Bogleheads® on Investing Podcast 067: Kaye Thomas on income taxes and how to lower them
00:00:00.000 | [music]
00:00:20.000 | Welcome everyone to Bogle Heads-On Investing episode number 67.
00:00:24.000 | Today our topic is taxes.
00:00:27.000 | And our special guest is Kay Thomas.
00:00:30.000 | Kay is a long-time tax attorney who has written several books,
00:00:34.000 | including the book we'll focus on today,
00:00:37.000 | "Capital Gains, Minimal Taxes."
00:00:40.000 | [music]
00:00:47.000 | Hi everyone, my name is Rick Ferry,
00:00:49.000 | and I am the host of Bogle Heads-On Investing.
00:00:52.000 | This episode, as with all episodes,
00:00:55.000 | is brought to you by the John C. Bogle Center for Financial Literacy,
00:00:59.000 | a non-profit organization that is building a world of well-informed,
00:01:03.000 | capable, and empowered investors.
00:01:06.000 | Visit the Bogle Center at boglecenter.net,
00:01:09.000 | where you will find a treasure trove of information,
00:01:12.000 | including transcripts of these podcasts.
00:01:15.000 | Today's episode is about taxes.
00:01:18.000 | And I have a saying.
00:01:20.000 | If you hate paying taxes,
00:01:22.000 | then you should love learning about taxes,
00:01:25.000 | because that's the way you reduce your taxes.
00:01:28.000 | My guest today is Kay A. Thomas,
00:01:31.000 | and he knows a lot about taxes.
00:01:34.000 | Kay's law degree is from Harvard University,
00:01:36.000 | where he served on the Harvard Law Review
00:01:39.000 | and graduated cum laude in 1980.
00:01:42.000 | He spent his career as a tax attorney,
00:01:44.000 | dealing with complex matters relating to business transactions,
00:01:48.000 | finance, and compensation.
00:01:50.000 | Kay now spends his time as a writer, publisher, public speaker,
00:01:55.000 | and consultant on topics relating to taxation and investments.
00:01:58.000 | He has written several books, including Capital Gains, Minimum Taxes.
00:02:03.000 | The book we'll be focusing on today.
00:02:05.000 | His other books include Go Roth!
00:02:08.000 | A Guide to the Roth IRA and Other Roth Accounts,
00:02:11.000 | and Consider Your Options!
00:02:13.000 | A Plain Language Guide to Company Stock and Stock Option Compensation Plans.
00:02:18.000 | Kay also maintains a website, Fairmark.com,
00:02:22.000 | where he provides free plain language guidance
00:02:26.000 | on the taxation of investments, taxes in retirement,
00:02:29.000 | kids in taxes, taxes on stock option compensation, and much more.
00:02:35.000 | So with no further ado, let me welcome Kay Thomas.
00:02:39.000 | Thank you so much for having me. It's an honor to be here.
00:02:42.000 | You've done a fantastic job writing about taxes in plain English.
00:02:47.000 | It's really difficult to find good investment tax books.
00:02:53.000 | So I want to thank you for being on the show today.
00:02:56.000 | Can you tell our listeners a little bit more about you and your books?
00:03:00.000 | First of all, I got into taxes.
00:03:02.000 | That's a little bit of a nerdy area among lawyers.
00:03:07.000 | In the tax area, I tended to gravitate toward investment side of things.
00:03:13.000 | And so I found myself doing quite a lot of that,
00:03:16.000 | both for partnerships and individual investors
00:03:20.000 | and people who had stock options.
00:03:23.000 | So that created a locus of interesting topics for me to write about.
00:03:29.000 | And I became interested in the Internet at a fairly early time in the 1990s.
00:03:37.000 | So I was trying to figure out how I could start a website
00:03:41.000 | and just doing it as a hobby.
00:03:43.000 | I was still a full-time lawyer at that time.
00:03:46.000 | And I started thinking about what are things that I'm knowledgeable about
00:03:50.000 | that people do not have very good guidance about them.
00:03:54.000 | And so I started writing it.
00:03:56.000 | And at that time, there was very little competition for this kind of thing.
00:04:01.000 | So the website became fairly successful.
00:04:04.000 | As I had written a number of topics on the website,
00:04:09.000 | I started to think about putting out my first book.
00:04:12.000 | And one of the things I had written about quite a bit was employee stock options.
00:04:19.000 | And that's what I chose for my first book,
00:04:22.000 | which was called Consider Your Options.
00:04:25.000 | And that came out in the year 2000.
00:04:28.000 | Those of us who are old enough will remember that the year 2000
00:04:31.000 | was a heyday for the Internet boom.
00:04:35.000 | And at that time, there was so much interest in stock options
00:04:40.000 | that this book just took off like crazy.
00:04:43.000 | And it also happened to be the time when Amazon was just really becoming very popular.
00:04:49.000 | And early adopters of Amazon tended to be people who had stock options.
00:04:55.000 | And so the book was one of the best sellers on Amazon for a time.
00:04:59.000 | And honestly, I thought publishing was very easy.
00:05:03.000 | I couldn't understand why people thought,
00:05:06.000 | "Oh, it's hard to make money writing books."
00:05:09.000 | I'd heard that many times, and I couldn't understand it
00:05:12.000 | because it just seemed like printing money.
00:05:15.000 | All you do, you write the book, you put it out there, and it sells like crazy.
00:05:19.000 | So then I learned it was a little bit harder.
00:05:22.000 | My second book was the Capital Gains book.
00:05:25.000 | And that was successful, but nothing like the Stock Options book.
00:05:29.000 | And I learned that I had to work for a living.
00:05:32.000 | It is a lot of work to explain taxes in non-technical language,
00:05:38.000 | make it readable, not just understandable, but readable,
00:05:41.000 | so that people don't have to slog through it in order to get to the main points.
00:05:46.000 | So that was a challenge, but I thought I was fairly good at it,
00:05:49.000 | and the book has done reasonably well over the years.
00:05:53.000 | The edition that I read was 2023 with all of the new tax information in it.
00:05:58.000 | Yes, I try to update all of my books.
00:06:01.000 | My books are tax-related, and people don't really trust a tax book
00:06:04.000 | that's been written many years earlier.
00:06:07.000 | And when did you write the Roth book, Go Roth?
00:06:10.000 | What enticed you to write that, and why did you write about it?
00:06:13.000 | The Roth originated about the time when I was really trying to get my website going.
00:06:19.000 | And initially, there was not a tremendous amount of information about the Roth.
00:06:25.000 | I thought that a book about Roth would be helpful.
00:06:29.000 | Initially, I had another book, a more limited book about Roth IRAs.
00:06:34.000 | I called it the Fairmark Guide to Roth IRAs.
00:06:37.000 | But then I wrote this book, Go Roth, to go right through the lifespan of a Roth,
00:06:43.000 | from creation of it to making contributions to managing while it's in place
00:06:49.000 | and then taking distributions from it.
00:06:52.000 | Well, we're going to get to some of this later on,
00:06:55.000 | but the focus today is going to be on capital gains, minimal taxes.
00:07:01.000 | The updated edition, 2023.
00:07:04.000 | And just to make sure we're all on the same sheet of music,
00:07:07.000 | we do have to begin with the basics of taxation.
00:07:13.000 | And so I am the government.
00:07:16.000 | I love to collect taxes.
00:07:18.000 | And I, the government, have come up with many, many ways to collect taxes--
00:07:23.000 | minimum tax, capital gains tax, net investment income tax,
00:07:27.000 | turn of the minimum tax.
00:07:29.000 | So I want to go through them very quickly.
00:07:31.000 | Let's say we start with just income tax.
00:07:35.000 | All right, we have, since 2017, tax brackets that go from 10% up to 37%.
00:07:43.000 | Those are the basic federal income tax brackets--
00:07:47.000 | 10% for people with very modest income,
00:07:51.000 | but 12% gets you into a more substantial amount.
00:07:56.000 | Then it's 24%, 32%, 35%, and 37%.
00:08:01.000 | And the break points that are most interesting there,
00:08:05.000 | you go from 12% to 22%.
00:08:08.000 | That's a huge difference in tax rate.
00:08:12.000 | If you happen to be at the border between those two tax rates,
00:08:17.000 | you've got a 10% difference, and you need to be really paying attention
00:08:21.000 | to anything that you can do to avoid going up into the 22% bracket
00:08:27.000 | or keeping yourself down as much as possible into the 12% bracket.
00:08:32.000 | We also have a break between the 24% and 32% brackets.
00:08:38.000 | So that's 8 percentage points, another really big one.
00:08:42.000 | And that's an area where, once again,
00:08:46.000 | you want to be paying very close attention
00:08:49.000 | to whether you can manage your income.
00:08:52.000 | Can you make an additional 401(k) contribution
00:08:56.000 | to avoid paying that 32% rate
00:08:59.000 | as opposed to having all of your income taxed at 24% or less?
00:09:04.000 | So those are the two important ones.
00:09:07.000 | The other ones are much smaller, obviously 22% to 24%.
00:09:12.000 | It's not completely negligible,
00:09:14.000 | but it's not anywhere near as important.
00:09:17.000 | And similarly for the other differences in tax brackets.
00:09:21.000 | If we have capital gains,
00:09:23.000 | or we have dividends that are treated as capital gains,
00:09:26.000 | that's a completely different set of brackets.
00:09:28.000 | Yes, it is.
00:09:30.000 | And we have the 0, 15%, and 20% brackets for capital gains.
00:09:38.000 | 0% roughly corresponds, it used to exactly correspond,
00:09:43.000 | and now it very closely corresponds
00:09:45.000 | to the 10 and 12% brackets for ordinary income.
00:09:51.000 | The 15% bracket takes you up into a fairly high level of income
00:09:57.000 | and doesn't correspond exactly to a tax bracket,
00:10:00.000 | but in a pretty high income level
00:10:02.000 | is where you start paying the 20% rate.
00:10:05.000 | And then there's another tax on top of that.
00:10:07.000 | Well, if you're single and you make more than $200,000 a year,
00:10:10.000 | or if you're married, filing jointly, and you make more than $250,000,
00:10:14.000 | and this is kind of a stealthy tax,
00:10:16.000 | it's called a net investment income tax.
00:10:18.000 | What is that?
00:10:19.000 | Net investment income tax was put in
00:10:22.000 | as part of the way to pay for the Affordable Care Act,
00:10:26.000 | what some of us call Obamacare.
00:10:28.000 | It really kind of matches up with Medicare tax
00:10:33.000 | that you would otherwise pay on other kinds of income,
00:10:37.000 | and so it's trying to make sure
00:10:39.000 | almost all kinds of income are going to contribute
00:10:42.000 | in one way or another toward health care.
00:10:44.000 | And this tax at 3.8% can hit capital gains,
00:10:49.000 | it can hit dividends, it can hit interest income,
00:10:53.000 | short-term capital gains and long-term capital gains.
00:10:56.000 | This is why people will say that capital gain taxes
00:11:00.000 | go up to 23.8% instead of just up to 20%.
00:11:05.000 | One point about this is that $200,000 break point
00:11:09.000 | that you mentioned where the net investment income tax
00:11:13.000 | clicks in for single investors
00:11:15.000 | and $250,000 for married filing jointly,
00:11:19.000 | those are not indexed for inflation.
00:11:22.000 | And so that's something that wears away every year a little bit
00:11:25.000 | and brings more people into paying it.
00:11:28.000 | And let's get into another tax,
00:11:30.000 | and this is called the alternative minimum tax,
00:11:33.000 | and this can hit people who have very large capital gains
00:11:37.000 | or perhaps had stock option compensation.
00:11:39.000 | So what is this tax?
00:11:41.000 | This tax originally came into existence
00:11:44.000 | out of a notion that there were people with very high incomes
00:11:49.000 | who pay either nothing or very little in the way of taxes.
00:11:54.000 | It seemed unfair to some in Congress
00:11:57.000 | that there would be this disparity
00:12:00.000 | where people with very modest incomes
00:12:03.000 | would be paying a substantial portion of that income
00:12:07.000 | in the form of taxes,
00:12:09.000 | and yet people with much higher incomes
00:12:11.000 | would pay little or nothing.
00:12:13.000 | And so this tax was instituted
00:12:17.000 | as a way to require that everyone will pay
00:12:21.000 | at least some minimum amount of tax.
00:12:24.000 | That's where the word "minimum" comes from in here,
00:12:27.000 | and the word "alternative" has to do with the notion
00:12:31.000 | that we figure out how much tax you should have to pay
00:12:36.000 | under how much your minimum amount of tax would be
00:12:40.000 | by using an alternative calculation.
00:12:44.000 | And so we step aside into a not entirely different
00:12:48.000 | but quite different set of rules
00:12:51.000 | for determining what your tax is.
00:12:53.000 | The tax rates here are 26% and 28%.
00:12:58.000 | You have a special deduction
00:13:01.000 | called the minimum tax exemption,
00:13:03.000 | but at the same time you are denied
00:13:06.000 | many of the tax deductions and tax benefits
00:13:10.000 | that you would otherwise get under the regular income tax.
00:13:14.000 | And the notion being,
00:13:16.000 | those are the deductions and credits
00:13:19.000 | that are allowing people who are very wealthy
00:13:22.000 | to avoid paying alternative minimum tax.
00:13:25.000 | Now this used to be a very big problem
00:13:28.000 | for a large number of people
00:13:30.000 | because the alternative minimum tax
00:13:33.000 | did away with certain items that were claimed by many people,
00:13:37.000 | such as personal exemptions,
00:13:40.000 | the state and local income tax deduction,
00:13:42.000 | and so people who have a lot of those kinds of deductions
00:13:47.000 | would be paying alternative minimum tax
00:13:49.000 | even though they were not necessarily very wealthy.
00:13:52.000 | This was substantially changed in the 2017 tax law
00:13:58.000 | where the minimum tax exemption amount became much larger
00:14:02.000 | and the place where that starts to phase out
00:14:06.000 | happens at a much higher income tax level.
00:14:09.000 | Now the alternative minimum tax
00:14:12.000 | affects a much smaller number of people.
00:14:16.000 | It tends to be mainly people who exercise
00:14:19.000 | a kind of stock option called incentive stock option.
00:14:24.000 | If you have that type of option
00:14:27.000 | and exercise it for a very large profit,
00:14:30.000 | then you do need to deal with the alternative minimum tax
00:14:34.000 | and my book Consider Your Options
00:14:37.000 | talks about how to plan for that.
00:14:39.000 | Other types of people generally don't have to
00:14:43.000 | concern themselves with alternative minimum tax
00:14:46.000 | for the most part,
00:14:47.000 | although it's still possible with certain types of tax benefits
00:14:51.000 | and particularly a large capital gain
00:14:55.000 | can bring someone into paying alternative minimum tax
00:15:00.000 | and the reason for that is that it causes
00:15:03.000 | a phasing out of this minimum tax exemption.
00:15:07.000 | I know all this is kind of abstract,
00:15:09.000 | it's kind of hard to talk about and understand,
00:15:13.000 | but that's the picture.
00:15:14.000 | All these different taxes, the income tax, capital gain tax,
00:15:17.000 | net investment income tax, alternative minimum tax,
00:15:20.000 | there's a lot of different ways the government can tax us directly,
00:15:24.000 | but there's also back doorways and that is phase-outs.
00:15:28.000 | As you make more money,
00:15:29.000 | your tax credits that you may get get phased out,
00:15:32.000 | the tax deductions that you may have get phased out,
00:15:36.000 | you're a business owner
00:15:37.000 | and you're getting the qualified business income deduction
00:15:41.000 | that gets phased out.
00:15:43.000 | Also, if you make more money and you're retired,
00:15:47.000 | more of your Social Security becomes taxable
00:15:51.000 | and you end up paying more in Medicare costs through IRMA.
00:15:55.000 | So could you kind of talk about these back doorways
00:15:58.000 | of which you can end up paying taxes?
00:16:00.000 | Right.
00:16:01.000 | The IRMA, of course, is not exactly a tax,
00:16:05.000 | but it's something that plays off
00:16:07.000 | of actually your adjusted gross income
00:16:10.000 | and causes you to pay a potentially significant amount
00:16:14.000 | of additional premium.
00:16:16.000 | So your Medicare premium can be substantially larger
00:16:20.000 | as a result of this.
00:16:23.000 | I mean, if your income is just very large every year,
00:16:26.000 | there's nothing you can do about paying this additional amount.
00:16:30.000 | But if you have a very large amount of additional income
00:16:34.000 | in a particular year,
00:16:36.000 | for example, you decided to do a Roth conversion.
00:16:40.000 | A Roth conversion can be a wonderful planning device,
00:16:44.000 | but it can cause you to run into the additional premium
00:16:49.000 | that you pay under Medicare as a result of IRMA.
00:16:53.000 | Now, you can deal with that by going to the Medicare website,
00:16:58.000 | obtaining the forms that you need to file,
00:17:02.000 | and say, "Look, my income for this one year was higher,
00:17:06.000 | but now my income has gone back and it's a normal income
00:17:10.000 | and I shouldn't be paying this higher premium
00:17:12.000 | because it doesn't reflect the income that I have right now."
00:17:16.000 | There's this two-year lag in IRMA,
00:17:19.000 | and the reason for that is that they need to have
00:17:23.000 | your tax information before they figure that out.
00:17:26.000 | The only tax information they have for you right now in 2024
00:17:31.000 | is your tax return from 2022.
00:17:34.000 | So it's two years ago that they have your tax information.
00:17:38.000 | So there is this two-year lag.
00:17:40.000 | You can deal with the situation
00:17:42.000 | if your income was very high for one year
00:17:45.000 | and it has gone down by the time the higher IRMA Medicare premium
00:17:50.000 | has clicked into effect,
00:17:52.000 | but very often you simply want to try to do planning
00:17:56.000 | to avoid having that happen in the first place.
00:17:59.000 | That form is SSA-44.
00:18:03.000 | Just type SSA-44 into an Internet search engine
00:18:08.000 | and a form will come up.
00:18:10.000 | You fill it out, you send it to the Social Security office,
00:18:13.000 | and within a few months,
00:18:15.000 | hopefully they will revert back to the lower premium amount.
00:18:20.000 | Yes, thank you for that.
00:18:22.000 | As to the other phase-outs,
00:18:24.000 | there are really too many of them to comprehensively cover here,
00:18:29.000 | but the thing that I would mention
00:18:31.000 | is that most of them play off
00:18:33.000 | against what's called modified adjusted gross income.
00:18:38.000 | And there are different modifications for different rules,
00:18:43.000 | but almost all of them involve foreign income.
00:18:47.000 | If you have foreign income that has been excluded
00:18:50.000 | for one reason or another,
00:18:52.000 | then you have to include that back in
00:18:55.000 | for purposes of that phase-out.
00:18:58.000 | A few of them, like the Social Security taxation,
00:19:02.000 | will also include tax-exempt income.
00:19:04.000 | But for the most part,
00:19:06.000 | we're talking about adjusted gross income,
00:19:09.000 | which is your income before itemized deductions.
00:19:12.000 | And you can think about,
00:19:14.000 | if you're running into one of these phase-outs,
00:19:17.000 | whether there's something you can do
00:19:19.000 | to your adjusted gross income.
00:19:21.000 | And, of course, retirement savings.
00:19:23.000 | Boosting your retirement savings
00:19:25.000 | is one of the ways to do that.
00:19:27.000 | Obviously, that would have to be
00:19:29.000 | in a traditional retirement account and not a Roth,
00:19:32.000 | because the Roth provides no deduction.
00:19:34.000 | But let's go ahead and get into that.
00:19:36.000 | The different types of ways you could save
00:19:38.000 | where you do get a tax benefit
00:19:40.000 | either now or ongoing or in the future.
00:19:44.000 | And what I'm talking about is
00:19:46.000 | there are different types of retirement accounts.
00:19:48.000 | One that you can invest in pre-tax
00:19:50.000 | and you get tax deferral.
00:19:52.000 | And then when you take the money out, you are taxed.
00:19:54.000 | The others are putting money in pre-tax
00:19:57.000 | and getting tax-free gain.
00:19:59.000 | And then when you take the money out later on, tax-free.
00:20:02.000 | I'm speaking about an HSA account.
00:20:04.000 | And then there are after-tax accounts
00:20:06.000 | you could put money into
00:20:08.000 | where it's either tax-deferred or tax-free.
00:20:10.000 | And at the end, when you take the money out,
00:20:12.000 | it's either non-taxable
00:20:14.000 | or only the interest portion is taxable.
00:20:16.000 | So just go over quickly the different types of accounts
00:20:19.000 | that people can put money into
00:20:21.000 | to either reduce their current taxes
00:20:23.000 | or reduce taxes ongoing,
00:20:25.000 | on investment gains,
00:20:27.000 | or reduce taxes at the end
00:20:29.000 | when they take the money out.
00:20:31.000 | Five different potential models
00:20:34.000 | for taxation of investment accounts.
00:20:38.000 | The simplest ones to understand,
00:20:41.000 | first of all, the fully taxable account.
00:20:43.000 | Your income that you have in there,
00:20:45.000 | income and capital gains,
00:20:47.000 | are going to be currently taxable.
00:20:49.000 | The Roth account,
00:20:51.000 | you get no deduction for the money going in,
00:20:54.000 | but it's entirely tax-free
00:20:56.000 | if you follow the rules.
00:20:58.000 | All your investment gains will be tax-free.
00:21:02.000 | We have the traditional retirement account
00:21:05.000 | that we're used to.
00:21:07.000 | That's the one where you get a deduction
00:21:09.000 | when the money comes in.
00:21:10.000 | It grows tax-deferred,
00:21:12.000 | but it's going to be taxable
00:21:14.000 | when the money comes out.
00:21:16.000 | And we have the HSA,
00:21:19.000 | which, as you mentioned,
00:21:21.000 | that's the gold standard,
00:21:23.000 | but it has somewhat limited reach right now.
00:21:27.000 | But anyone who has it available
00:21:29.000 | should really give some thought
00:21:31.000 | to studying up on it
00:21:32.000 | and whether they want to be in it,
00:21:34.000 | because it provides that unique situation
00:21:38.000 | where you get a deduction for the money going in,
00:21:41.000 | tax-deferred growth,
00:21:43.000 | and then the opportunity to take that money out,
00:21:46.000 | tax-free at the end as well.
00:21:48.000 | Again, all subject to limitations,
00:21:51.000 | but that is the one type of account for that.
00:21:55.000 | I've mentioned four,
00:21:57.000 | and the fifth model is
00:21:58.000 | when you make a non-deductible contribution
00:22:01.000 | to a traditional retirement account,
00:22:05.000 | that produces its own set of results.
00:22:08.000 | I think one of the key things to understand here
00:22:13.000 | is that the taxable account
00:22:15.000 | isn't as bad as it might seem
00:22:18.000 | compared to the tax-favored accounts,
00:22:22.000 | because you can actually get a lower tax rate
00:22:27.000 | with a buy-and-hold strategy,
00:22:29.000 | which I know is what many Bogleheads are looking for.
00:22:33.000 | That long-term deferral of capital gains
00:22:36.000 | as you grow your capital gains
00:22:39.000 | over a period of many years
00:22:42.000 | in a taxable account
00:22:44.000 | in effect lowers the tax rate
00:22:46.000 | that you're going to pay
00:22:47.000 | on those capital gains in the end.
00:22:50.000 | You may pay the same actual rate,
00:22:52.000 | that 20% rate, let's say,
00:22:54.000 | if you're at the top bracket,
00:22:56.000 | but deferring that tax
00:22:58.000 | over a period of many years
00:23:00.000 | can have the effect of lowering that
00:23:03.000 | as an effective rate to 18% or 16% or lower,
00:23:08.000 | depending on how long you held that stock
00:23:11.000 | or other investment
00:23:13.000 | and how well that investment performed
00:23:15.000 | over that period of time.
00:23:17.000 | One of the investments that we often highlight
00:23:20.000 | to go into a taxable account
00:23:22.000 | is a simple total stock market index fund,
00:23:26.000 | which, if it's in an ETF format,
00:23:29.000 | what I'm thinking of
00:23:31.000 | is the Vanguard Total Stock Market ETF.
00:23:34.000 | The ticker is VTI.
00:23:36.000 | If this goes into a taxable account,
00:23:38.000 | there are no capital gain distributions
00:23:40.000 | in the fund.
00:23:42.000 | The dividends on it are only about 1.5%.
00:23:46.000 | Most of that dividend is a qualified dividend,
00:23:51.000 | which, as we'll talk about in a minute,
00:23:54.000 | is treated as a long-term capital gain.
00:23:57.000 | This is a very tax-efficient,
00:24:00.000 | broadly diversified index fund
00:24:04.000 | for a taxable account.
00:24:06.000 | Usually, when we're talking about investing
00:24:09.000 | on the Bogleheads Forum
00:24:11.000 | and we're talking about taxable accounts,
00:24:13.000 | this fund often comes up.
00:24:15.000 | I have to admit,
00:24:17.000 | because I got into investing
00:24:19.000 | at a time when ETFs were really just coming out,
00:24:24.000 | so I don't have ETFs
00:24:26.000 | as part of my own main investments,
00:24:28.000 | but I do understand the advantage here
00:24:31.000 | because of the way they operate.
00:24:34.000 | When people cash out of ETFs,
00:24:37.000 | the ETF does not have to sell its own investments
00:24:41.000 | and create gains for its investors,
00:24:43.000 | whereas an index fund,
00:24:45.000 | and especially a managed fund,
00:24:47.000 | would have to incur in capital gains
00:24:49.000 | that have to be distributed to investors
00:24:52.000 | whenever their investors start cashing out.
00:24:55.000 | Unfortunately for Vanguard investors,
00:24:57.000 | the ETF and the mutual fund are the same.
00:25:01.000 | They are just share classes of the one fund,
00:25:05.000 | so the tax benefits
00:25:07.000 | extend to the opened-end index funds as well,
00:25:10.000 | and that's not true for almost all other fund companies.
00:25:13.000 | They have a separation
00:25:15.000 | between their index mutual funds
00:25:17.000 | and their index ETFs,
00:25:19.000 | and theoretically, the index mutual fund
00:25:22.000 | could actually create a capital gain tax,
00:25:25.000 | whereas that same company, same fund company,
00:25:28.000 | had an ETF following the same index.
00:25:31.000 | It typically wouldn't happen,
00:25:33.000 | but with Vanguard, it just happens to be
00:25:35.000 | that both the ETF and the fund,
00:25:37.000 | it's a unique structure.
00:25:38.000 | They're all taxed the same,
00:25:39.000 | and so the opened-end index fund
00:25:41.000 | gets the tax benefit of the ETF.
00:25:44.000 | And if you bought funds that had low dividend yield,
00:25:47.000 | that works even better.
00:25:48.000 | And of course, in the end, too,
00:25:50.000 | if you own these funds when you passed away,
00:25:53.000 | right now we get a stepped-up basis on death,
00:25:55.000 | so all of that capital gain
00:25:57.000 | goes on to the next generation
00:25:59.000 | or whomever's going to inherit the stock
00:26:02.000 | or the ETFs at no tax.
00:26:04.000 | So let's just talk about that for a second,
00:26:06.000 | the step-up on death.
00:26:07.000 | That is a huge benefit
00:26:10.000 | for people who do hold assets
00:26:12.000 | that are going to pass to the next generation
00:26:15.000 | that are highly appreciated.
00:26:17.000 | This has been in place for many years.
00:26:20.000 | There was one attempt to do away with it,
00:26:24.000 | and for one year, they did away with it.
00:26:27.000 | I think it was the year 1979,
00:26:30.000 | and it was such a disaster
00:26:32.000 | that Congress immediately did an about-face
00:26:35.000 | and went back to having this stepped-up basis at death.
00:26:39.000 | For many years afterward, we had to say,
00:26:41.000 | "Well, did this person die in '79?"
00:26:44.000 | and deal with whatever problems came up
00:26:47.000 | as a result of that one-year repeal.
00:26:50.000 | And there's still some talk about trying to do something
00:26:54.000 | that would rein in this tax benefit
00:26:57.000 | because it is such a huge benefit.
00:26:59.000 | So this is one of the ways
00:27:01.000 | of completely avoiding capital gain tax.
00:27:04.000 | Another is donating appreciated assets to charity.
00:27:08.000 | And those two are really major ways
00:27:12.000 | of benefiting from special treatment
00:27:15.000 | of long-term capital gains.
00:27:18.000 | We mentioned doing Roth conversions.
00:27:20.000 | I want to talk about why it's more beneficial
00:27:23.000 | to do Roth conversions before taking Social Security
00:27:27.000 | and before hitting required minimum distribution age
00:27:31.000 | on your pre-tax retirement funds.
00:27:33.000 | So can you talk first about what Roth conversions are
00:27:36.000 | and then when you should do them
00:27:38.000 | and when maybe you should not do them?
00:27:40.000 | Roth conversion is the transfer of money or assets
00:27:45.000 | from a traditional retirement account into a Roth account.
00:27:49.000 | Now, in the traditional account,
00:27:51.000 | you received a deduction when the money went in.
00:27:54.000 | So when that money goes to a Roth,
00:27:57.000 | you need to pay tax on those dollars.
00:28:01.000 | And the general rule is you don't want to pay tax
00:28:04.000 | any sooner than necessary.
00:28:06.000 | And so some people are immediately skeptical
00:28:09.000 | of even considering the idea of a Roth conversion.
00:28:14.000 | We've just talked about the benefit
00:28:16.000 | of avoiding paying tax earlier than necessary
00:28:19.000 | on a capital gain for all the benefits
00:28:22.000 | that you get from deferring that capital gain.
00:28:25.000 | So why would you do a Roth conversion?
00:28:28.000 | This kind of starts from what I call the parity principle,
00:28:33.000 | which is that a Roth can produce exactly the same results
00:28:40.000 | as a traditional retirement account
00:28:43.000 | if certain things are true.
00:28:46.000 | And those things are that the tax rate
00:28:49.000 | remains the same at all times.
00:28:52.000 | The dollar amount that goes into the Roth
00:28:56.000 | is the same dollar amount that was in the traditional account
00:29:01.000 | reduced by the amount of tax
00:29:04.000 | that is imposed on that conversion.
00:29:07.000 | The amount of time invested remains the same.
00:29:11.000 | And the fourth thing that has to be the same
00:29:13.000 | is the investment results are the same.
00:29:16.000 | If you do all those four things together,
00:29:19.000 | you get exact parity between those two.
00:29:23.000 | And the tendency has been to focus on the tax rates
00:29:28.000 | and saying, well, the tax rate that is imposed
00:29:32.000 | on the Roth conversion should not be higher
00:29:36.000 | than the tax rate that you would have
00:29:38.000 | on withdrawal of those assets during retirement.
00:29:41.000 | And that's generally true.
00:29:43.000 | It's a pretty good rule of thumb,
00:29:45.000 | but it's not the whole story.
00:29:47.000 | The second one that I mentioned
00:29:49.000 | was that the dollars going into the Roth
00:29:52.000 | in order to achieve this exact parity
00:29:55.000 | have to be the same number of dollars
00:29:57.000 | reduced by the amount of tax,
00:30:00.000 | and yet you're not required to reduce those dollars
00:30:03.000 | by the amount of tax.
00:30:05.000 | So to make this simple,
00:30:08.000 | if you have $100,000 in a traditional retirement account
00:30:13.000 | and $100,000 in a Roth retirement account,
00:30:16.000 | that $100,000 in the Roth is worth more.
00:30:19.000 | You're going to take that out tax-free
00:30:22.000 | during retirement, or your heirs will.
00:30:24.000 | That $100,000 in the traditional retirement account
00:30:27.000 | is going to bear some tax when it comes out,
00:30:30.000 | and so it's worth less.
00:30:32.000 | And so the Roth account is actually larger.
00:30:36.000 | It may have the same dollar amount in it,
00:30:39.000 | but in terms of usable assets,
00:30:42.000 | it's larger than the traditional retirement account.
00:30:46.000 | And that's where we start thinking
00:30:48.000 | about all the benefits of a Roth conversion.
00:30:51.000 | But we would want to do these
00:30:53.000 | before we start taking RMDs
00:30:56.000 | because RMDs, you cannot put that into a Roth.
00:31:00.000 | And maybe before you start taking Social Security
00:31:03.000 | because that closes the window a little bit
00:31:06.000 | because Social Security becomes taxable
00:31:08.000 | and anything that you take out of a retirement account
00:31:11.000 | just increases your ordinary income,
00:31:13.000 | which could make more of your Social Security taxable.
00:31:16.000 | So could you talk about, say you retired early,
00:31:19.000 | should you start then?
00:31:21.000 | Yeah, it's one of these very forward-looking planning ideas
00:31:25.000 | of making the Roth conversion, as you said,
00:31:29.000 | before Social Security.
00:31:32.000 | I do want to mention, though,
00:31:34.000 | that there are circumstances
00:31:36.000 | where you can do a Roth conversion,
00:31:39.000 | even in retirement, and it can be beneficial.
00:31:43.000 | Even after you've started RMDs
00:31:45.000 | and you're into that whole later years of your retirement,
00:31:50.000 | you can still potentially benefit from a Roth conversion.
00:31:54.000 | You do have to be careful.
00:31:56.000 | The first dollars that come out of your traditional account
00:32:00.000 | are going to be treated as your RMD.
00:32:03.000 | And so if you make a mistake
00:32:05.000 | and convert the first dollars that you take out,
00:32:10.000 | do the conversion before taking your RMD,
00:32:13.000 | that's a mistake I've seen fairly often,
00:32:15.000 | then you've got a bad conversion
00:32:17.000 | because you have converted dollars
00:32:19.000 | that you're not allowed to convert
00:32:21.000 | because you cannot convert RMD dollars.
00:32:23.000 | However, after you get beyond that,
00:32:26.000 | you've taken your RMD,
00:32:28.000 | now you take your Roth conversion.
00:32:32.000 | What you're doing, if you can pay tax on that conversion
00:32:35.000 | with dollars that you have
00:32:37.000 | otherwise sitting in a taxable account,
00:32:40.000 | now, in effect, you've moved dollars
00:32:42.000 | out of your taxable account and into a Roth IRA.
00:32:46.000 | And that, of course, is a very beneficial thing to be doing.
00:32:50.000 | The impact may not be huge,
00:32:52.000 | but again, it's one of those little tax planning scenarios
00:32:56.000 | that people tend to overlook
00:32:58.000 | because they're getting into those years
00:33:00.000 | where they think, "Oh, Roth conversion is no longer for me."
00:33:03.000 | I want to take a moment here
00:33:05.000 | to talk about qualified charitable distributions.
00:33:07.000 | And this is where, if you're 70 1/2,
00:33:10.000 | you can take up to $100,000 per year per person
00:33:13.000 | from your IRA and donate it directly to a charity.
00:33:18.000 | It can't go to a donor advised fund.
00:33:20.000 | It has to go directly to a charity.
00:33:22.000 | And you're not taxed on this money.
00:33:24.000 | Now, when you hit RMD age at either 73 to 75,
00:33:29.000 | then the amount that you gave to charity
00:33:34.000 | as a qualified charitable distribution
00:33:36.000 | is deducted from your RMD amount.
00:33:40.000 | So if you gave $25,000 to a charity
00:33:43.000 | directly from your IRA and your RMD was $35,000,
00:33:47.000 | you would only have to take a $10,000 RMD.
00:33:50.000 | Now, the trick here, though,
00:33:52.000 | is you have to make the contribution to the charity first,
00:33:56.000 | and then you make the RMD second.
00:34:00.000 | You can't do it the other way around.
00:34:02.000 | You can't do the RMD first
00:34:04.000 | and then the charitable contribution second.
00:34:07.000 | Which is, by the way, the exact opposite
00:34:09.000 | of what we just talked about,
00:34:11.000 | which is if you're going to do a Roth conversion from your IRA,
00:34:15.000 | you have to do that after doing your RMD, not before.
00:34:19.000 | So remember, QCDs must be done before you do your RMD,
00:34:23.000 | whereas Roth conversions are done after you do your RMD.
00:34:28.000 | Clear as mud, as we used to say in the Marine Corps.
00:34:31.000 | I've got one other K.
00:34:33.000 | So let's say that you are past required minimum distribution age,
00:34:38.000 | but you're still working for a company.
00:34:41.000 | This is a company that you do not own more than 5% of.
00:34:45.000 | It could be a nonprofit and it's a 403(b).
00:34:48.000 | They could have a 401(k).
00:34:51.000 | But you are working for this company
00:34:53.000 | and you're participating in their 401(k) or their 403(b).
00:34:57.000 | You do not have to take required minimum distributions
00:35:00.000 | from that 401(k) or 403(b) for as long as you work there.
00:35:06.000 | So if you work there until you're 85,
00:35:08.000 | you don't have to do RMDs from that account.
00:35:11.000 | Now, the IRS also allows you to take IRA money
00:35:15.000 | and old 401(k) or 403(b) money
00:35:18.000 | and roll it into your current employer's 401(k).
00:35:22.000 | So technically, any money that you roll into that 401(k),
00:35:27.000 | also you wouldn't have to take an RMD from.
00:35:31.000 | That's right, Rick.
00:35:32.000 | And you're making it sound attractive for me
00:35:35.000 | to go back to work in a law firm.
00:35:38.000 | But the prospect of doing all those billable hours
00:35:41.000 | just makes that hard.
00:35:44.000 | And I have to mention here that anything we talk about
00:35:47.000 | on this podcast is strictly informational.
00:35:50.000 | You need to check with your tax advisor
00:35:53.000 | to see if these strategies work for you.
00:35:56.000 | All right, let's get into the title of your book,
00:35:58.000 | "Capital Gains."
00:35:59.000 | And here it can get complicated.
00:36:01.000 | We have long-term capital gains, short-term capital gains.
00:36:04.000 | How do the taxes work?
00:36:06.000 | So short- and long-term capital gains
00:36:08.000 | are basically the differences between
00:36:11.000 | whether you've held your investment
00:36:13.000 | for more than a year.
00:36:15.000 | And we have to be specific about saying
00:36:17.000 | it is more than a year and not just one year.
00:36:20.000 | You have to sell no sooner than the anniversary
00:36:24.000 | of the day after you acquired your asset
00:36:27.000 | in order to have a long-term capital gain.
00:36:30.000 | There are various circumstances that can cause
00:36:33.000 | an adjustment in your holding period,
00:36:36.000 | but that's the basic rule.
00:36:38.000 | Now, generally speaking, a long-term capital gain
00:36:42.000 | is going to be more favorable than a short-term capital gain
00:36:46.000 | because of the favorable tax rates
00:36:49.000 | that we spoke about earlier for long-term capital gains.
00:36:53.000 | Short-term capital gains are going to be taxed
00:36:56.000 | at the same rates as ordinary income.
00:36:59.000 | But there are various rules that cause these to interact.
00:37:04.000 | If you have a combination of short-term
00:37:07.000 | and long-term capital gains and capital losses,
00:37:11.000 | then you're going to net the long-term capital gains
00:37:15.000 | against your long-term capital losses.
00:37:19.000 | And this is why a capital loss is actually more favorable
00:37:23.000 | if it's short-term, whereas a capital gain
00:37:27.000 | is more favorable if it's long-term.
00:37:30.000 | Now, once you've done all that netting out,
00:37:32.000 | if you have a net long-term capital gain,
00:37:35.000 | that's when you get the favorable tax result.
00:37:38.000 | And if you have a capital loss,
00:37:41.000 | it's going to be deductible,
00:37:44.000 | but only to the extent of $3,000.
00:37:47.000 | And this, by the way, is one of those strange items
00:37:50.000 | that is not indexed for inflation.
00:37:53.000 | Almost all of the dollar amounts that are in the tax law
00:37:57.000 | are indexed for inflation, but this one is not.
00:38:01.000 | So we've had this $3,000 going back to the Reagan administration,
00:38:05.000 | and if you adjusted this for inflation since then,
00:38:09.000 | I don't know what the dollar amount is now,
00:38:11.000 | it's probably $15,000 or more,
00:38:13.000 | but we're still stuck with only $3,000
00:38:16.000 | as a potential deduction for capital loss.
00:38:19.000 | That's an important fact for people who have variation
00:38:23.000 | in their capital gains and losses
00:38:26.000 | that they recognize each year.
00:38:29.000 | Because if you have a large capital gain one year
00:38:32.000 | and a large capital loss the next year,
00:38:35.000 | there's no carryback.
00:38:37.000 | You've already paid tax on your capital gain,
00:38:40.000 | and this capital loss,
00:38:42.000 | you're only going to deduct $3,000 of it,
00:38:45.000 | and so this is what we call a capital loss whipsaw.
00:38:49.000 | And it's a very unfavorable situation.
00:38:52.000 | The opposite is not as much of a problem.
00:38:55.000 | If you have a large capital loss one year,
00:38:58.000 | you do carry it forward,
00:39:00.000 | and you can use that against capital gain in the next year.
00:39:03.000 | So it's very important if you have these kind of variations
00:39:08.000 | in your capital gains and capital losses
00:39:11.000 | to keep this in mind,
00:39:13.000 | that you can only deduct $3,000 of your loss.
00:39:17.000 | Now a lot of people think, and incorrectly,
00:39:20.000 | that the dividends you get from stock,
00:39:22.000 | which are treated as long-term capital gains,
00:39:24.000 | some of them the qualified dividends that you get,
00:39:27.000 | are treated as long-term capital gain for tax purposes,
00:39:30.000 | but they don't get offset by capital losses, correct?
00:39:34.000 | Yes, that's absolutely right.
00:39:37.000 | Long-term capital gains do get offset by capital losses,
00:39:41.000 | including even short-term capital losses,
00:39:44.000 | if they exceed your short-term capital gains.
00:39:47.000 | But none of that will offset a qualified dividend.
00:39:51.000 | Qualified dividend benefits from the long-term capital gain rates,
00:39:55.000 | but not the full capital loss treatment.
00:39:58.000 | So I want to get into something that would help
00:40:01.000 | if you had capital gain,
00:40:02.000 | and that is to have done tax loss harvesting,
00:40:05.000 | which is basically if something goes down in value
00:40:08.000 | and you've got a capital loss,
00:40:10.000 | sell it and replace it with something that is close,
00:40:14.000 | but not substantially identical.
00:40:16.000 | So could you cover tax loss harvesting
00:40:18.000 | and what substantially identical actually means?
00:40:22.000 | Well, the concept of tax loss harvesting is,
00:40:25.000 | as you described, something has gone down in value,
00:40:28.000 | you're going to sell it.
00:40:30.000 | And a lot of people think about doing this
00:40:33.000 | just at the end of the year.
00:40:35.000 | They're reviewing their investments.
00:40:37.000 | Should I sell something before the end of the year
00:40:39.000 | in order to get a deduction?
00:40:41.000 | But the reality is that tax loss harvesting
00:40:45.000 | that is done throughout the year can be more beneficial.
00:40:49.000 | I've seen some research on this where they did projections
00:40:54.000 | and worked out that a portfolio
00:40:57.000 | in which tax loss harvesting is done at reasonable intervals,
00:41:02.000 | you don't want to be doing it every day,
00:41:04.000 | can outperform a simple buy and hold portfolio
00:41:09.000 | for a number of years by up to one percentage point,
00:41:14.000 | 100 basis points.
00:41:16.000 | That gradually wears away over a number of years.
00:41:19.000 | And that's for the simple reason that the stock market
00:41:22.000 | over many years will go up in value
00:41:25.000 | and most of what you have in your portfolio
00:41:28.000 | will be stocks that have gone up.
00:41:31.000 | And so your opportunity to be benefiting
00:41:35.000 | from tax loss harvesting does kind of wear away
00:41:38.000 | over a period of time.
00:41:40.000 | But on a brand new portfolio,
00:41:43.000 | tax loss harvesting can produce a very substantial benefit
00:41:47.000 | and Bogleheads certainly know that one percentage point
00:41:51.000 | or 100 basis points is a really big deal.
00:41:54.000 | And to be able to do that over several years
00:41:57.000 | can be highly beneficial to your long-term financial health.
00:42:02.000 | So that's basically the idea.
00:42:04.000 | Now what constrains this primarily
00:42:07.000 | is something called the wash/sale rule.
00:42:10.000 | And in simple terms, the wash/sale rule says
00:42:14.000 | that if you sell a security at a loss
00:42:17.000 | and buy a substantially identical security
00:42:22.000 | within 30 days before or after,
00:42:26.000 | then you don't get to claim that loss.
00:42:29.000 | The loss gets added to the basis
00:42:31.000 | of whatever you bought as a replacement,
00:42:34.000 | but you don't get to claim that loss on your tax return.
00:42:37.000 | So this creates something of a stumbling block
00:42:40.000 | for the people who are into tax loss harvesting.
00:42:44.000 | We have a 61-day period.
00:42:47.000 | It's the day of the sale, 30 days before, and 30 days after.
00:42:51.000 | So you have to be very careful about measuring that
00:42:54.000 | if what you're looking to do is sell
00:42:57.000 | and then go back to the same exact investment
00:43:00.000 | or something that is substantially identical.
00:43:03.000 | In your book, you gave March 31st as a good example.
00:43:06.000 | If you sold it on March 31st,
00:43:08.000 | it means you couldn't have bought it in March
00:43:10.000 | or you couldn't have bought it in April,
00:43:12.000 | which is only 30 days, and I thought it was a great example.
00:43:15.000 | Right. Well, thank you for that.
00:43:17.000 | So substantially identical.
00:43:19.000 | Yes, substantially identical is something
00:43:22.000 | that has not been fully defined ever.
00:43:25.000 | And there is one ruling out there
00:43:27.000 | where the IRS talks about a situation
00:43:30.000 | where a takeover is pending,
00:43:33.000 | and it has not yet closed.
00:43:36.000 | And the two stocks that are involved in the takeover
00:43:40.000 | are going to trade exactly in tandem.
00:43:43.000 | They say that even though these are different stocks,
00:43:47.000 | they are going to be treated as substantially identical,
00:43:52.000 | and that makes a lot of sense,
00:43:54.000 | that you shouldn't be able to sell one at a loss
00:43:56.000 | and buy the other one when you are really
00:43:59.000 | trading into the same situation that you traded out of.
00:44:02.000 | The place where questions come up a lot
00:44:04.000 | is mutual funds, in particular index funds.
00:44:07.000 | Can I sell one total market index fund
00:44:11.000 | and buy a different one from a different company,
00:44:15.000 | and will those be considered substantially identical?
00:44:19.000 | And the IRS has never ruled on this.
00:44:22.000 | And of course there are related questions
00:44:24.000 | about overlapping index funds,
00:44:27.000 | or you take a total market fund
00:44:30.000 | and replace it with a small cap and a large cap index fund
00:44:35.000 | that together add up to that total market fund.
00:44:39.000 | There are no rulings on this.
00:44:41.000 | What I say in my book is that
00:44:45.000 | unless you want to be a wise guy
00:44:48.000 | and play loose with the rules,
00:44:51.000 | you are going to treat it as substantially identical
00:44:54.000 | if the two investments,
00:44:57.000 | once you lay one on top of the other,
00:45:00.000 | they are going to perform exactly the same.
00:45:03.000 | If you know the investments are going to perform the same,
00:45:06.000 | that was the basis for that one ruling
00:45:08.000 | that I mentioned by the IRS,
00:45:10.000 | and so those are what are going to be
00:45:13.000 | or should be treated as a wash sales situation.
00:45:17.000 | The IRS doesn't have a way of tracking this realistically,
00:45:21.000 | but if your return gets audited for some other reason
00:45:24.000 | and they see that you were kind of a wise guy about this,
00:45:27.000 | they may decide to go after you.
00:45:30.000 | Okay.
00:45:32.000 | Well, I'm a wise guy.
00:45:35.000 | If I sell the Vanguard Total Stock Market Index Fund,
00:45:39.000 | which is run by Vanguard
00:45:42.000 | and tracks the CRISP Total Stock Market Index,
00:45:46.000 | which is the Center for Research and Security Prices,
00:45:50.000 | an affiliate of the University of Chicago,
00:45:53.000 | and I take a loss and I buy
00:45:56.000 | the Fidelity Total Stock Market Index Fund,
00:45:59.000 | which tracks the Dow Jones Total Stock Market Index,
00:46:03.000 | which is owned by Standard & Poor's,
00:46:06.000 | neither the index provider nor the index fund provider
00:46:10.000 | are similar or affiliated.
00:46:13.000 | And to me, that means they are not substantially identical.
00:46:16.000 | But again, I'm a wise guy.
00:46:18.000 | Yeah, and I have no problem with that.
00:46:21.000 | Perhaps using the wise guy,
00:46:24.000 | that's sort of characterization.
00:46:26.000 | Forget about it.
00:46:29.000 | I don't mean to imply that that means you're cheating.
00:46:33.000 | You're playing in an area
00:46:35.000 | where the IRS probably wouldn't like it.
00:46:38.000 | I'll put it that way, if they took a close look at it.
00:46:41.000 | As you said, the IRS has never said anything
00:46:43.000 | about mutual funds or particularly index funds,
00:46:46.000 | which have been around now for 45 years.
00:46:48.000 | I wish they would say something and just get it over with,
00:46:50.000 | but so far we've heard nothing.
00:46:52.000 | So it's up to each person to make their own decision,
00:46:55.000 | with the help of their tax advisor, of course.
00:46:57.000 | In the last few minutes we have left,
00:46:59.000 | I want to talk about dividends.
00:47:00.000 | There's different types of dividends.
00:47:02.000 | We're all getting our 1099s and we already got them.
00:47:05.000 | 1099-DIV or 1099-INT, which is for interest,
00:47:09.000 | and there's ordinary dividends,
00:47:10.000 | there's capital gain distributions,
00:47:12.000 | non-qualified dividends, qualified dividends,
00:47:14.000 | exempt dividends.
00:47:15.000 | I mean, all kinds of different dividends.
00:47:17.000 | Could you give us a kind of litany of what is this all about?
00:47:20.000 | For the most part, individual stocks are going to pay
00:47:23.000 | ordinary dividends, which will be qualified
00:47:26.000 | if you hold the stock for 61 days.
00:47:29.000 | You don't have to hold it for 61 days before the dividend,
00:47:33.000 | but you have to hold it for a total of 61 days
00:47:36.000 | in order to get that qualified dividend treatment.
00:47:39.000 | Mutual funds, their dividends can include a variety of items.
00:47:44.000 | If the mutual fund has interest income,
00:47:47.000 | that will come out as an ordinary non-qualified dividend.
00:47:52.000 | So technically it's not interest,
00:47:54.000 | but it is treated essentially the same as interest.
00:47:57.000 | It's ordinary income and it's going to be taxed
00:48:00.000 | at ordinary rates.
00:48:02.000 | If the mutual fund has received qualified dividend,
00:48:06.000 | then that qualified dividend can be passed through
00:48:10.000 | to the shareholders of that mutual fund.
00:48:14.000 | Those shareholders, again, have to hold for 61 days
00:48:17.000 | in order to get the qualified treatment.
00:48:20.000 | We get into more interesting aspects with, for example,
00:48:24.000 | if you have a mutual fund that pays out tax-exempt income.
00:48:28.000 | If the mutual fund invests in municipals,
00:48:32.000 | then it's going to have tax-exempt interest.
00:48:34.000 | It can pass that through as tax-exempt interest,
00:48:37.000 | and that interest can be tax-exempt federal,
00:48:40.000 | it can be tax-exempt on your state income tax,
00:48:45.000 | if that's applicable depending on the rules of your state
00:48:50.000 | and what state's municipals that the mutual fund invests in.
00:48:56.000 | So those are other possibilities.
00:48:59.000 | There's a special rule for mutual funds
00:49:02.000 | that says that if you have invested in that mutual fund
00:49:09.000 | for a period of less than six months
00:49:11.000 | and you receive a capital gain distribution from that fund,
00:49:15.000 | you can treat that capital gain distribution
00:49:19.000 | as capital gain on your tax return,
00:49:21.000 | but if you sell that mutual fund within six months
00:49:25.000 | and you sell it for a loss,
00:49:27.000 | then that part of that dividend is going to be converted
00:49:32.000 | into a short-term capital gain instead of a long-term capital gain.
00:49:37.000 | Now the reason for this is,
00:49:39.000 | imagine that if you have a clever, a wise guy, let's say,
00:49:44.000 | who is investing in mutual funds and selling
00:49:47.000 | and trying to get a tax advantage.
00:49:50.000 | You buy the mutual fund immediately before it pays out a capital gain dividend.
00:49:56.000 | You treat that as long-term capital gain
00:49:59.000 | and then you immediately sell that mutual fund for a loss.
00:50:04.000 | And it would be a loss immediately after the dividend pays out
00:50:07.000 | because that dividend payout reduces the net asset value of the mutual fund.
00:50:13.000 | So you sell it for a loss and you claim a short-term capital loss
00:50:17.000 | because you held it for less than a year.
00:50:20.000 | Well, that would create an artificial advantage for someone who did that.
00:50:24.000 | They're getting a long-term capital gain
00:50:27.000 | and immediately turning around and getting a corresponding short-term capital loss.
00:50:32.000 | So now we have a rule that says you don't have to wait a year,
00:50:37.000 | but if you wait less than six months before selling that mutual fund at a loss,
00:50:42.000 | you're going to get this corresponding treatment
00:50:45.000 | that wipes out the benefit you would get from that.
00:50:48.000 | And the same thing happens to a tax-exempt payout from a mutual fund.
00:50:54.000 | If you sell at a loss within six months after receiving one of those,
00:50:59.000 | then you're going to get a treatment that wipes out that loss
00:51:02.000 | up to the extent of the tax-exempt dividend that you received.
00:51:07.000 | Well, the very last thing I'd like to talk about is gifting.
00:51:12.000 | Gifting of appreciated stock, gifting it to charity, or gifting it to, say, your children.
00:51:18.000 | The benefits of that or the disadvantages of gifting of appreciated assets.
00:51:24.000 | Well, when you gift long-term appreciated assets to a charity,
00:51:32.000 | then you can, subject to limitations, treat the value of that gift
00:51:38.000 | as a charitable contribution deduction without having recognized any gain.
00:51:43.000 | So you're getting the same deduction that you would get
00:51:47.000 | as if you sold the stock or other investment and then gifted the proceeds,
00:51:54.000 | but you're getting that benefit in terms of charitable contribution deduction
00:51:59.000 | without having to report gain on a sale.
00:52:03.000 | So that's a very beneficial way of dealing with substantial charitable contributions.
00:52:10.000 | And I say substantial because nowadays small ones don't produce benefit for most people
00:52:16.000 | because most of us are not itemizing anymore.
00:52:18.000 | That's a really important point because a lot of people,
00:52:21.000 | they might only have their state and local taxes as a deduction and that's limited to $10,000.
00:52:27.000 | And then maybe their house is paid off so they don't have any interest,
00:52:30.000 | mortgage expense on their house and maybe they don't have high medical expenses.
00:52:34.000 | So the only other thing is a charitable contribution.
00:52:38.000 | And so if you're married, filing jointly, your standard deduction this year is almost $30,000.
00:52:44.000 | And so the first $20,000 that you would donate to charity wouldn't be a tax deduction
00:52:49.000 | because you're not going to be itemizing.
00:52:51.000 | You have to get over that amount.
00:52:53.000 | Yeah, that's correct.
00:52:54.000 | The massive increase in the standard deduction, again, this goes back to the 2017 tax law,
00:53:02.000 | a huge reduction in the number of people who itemize.
00:53:05.000 | And it is, in a sense, a great benefit for those people who,
00:53:10.000 | you'd rather take a $30,000 standard deduction than a $20,000 itemized deduction.
00:53:18.000 | But it also means that deductions of this kind, like charitable deductions,
00:53:24.000 | are of no benefit to a large number of people.
00:53:28.000 | What we do talk about a lot with the mogul heads is bunching of these charitable deductions
00:53:33.000 | and putting them into a donor advised fund.
00:53:35.000 | And I know we don't have a lot of time to get into what donor advised fund is,
00:53:38.000 | but if you're going to be giving $20,000 to charity every year
00:53:42.000 | and you're going to be giving appreciated stock,
00:53:44.000 | that it's better to give $100,000 in one year and put it in a donor advised fund.
00:53:49.000 | You get a $100,000 tax deduction on that because now you're above the standard deduction,
00:53:55.000 | plus your state and local taxes, so call it $110,000.
00:53:59.000 | And so you'd be able to take all of the amount of the deduction above the original $20,000
00:54:05.000 | that you donated can be given tax deductions.
00:54:08.000 | This is if you're in a high tax bracket because only 30% of your AGI would qualify for this.
00:54:13.000 | And then you put it in a donor advised fund and then over the next five years,
00:54:16.000 | you just dole out the money from the donor advised fund $20,000 a year to the charity that you want to give to.
00:54:22.000 | Now, you don't get a deduction in the following years,
00:54:25.000 | but you do get to deduct a large portion of that $100,000
00:54:29.000 | rather than every single year putting $20,000 to the charity
00:54:33.000 | and not getting any deduction for that $100,000.
00:54:36.000 | Yeah, the donor advised fund has been a huge benefit for people who want to do
00:54:42.000 | bunching or simply just want to be putting money in it into a charitable vehicle,
00:54:48.000 | but without having chosen those charities yet and paid that money out yet.
00:54:54.000 | It is, in a sense, kind of a workaround from the private foundation rules.
00:55:00.000 | The private foundation is another way of doing a similar thing, but at a far more expensive level,
00:55:06.000 | but with greater control by the individual who is setting it up.
00:55:10.000 | This is all great for charity, giving appreciated property to charity,
00:55:14.000 | but it's not something you may want to give to your children, correct?
00:55:18.000 | Well, they will still have to pay tax on the gain, so you're not avoiding that gain.
00:55:24.000 | It's property that you otherwise would be able to pass to your children at death if you hold on to it.
00:55:32.000 | I've seen people make this mistake.
00:55:34.000 | They're in their leader years and they think,
00:55:36.000 | "Oh, I should benefit my children by giving them this appreciated property."
00:55:42.000 | Of course, then they lose that step-up in basis.
00:55:46.000 | It can be one of the classic mistakes that people make.
00:55:50.000 | We could be talking about this for hours, if not days,
00:55:53.000 | all of the different things that we could do to lower our taxes.
00:55:57.000 | I do have a saying that if you hate paying taxes,
00:56:00.000 | then you should love to learn about taxes because that's how you can reduce your taxes.
00:56:07.000 | With that in mind, I want to thank you so much for being with us today.
00:56:13.000 | I learned a lot, and hopefully our listeners did also.
00:56:16.000 | It's been a great pleasure being here. Thank you for having me.
00:56:19.000 | This concludes this episode of Bogleheads on Investing.
00:56:23.000 | Join us each month as we interview a new guest on a new topic.
00:56:27.000 | In the meantime, visit boglecenter.net, bogleheads.org,
00:56:31.000 | the Bogleheads Wiki, Bogleheads Twitter.
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00:56:41.000 | Join one of your local Bogleheads chapters and get others to join.
00:56:45.000 | Thanks for listening.
00:56:46.000 | [Music]