money for the future and avoid taxes? The answer is no. But you can invest your money and minimize the taxes you pay by staying educated, implementing a tax aware investment strategy, and by partnering with a fee-only financial advisor who is a fiduciary required to act in your best interest. Why the shameless plug for fiduciaries? Because mistakes can and do happen when trying to DIY. More risks apply if you work with an advisor who doesn’t have your best interest in mind.
In my twelve years of working for asset management firms and consulting on the investment strategies managed by thousands of financial advisors, the most common mistake I found people (including advisors) making was investing all of their accounts just like their retirement accounts. In other words, they invested as if they are oblivious to taxes.
HOW TO BE TAX AWARE
Now that you know taxable accounts have taxable consequences each year, it’s time to learn about a strategy that can reduce the cost of taxes in your portfolio, if implemented correctly. Asset location is a strategy that takes advantage of the tax treatment of different types of investments. The more tax-friendly an asset is (meaning that it generates a small tax bill each year), the more likely it belongs in a taxable account. The less tax-friendly an investment (meaning that it generates a bigger tax bill each year), the more it belongs in a tax-deferred account.
How do you know if an investment is tax-friendly? Under the 2010 tax code, dividends and capital gains get favorable treatment while interest income does not. While qualified dividends and long term capital gains get taxed at 20% for the highest income earners, interest income and short term capital gains get taxed at your ordinary tax bracket which tops out at 37% for the highest income earners. In addition, individuals with an AGI above $200,000 (and married couples over $250,000) also face a 3.8% Medicare surtax on net investment income, which includes interest, dividends, rents, royalties, annuity gains, passive income, and virtually any otherwise-taxable capital gain. Bottom line: if you had to pay a 20% tax on something or a 37% tax on something, which tax bill would you choose?
Tax Friendly = Paying 0-23.8% for your investment gains or interest.
Tax Unfriendly = Paying your ordinary income tax rate, which tops out at 37% for an individual making over $510,301 or a married couple filing jointly at $612,351 + 3.8% for the medicare surtax on net investment income.
PUTTING A TAX AWARE STRATEGY TO WORK
The first step in a proper asset location strategy is to minimize your investments that generate income taxed at ordinary income rates.
Here are three strategies you can employ today to minimize the taxes you’ll pay at the end of the year:
Understand the difference between your long-term and short-term capital gains tax. Capital gains are the profits that you earn when you sell a piece of property or an investment for a higher price than you paid for it. Both real estate and investment assets are subject to capital gains tax. When it comes to minimizing your tax liability, the simple rule is to hold your investment for longer than one year. If you sell your investment after holding onto it a year, you’ll pay long term capital gains - which are currently taxed at 20% for those in the top tax bracket. Add in the 3.8% tax on unearned income tied to the Affordable Care Act and the top rate is 23.8%. If you sell before one year, the money you made on your investment will be taxed at your ordinary income tax rate.
Pick investments that generate qualified dividends or tax-free income: Qualified dividends are treated as long-term capital gains (again, 20%) and Non-qualified dividends are taxed at your ordinary income rate.
If you’re looking to steer clear of non-qualified dividends, you’ll want to avoid REITs, MLPs, tax-exempt organizations and foreign corporations in countries that do not have a tax treaty in place with the U.S.
If you’re looking to generate tax free income, you’ll want to own municipal bonds which a bond issued by a non-profit organization a private-sector corporation or another public entity using the loan for public projects such as constructing schools, hospitals and highways. If you live in California and buy a New York municipal bond, the interest will be tax free on the federal level. If you live in California and buy a California municipal bond, the interest is tax-free on both the federal and state levels.
Offset capital gains with capital losses: Known as tax-loss harvesting, this process involves selling positions you’ve lost money on to offset the gain from the sale of a position you’ve made money on.
MUTUAL FUNDS AND TAX EFFICIENCY
Do you have mutual funds? Half of the taxable assets in America today are invested in open-end mutual funds. Mutual funds can have some of the highest tax cost which can result in more of a tax bill and less of a return.
Tax cost = pre-tax returns - after-tax returns.
According to Morningstar, as a whole, U.S. equity mutual funds gave up 2% of returns to taxes for the three-year period ending June 2019. That means a mutual fund with a 10% pre-tax, three-year annualized return actually had a return of only 8% on an after-tax basis. A tax cost of 2% could mean a lost opportunity. This hypothetical illustration created by Russell Investments shows that an initial $500,000 investment with an annualized 2% tax cost could amount to $177,000 in dollars lost over a 10 year period.
Why do mutual funds tend to have a high tax cost? Because they’re required to distribute at least 95% of their gains to their shareholders each year. Just like you and me, a mutual fund recognizes a gain every time the manager buys or sells an investment. Even though you might have invested in a mutual fund a year or two ago, your manager may sell a position in a security he or she has held for much longer than that...which leads to years like 2018, where mutual funds lost money and still distributed capital gains that you’d have to pay. A double whammy - ouch!
Alternatively, exchange-traded funds tend to be more tax-efficient than mutual funds, chiefly because they tend to distribute fewer (if any) and smaller capital gains. In 2018, just 6.2% of all US-listed ETFs paid a capital gain, compared to more than 60% of US mutual funds. One of the main reasons why ETFs are more tax efficient than mutual funds is because there is less buying and selling going on throughout the year.
Whether you are managing your taxable money yourself, or an advisor is doing it for you, it’s always a good idea to check in and understand whether your current investment strategy is tax-oblivious or tax-aware.
BRINGING IT ALL TOGETHER
As you make more money - whether through stock compensation or straight cash compensation - it’s important to stay educated about ways you can minimize the tax impact to your bottom line. Although you will inevitably be paying more in taxes as you make more, the strategies outlined above could help you lessen the burden of your tax bill when it comes to your investments.
Cristina Livadary is a fee-only financial planner based in Los Angeles, California and is the CEO of Mana Financial Life Design. Mana Financial Life Design provides comprehensive financial planning and investment management services to help clients organize, grow and protect their wealth throughout life’s journey. Mana specializes in advising professionals in the tech industry, as well as women who work in institutional investing, through financial planning and investment management. As a fee-only fiduciary and independent financial advisor, Cristina never receives commission of any kind. She is legally bound by her certification to provide unbiased and trustworthy financial advice.