What To Do With Your Cash?

Disclaimer: This article explains some potential options related to investing but does not constitute investment advice. Please get in touch if you would like to discuss your particular situation.

After years of near-zero interest rates, it is no surprise many people have left cash sitting around their checking, savings, and brokerage accounts. When rates were lower, there was little opportunity cost. However, that is no longer the case. Indeed, one glass-half-full takeaway from the investment malaise of 2022 would be the higher rates that are now available. Specifically, we now have much better opportunities to invest our cash than a year ago.

While banks have increased their rates in checking and money market accounts (MMAs), they still appear to be lower than many of the money market funds that can be easily accessed via brokerage platforms like Charles Schwab. For those who are not familiar with these investment options, money markets are generally viewed as a safe place with low risk where you can earn competitive rates of interest on your money. You can click here for Investopedia’s description of money market accounts and funds.

Given our newly found opportunity cost of leaving cash idle, I have found myself repeatedly explaining low-risk options for investing idle cash. So I thought it would be sensible to write a quick article summarizing the process. Hence this article!

For the most part, the following discussion explains how to invest using the Charles Schwab platform but I am sure you can do this with most major brokerage firms. I have broken the process down into three convenient steps:

1. Open an account

The first step is to open an account. If you do not already have an account at Charles Schwab, you can easily do this by clicking on the brown-ish OPEN AN ACCOUNT button located in the top right corner of www.Schwab.com.

open an account

The directions are relatively easy to follow but Schwab has excellent customer service (1-800-435-4000) should you need some assistance.

2. Transfer money & Schwab MoneyLink

Once your account is set up, you will need to move money into it. There are a variety of ways to do this (e.g., wire the money or send a check) but I find Schwab’s MoneyLink tool offers the most convenience. This tool allows you to easily transfer money between your bank and Schwab accounts. However, you do have to set up Moneylink first.

You can do this manually by filling out and submitting the Schwab MoneyLink form (accessible here: https://www.schwab.com/resource/moneylink-electronic-funds-transfer-form). However, I find it is easiest to set up MoneyLink from within your Schwab account. Of course, I can do most of this for you but you would have to be a client!

Note: The Moneylink setup process will typically only take 10-15 minutes in total time spent but will be spread over a couple of days for the deposit/withdrawal step detailed below.

mone money tab

Once you are logged in, simply choose the MOVE MONEY tab at the top and the corresponding TRANSFER & PAYMENTS option (see the screenshot above). Then you will see a link for connecting your bank account  (see the screenshot below).

link external bank account

This link will take you to another screen where you enter the details for your bank account. You will just need your banks routing number and your account number. If you do not know these, you can get them from the bottom of a check for that account (for checking accounts, of course). The screenshot below shows the inputs. As you can see, you should be listed as an account holder on the bank account as well.

bank details

Once you have completed this step, Schwab will make a couple of small deposits and withdrawals into and from your bank account (e.g., $0.06 and $0.13). Then they will ask you to confirm these figures to ensure that it is indeed the right bank account.

Et voile! Once you have completed this process, you should not have access to transfer money between Schwab and your bank account. Moving money is super simple and can be done via Schwab’s app (phone or tablet) or a web browser.

You just go to the same TRANSFER & PAYMENTS screen (under the MOVE MONEY tab) and choose the ONLINE TRANSFER option at the top of the page. From there, the directions should relatively straightforward. You will select the source account (your bank account where the money is coming from) and then select the destination account at Schwab (where the money is going to). NOTE: Transfer money to your brokerage or living trust account – NOT your retirement accounts as that would constitute a retirement contribution. Lastly, you will specify how much money to transfer. Then it usually only takes one business day (maybe two if you do this later in the afternoon) for the money to transfer.

online transfers

3. Invest the funds

The last step is to invest the funds that are now in your Schwab account. I cannot give general investment advice here but I will mention several options. Moreover, I will not go into much detail about these investment options as that would bloat the size of this article which is already longer than I anticipated.

Note: Unless otherwise mentions, all of the following investments can be implemented via the TRADE tab when you are logged into your Schwab account.

Money market funds

One of the easiest options is to invest in money market funds. Here is a link to various money market funds Schwab offers. You will see various types of money market funds. Just pick the one that is most appropriate for your situation, invest your money, and then take it out when you need it.

There are three primary categories – some of which are split into subcategories and tiers based on the size of your investment:

  • Prime money market funds: Invest in a diversified portfolio of short-term, high quality corporate and government bonds.
  • Government market funds: Invest in a diversified portfolio of short-term government bonds.
  • Municipal money market funds: Invest in a diversified portfolio of short-term municipal bonds.
CDs and bonds

You could also purchase certificates of deposit, treasury, or other low-risk bonds. Schwab’s fixed income tab displays many of these options so that it is easy to compare their interest rates across a variety of maturities. While holding any of these investments to maturity should result in getting your original investment back with interest, changes in interest rates could impact the value of these investments in the interim.

Multi-year guaranteed annuities (MYGAs)

One more option many investors favor is the multi-year guaranteed annuity or MYGA. This product is very similar to a CD but is only offered through insurance companies. Like a CD, a MYGA offers a fixed and guaranteed rate of interest based on the maturity chosen (e.g., 2-year versus 3-year).

 

Note: MYGAs are not accessible on the Schwab platform but I would be happy to assist you. I am an independent agent who can help you find the best rate by obtaining quotes from a variety of high-quality insurance carriers. Please get in touch if you are considering a MYGA or other type of annuity.

 

Another similarity is that an MYGA will also impose a penalty for money withdrawn before the contractually guaranteed period. However, one advantage MYGAs also have is a provision whereby investors can take out a certain amount of money each year without penalty before the product maturity. While investors may appreciate this extra penalty-free liquidity, there are two other factors that I believe investors find most attractive about MYGAs.

The first is its interest rate. MYGAs often offer rates that are higher than comparable CDs or bonds. However, you should exercise some caution. Just like bonds, lower-quality issuers typically offer higher interest rates to compensate for the higher risk. So I recommend only buying annuities (or bonds) from higher quality insurance companies with A-ratings.  This article provides a nice summary and comparison of CDs, bonds, and MYGAs.

The second factor that I believe attracts the most investors to MYGAs is their tax deferral. While interest is taxed along the way for CDs and bonds, MYGAs (like many annuity products) are only taxed when money is taken out. So they can allow your investment to compound without tax friction. Moreover, this gives investors more control over their taxation.

For example, one common application arises when someone is just a few years away from retirement. Instead of investing in a bond or CD and triggering taxes while they are still employed, a MYGA could allow them to defer the taxation of this investment until they are in retirement and presumably in a lower tax bracket.

Summary

This article outlined some simple steps that can allow you to start generating more interest on your idle money. It also highlighted the various types of low-risk investments that are available. I hope it was helpful but please do not hesitate to reach out if you have any questions.

Exchange-traded Fund (ETF) Tax Efficiency

Disclaimer: This article explains some potential options related to investing but does not constitute investment advice. Please get in touch if you would like to discuss your particular situation.

Note: Please see my video  discussion of this topic below or other videos on my videos page. You may also want to read my PDF guide entitled Sensible Strategies to Reduce Your Taxes or other articles regarding retirement accounts on my Research page

 

Some people attribute their tax efficiency to the low-turnover nature of the indices underlying many ETFs. Low turnover is a factor but there is another critical driver of ETF tax efficiency: their in-kind creation and redemption process. If are interested in this topic, here is a link to an article on this topic: WHY ETFS ARE MORE TAX-EFFICIENT THAN MUTUAL FUNDS.

Related content

You may also learn more about me and my firm here:

Video on ETF tax efficiency:

Tax Efficiency Part III: Asset Location

Disclaimer: This article discusses topics at the nexus of investments and taxes, but does not provide and should not be construed as providing tax advice. Please contact your CPA or tax professional for guidance on tax-specific issues.

Note: Please see my video  discussion of this topic below or other videos on my videos page. You may also want to read my PDF guide entitled Sensible Strategies to Reduce Your Taxes or other articles regarding retirement accounts on my Research page\

This article discusses asset location and should not be confused with asset allocation. The latter refers to how your portfolio is allocated across different asset classes (e.g., 60% stocks/40% bonds). Once you have determined your asset allocation, asset location determines how those assets are distributed across types of accounts and investment vehicles with different tax characteristics.

As you may recall from my previous blog article, investment-related taxes are those which stem from your investment holdings. These include dividends, interest, rental income, and capital gains (e.g., via portfolio rebalancing or liquidation). These are different than the income taxes you pay on money you earn – which we discussed in my first blog article. However, it is worth noting that bond interest and rent (minus costs and depreciation) are also taxed as ordinary income. Please see the Income Stacking section of my previous blog article to understand how these interact with each other.

Given that asset location relates to both income and investment-related taxes, this topic could have been included in either of my previous two blog articles. However, I figured those articles were already long and complicated enough. Moreover, I find asset location represents lower-hanging fruit. That is, the relevant logic is fairly intuitive and you can often apply it almost instantly once you learn about it. For these reasons, I decided to carve it out and address asset location on its own.

Some preliminaries

Before we discuss the logic and strategy around asset location, it is helpful to understand how taxation differs across some of the primary types of investment accounts and investment vehicles. Please click to expand the boxes below for more details regarding how these accounts and vehicles are taxed.

  • Taxable accounts: Standard brokerage (and living trust) accounts hold are 100% taxable when it comes to investment-related taxes. The same goes for interest-bearing bank accounts including certificates of deposit (CDs).
  • Tax-deferred retirement accounts (TDA): These are your standard retirement accounts where you contribute money while you are working (401K, 403B, IRA, etc.). These contributions are (effectively) not taxed when you earn them. Moreover, this money can compound and grow without investment-related taxes. Ultimately, these funds will ultimately be taxed as ordinary income once they are distributed.
  • Tax-free (i.e., Roth) retirement accounts: These are your Roth retirement accounts (e.g., Roth 401K or Roth IRA). Money in Roth accounts can also compound and grow without investment-related taxes. However, unlike TDAs, income taxes have already been paid on these funds and they can grow tax-free until the funds are distributed.
 
  • Municipal bonds: Interest from municipal bonds is generally exempt from federal income tax. However, it may still trigger other taxes. For example, state and local taxes may still apply and municipal bond income is still included in other tax calculations (e.g., those that depend on MAGI). It is also worth noting municipal bond yields are typically lower than comparable taxable bonds with similar risk. So yields should be compared on an after-tax basis. Lastly, bond decisions should also account for portfolio effects since some types of bonds provide better diversification benefits than others.
  • Annuities: These are products issued by insurance companies whose performance may or may not depend on one’s longevity. Annuities typically provide tax benefits that are similar to tax-deferred accounts (like IRAs). That is, there are not taxes on the growth within annuity products. However, the growth is eventually taxes as ordinary income (not capital gains) once it is distributed. While some are complex and have garnered criticism, not all annuities are bad; some allow for flexibility in financial/tax planning (lifelong income, tax exclusion ratios, etc.). For more on this topic, please see my articles on annuities here and here.
  • Life insurance: Life insurance (if properly structured) is a unique asset in the sense there is no tax on its growth and the death benefit is tax-free as well (i.e., income or capital gains taxes do not apply) – similar to a Roth retirement account. While I think life insurance is oversold due to the incentives from its commissions, I do believe it can still be helpful in specific situations.
  • Trusts: Trusts are separate legal entities created for the benefit of specific persons (beneficiaries) and managed by another party (a trustee – who may also be a beneficiary) on behalf of the beneficiaries. There are various tax implications for the creation and funding of trusts, the investment-related taxes within trusts, and the distributions made from trusts. While beyond the scope of this article on asset location, many trusts (e.g., irrevocable and charitable trusts) can be used for the purpose of tax efficiency (e.g., reducing investment-related, income, and estate taxes).

Some people claim it is better to pay taxes on money before it grows instead of paying a bigger tax bill (in absolute terms) after it grows. However, this logic is faulty. All else equal (tax rates, time horizon, and growth), paying tax at the outset or at the end results in the same exact amount of after-tax dollars being available at the end. The simple fact is that the tax rate applies multiplicatively and it does not matter what order you multiply numbers. If C is the original amount of the contribution, G is the investment growth, and T is the tax rate, then the amount of after-tax money at the end is the same:

Let’s follow what happens to $1 of retirement money when we contribute to a 401K that grows 10-fold to $10 while invested. The $1 becomes $10 via investment growth and then tax consumes $2.50 when it is ultimately distributed – leaving $7.50 to spend. Now let’s follow what would happen if we used a Roth 401K instead where we paid the tax upfront. In this case, we start with $0.75 in the Roth 401K and it grows 10-fold to $7.50 with no more taxes due. So the results are the same.

Truth be told, I brushed some details under the rug here; all else is not equal. For example, Roth accounts effectively allow for higher contributions. That is, we could have contributed one full dollar to the Roth if we had external cash on hand to pay the tax. Roth accounts also avoid required minimum distributions down the road. So that money may be able to enjoy the tax-shielding benefits longer than if they were forced out into taxable accounts.

On the flip side, taxes are typically lower during retirement. So it might make it more sensible to use traditional (non-Roth) retirement accounts. For more on these nuances, I went into significantly more detail here and here (warning: these articles are a bit more technical).

Asset location strategy

Now that we have listed the tax characteristics for various types of accounts and investment vehicles, we can start to think about strategies for where to place the assets you have decided to own (recall: the asset allocation decision takes priority). Unfortunately, there are too different factors that can determine your optimal asset location strategy.

  • Relative levels of taxation on retirement accounts versus capital gains
  • Likelihood of needing to liquidate assets during life
  • Availability of step-up basis (politicians are discussing this notion)
  • Longevity expectations
  • Gifting intentions
  • Tax credits + eligibility for various subsidies (e.g., affordable care)
  • IRMMA (investment-related monthly Medicare adjustments)
  • NIIT (net investment income tax)
  • Taxation of Social Security (watch out for the torpedo!)

Given the number of factors involved as well as how they interact, financial planning software is required to truly optimize your asset location. Notwithstanding, here I highlight two primary rules of thumb that are both important and intuitive. In particular, you may be able to use these factors to quickly and easily make sensible adjustments to your own asset location.

The first rule of thumb

The first rule of thumb focuses on the tax efficiency/inefficiency of different assets. When it comes to investment-related taxes (i.e., from dividends, interest, and capital gains via portfolio rebalancing/liquidation), some asset classes or strategies are more tax efficient than others. Here are three examples:

  • Funds or strategies with high turnover (e.g., hedge funds) would likely spin off significant short-term capital gains. Accordingly, these types of funds would typically be placed in a retirement account where those taxes would not apply.
  • Taxable bonds and bond funds (i.e., not municipal bonds/funds) pay interest that is taxed as ordinary income. This makes them tax-inefficient as the tax on the interest can significantly reduce the benefits of compounding. Moreover, this is especially true for high-yield bonds where the yields (hence taxes) are higher. As a result, it often makes sense to hold taxable bonds and bond funds in retirement accounts as well.

Low-turnover stock portfolios and funds – especially exchange-traded funds  (ETFs) – are typically much more tax efficient. Less turnover leads to fewer capital gains but the dividends they pay (assuming they are qualified) are taxed at the long-term capital gains rate – not as ordinary income. So it often makes sense to  hold these in taxable accounts.

The second rule of thumb

The second rule of thumb I highlight relates to growth expectations. Recall that tax-deferred retirement accounts (e.g., 401Ks, 403Bs, and IRAs) will ultimately be taxed as ordinary income. Thus, if you grow your traditional IRA, then you will also grow your tax bill too. So that may be the last place you want to place higher-growth assets. Instead, it is generally better to hold them in either Roth or taxable accounts.

In a Roth account, the growth will be tax-free. So this can be the ideal location for higher-growth assets like stocks over the long term. Of course, if you experience gains in a taxable brokerage account, then those gains will be taxable. However, this growth is only taxed as a capital gain (not ordinary income). Moreover, if you were to hold this asset throughout retirement and pass it on to heirs, then it would receive a step-up in basis. In particular, this would result in no tax on the growth (assuming current tax law and the taxes on dividends along the way).

Tax on investment growth

Parting words

I find asset location offers low-hanging fruit in terms of an opportunity for investors to reduce their taxes. The factors I described above should help in understanding some of the logic involved. However, as with other areas of financial planning (especially those involving taxes), I strongly advise utilizing a financial planner who uses financial planning software that is devoted to this purpose. I prefer Income Solver due to its superior calculation engine even if its interface and reports are less glamorous than other packages.

Unfortunately, I find many advisors opt for planning software packages that are easier to use and create more aesthetic (interactive) reports to show to their clients. Moreover, I believe it is also important for financial planners to augment software output to address areas the software does not (e.g., disclaiming and beneficiary strategies – see my video discussion of this topic on my videos page).

Related content

You may also learn more about me and my firm here:

Video on the same topic:

Tax Efficiency Part II: Investment-related Taxes

Disclaimer: This article discusses topics at the nexus of investments and taxes, but does not provide and should not be construed as providing tax advice. Please contact your CPA or tax professional for guidance on tax-specific issues.

Note: Please see my video  discussion of this topic below or other videos on my videos page. You may also want to read my PDF guide entitled Sensible Strategies to Reduce Your Taxes or other articles regarding retirement accounts on my Research page

This article discusses investment-related taxes. These are the various taxes that surface when you have an investment portfolio held in a taxable account (e.g., not a retirement account). For the purpose of this discussion, please assume the context is always a taxable account unless otherwise specified. I describe three primary examples of investment-related taxes below.

  1. Capital gains: When you purchase an investment and sell it for more than the purchase price (putting potential depreciation or cost basis changes aside), then you have made a capital gain and this gain may be taxed. The capital gains tax rate is typically lower than the corresponding ordinary income tax rate when it is a long-term (LT) capital gain (i.e., the investment was held for more than one year). Otherwise, it would be a short-term (ST) capital gain and taxed as ordinary income.
  2. Stock dividends: If you own stocks or stock funds (e.g., mutual funds or ETFs), then you will very likely receive dividends from many of the companies in your portfolio. Most of these dividends will be qualified (for more details on the definition of qualified dividends, please see page 19 of IRS publication 550) and are effectively taxed as capital gains. However, some are classified as non-qualified (a.k.a. ordinary) dividends and are taxed as ordinary income.
  3. Bond interest: Any interest paid by bonds is taxable as ordinary income. It is worth noting that interest accrued while holding a bond but not paid out (e.g., a zero-coupon bond) is also taxable. Note: Interest from municipal or tax-exempt bonds is generally not taxable.

Some strategies to minimize investment-related taxes

Now that I have defined these primary types of investment-related taxes, let’s discuss ways to minimize them. Below I highlight many of the most common strategies to do so.

I know many investors enjoy picking stocks and investments. However, the math is rather unforgiving as few investors actually beat the market – let alone on an after-tax basis (see Sharpe’s Arithmetic of Active Management but I plan on addressing this in a future blog article/video). Even if one manages to beat the market with their skills, the tax friction can significantly reduce the rate of compounding and their ultimate after-tax return.

Based on the same logic as the previous point, it is sensible to use low-turnover investment mutual funds. Many of these are index funds tracking broad market indices. While many fund products and portfolio managers may advertise tax-aware strategies to address this, there can still trigger significant capital gains taxes.

I believe ETFs represent the greatest invention for the taxable investor in the history of investing. I plan to discuss this is more detail in a future blog article/video but the bottom line is that the IRS has blessed ETFs with a particular tax benefit that allows them to minimize – if not eliminate – taxes from their internal rebalancing (spoiler: they use in-kind creation and redemption). This gives investors and advisors much more control over their taxes. This benefit is so powerful that many mutual fund companies are converting existing funds and launching new ones using the ETF structure. While many people associate ETFs with index investing, even active managers are starting to use the ETF wrapper for their strategies (see this Barron’s article). If you cannot wait for my content, here are two articles discussing this topic from Alpha Architect and the balance.

While similar logic applies to stock dividends, I find high-yield (HY) bonds can be the most problematic from a tax perspective. Recall from above that bond interest is taxed as ordinary income. So HY bonds naturally create more ordinary income. This can significantly increase the taxes on one’s portfolio. One solution could be to place these types of investments in retirement accounts (spoiler: I will discuss this in the context of the broader topic of asset location in my next blog article and video). While unrelated to taxes, I think it is also worth pointing out that HY bonds involve more risk and typically provide less diversification benefit during volatile periods. I rarely use these products for these reasons.

In an effort to support various government entities, the IRS does not directly tax the income from bonds issued by many municipalities. In other words, this makes their interest payments more taxable to investors since they are generally not taxed (though the interest may be used for other tax calculations). However, this is not necessarily a free lunch for investors since the prices of municipal bonds are often pushed up to a point where the resulting yields (intuitively, this can be thought of as the annual interest payments divided by price) are lower than the rest of the market. So one should compare after-tax performance and this depends on their specific tax situation.

When one’s portfolio holds investments that have decreased in value, it can be advantageous to sell those investments to capture the loss (and possibly replace them with similar investments). This loss can allow one to sell other holdings with gains as withdraw funds or rebalance a portfolio with greater tax efficiency. Moreover, the first $3,000 of (net) capital losses can be used to offset income in each calendar year. This makes tax-loss harvesting a potentially valuable strategy. For those in lower tax brackets, tax gain harvesting may also be helpful. That is, investors can make use of their zero tax brackets for capital gains by taking gains that trigger no or little taxes. This can create liquidity for withdrawals or be used to systematically increase the cost basis for some of their holdings. It is worth noting the IRS has put in place various restrictions around these activities (e.g., the wash sale rule). So you should be careful when implementing these strategies.

Under the current tax code (February 2022), inherited assets receive a step-up in basis. That is, even if the deceased previous owner had large gains in an asset, the cost basis is adjusted upward to current market value when they are inherited by someone else. It is worth noting this can include spouses if assets are individually titled (or in a community property state or trust). For example, married couples may find it advantageous to title appreciated assets in the name of the person with the shortest expected longevity.

While I could write an entire book about this topic, the basic idea is that it is very important for retirees to strategically withdraw money from their accounts in such a way to minimize their tax burden over the long term. All too often I see retirees (and accountants!) minimizing taxes in the current year or stubbornly not touching their Roth accounts. This almost inevitable creates a ballooning tax bill somewhere else. Given the way various taxes interact with each other (e.g., see the section below on Income Stacking) this topic is too complex to describe in detail. However, the basic idea is to proactively manage your tax brackets to maximize the after-tax performance of your assets.

While annuity tax benefits are strongly marketed, you have to be very careful; the tax implications can be good or bad depending upon the product and how it is used. One benefit annuities can provide is tax-deferred growth. However, that growth is ultimately taxed as ordinary income. This can be quite punitive for stock-based investments since the growth would only be taxed as capital gain otherwise (i.e., without an annuity). Moreover, the IRS looks at withdrawals on a LIFO (last in first out) basis. That means they assume the first withdrawals will be the growth portion and will thus be taxed as ordinary income. Then the last withdrawals will comprise the original investment basis (return of capital) and not be taxed. This can be good or bad depending upon one’s situation.

While many people are unaware of the distinction, the tax treatment for annuitization is different than for withdrawals. Withdrawals maintain some degree of liquidity to the account from where they are being taken. However, annuitization represents an irreversible decision to convert cash into guaranteed income. As such, the IRS taxes annuitized income differently. While I will not go into the details here, these tax calculations make use of an exclusion ratio to define what portion of each payment is and is not taxable (i.e., interest or growth versus basis). This approach is generally beneficial to investors – especially if they structure their income annuities in an optimal manner (see Optimizing Income Annuity Tax Deferral).

Life insurance is an interesting option in that it represents the only asset (to my knowledge) that can grow on a tax-deferred basis but also incur no tax when paid out (as a death benefit). Of course, Roth accounts tick these boxes but require one to earn money to qualify and then there are contribution limits that constrain the amount one can put into these accounts.

Life insurance policies are increasingly being structured to leverage this benefit from a tax and investment perspective. Moreover, they can do it in such a way (building cash value) whereby the owner can maintain tax-efficient liquidity by borrowing from their policies. Of course, the old saying still stands: Life insurance is not bought; it is sold. So you really have to be careful here too. Less scrupulous agents toss around illustrations and language that can be misleading. One piece of advice if you are considering life insurance: Always ask what the worst-case scenario is. Agents are required to include this guaranteed outcome illustration within broader illustrations. This outcome will not depend on the performance of an index or investment and it will not involve the insurance carrier’s dividend if you are speaking with a mutual insurance company (i.e., a carrier that is owned by its policyholders). In my experience, agents tend to lead with illustrations that are based on some presumed investment performance and are thus not guaranteed.

Another consideration: Income stacking and tax rates

As highlighted above, capital gains and dividends are eligible for tax rates that are typically lower than income tax rates. Moreover, there are multiple tax brackets for capital gains and the standard deduction applies to them as well. However, the calculations of ordinary income and capital gains are not separate; they are combined.

I find the most intuitive way to think about the combined calculation of income and capital gains taxes is to visualize them as being ‘stacked’ with ordinary income on bottom and capital gains on top. However, the ordinary income and capital gains are taxed according to their respective tax brackets and rates.

Ordinary income and LT capital gain stacking

Income stacking

Source: Aaron Brask Capital

Note: I did my best to reflect current tax rates and make this illustration to scale (as of 2022) but both the tax brackets and rates of taxation are subject to change.

Benefits of income ‘stacking’

There are two benefits worth highlighting here. First, stacking income with capital gains on top is beneficial for most tax payers due to the fact income tax rates are significantly higher than LT capital gains tax rates. If the stacking was reversed (with income tax on top of capital gains), then tax bills would generally be higher due to the higher marginal rates on ordinary income For example, last dollar of income depicted in this illustration is taxed at a 15% rate since it is a capital gain. If income were on top, this last dollar of income would be taxed at 35%.

The second benefit derives from the fact that LT capital gains taxation has a 0% tax bracket. This bracket exists above and beyond the standard deduction – which effectively functions like an initial 0% tax bracket itself. This additional 0% tax bracket for capital gains may allow for a significant amount of tax loss harvesting depending on one’s situation.

In retirement, we often want to make use of any spare capacity in lower tax brackets (see my article + video on income tax). However, there is another option: tax-gain harvesting. That’s right: gain harvesting. Some of you might be familiar with tax-loss harvesting but this is different. An example may be instructive.

Example: Let us assume Jane is single, 60 years old, has no ordinary income, and has a portfolio with unrealized capital gains. In this situation, she would be able to realize a significant amount of capital gains without paying any taxes. How is that?

Well, first she has her standard deduction ($12,550 in 2021). So there would be no tax on realized gains up to this amount. Then there is no tax on the capital gains in the first 0% tax bracket (up to $40,400 in 2021). So that means Jane could trigger as much as $52,950 ($12,550 + $40,400) in capital gains without paying a penny in capital gains taxes.

When these situations arise, it is almost always sensible to harvest the gains and re-establish the same or similar positions. This raises the cost basis of these positions and minimizes potential capital gains taxes paid later. However, you must be sure that all of the shares have gains. That is, it is possible that some holdings actually embed a loss even if the average price of that holding embeds a gain. If you sell a position that triggers a loss and then buy it back too quickly, you can violate the wash-sale rule.

Astute readers may have noticed I made two different recommendations for utilizing spare capacity in lower tax brackets: tax-gain harvesting (this article) and Roth conversions (my previous article). Prioritizing between or combining these strategies can be tricky. Complicating matters further are factors such as:

  • Tax credits + eligibility for various subsidies (e.g., affordable care)
  • IRMMA (investment-related monthly Medicare adjustments)
  • NIIT (net investment income tax)
  • Taxation of Social Security (watch out for the torpedo!)

As with income tax planning, I strongly advise utilizing a financial planner who uses financial planning software that is devoted to this purpose. I prefer Income Solver due to its superior calculation engine even if its interface and reports are less glamorous than other packages.

Unfortunately, I find many advisors opt for planning software packages that are easier to use and create more aesthetic (interactive) reports to show to their clients. Moreover, I believe it is also important for financial planners to augment software output to address areas the software does not (e.g., disclaiming and beneficiary strategies – see my video discussion of this topic on my videos page).

Related content

You may also learn more about me and my firm here:

Video on the same topic:

Tax Efficiency Part I: Income Tax

Disclaimer: This article discusses topics at the nexus of investments and taxes, but does not provide and should not be construed as providing tax advice. Please contact your CPA or tax professional for guidance on tax-specific issues.
Note: Please see my video  discussion of this topic below or other videos on my videos page. You may also want to read my PDF guide entitled Sensible Strategies to Reduce Your Taxes or other articles regarding retirement accounts on my Research page

Many (most?) people I encounter tend to focus on investing and returns. Of course, this is an important part of financial planning. It can be fun and many people enjoy (or are addicted to?!) taking active roles in their portfolios.  However, investing can be a double-edged sword. Indeed, higher returns often involve higher risk, most people underperform the broader market (see Sharpe’s Arithmetic), and active portfolio management can trigger unnecessary capital gains. Note: These are three key reasons why I tend to lean toward low-cost index funds and ETFs (exchange-traded funds).

Unfortunately, these same investors rarely have a solid grasp on broader financial planning and how it can lower their taxes. So that is the point of this article. In particular, I will provide a broad description of strategies used to minimize taxes on your income. I will discuss strategies to lower what I call investment-related taxes (i.e., taxes on capital gains, dividends, and interest) in another article down the road.

A general example

Before delving into some of these strategies below, I would like to introduce a simple example. As of this writing, it is the last week of 2021 and Jane Doe has the opportunity to make $100,000 by doing two different projects for $50,000 each. We will assume she has no other income this year and does not anticipate any next year either.  We will further assume she has the ability to choose when she completes these projects. This translates into three options:

  1. Complete both projects immediately and earn $100,000 in 2021
  2. Relax until the new year, then complete both projects and earn $100,000 in 2022
  3. Complete one project immediately and one in 2021 so she earns $50,000 in each year

From a tax perspective, the best option is #3. This is due to the progressive tax system we follow in the United States. If she earns $100,000 in a single year, many of those dollars will likely be taxed at a marginal rate of 24% even after her standard deduction. However, if she splits it up, she would get the benefit of applying her standard deduction twice and never climbing higher than the 12% bracket.

While this is a single hypothetical example considering just two years, the idea generalizes throughout one’s lifetime. The idea is to use different strategies in order to level or flatten out our income throughout our lifetimes. This will help us minimize the amount of income that pokes up into higher brackets and incurs higher marginal tax rates.

The most popular tool: Retirement accounts

I think the most popular strategy to lower your income taxes is to contribute to your traditional (i.e., non-Roth) retirement accounts. By making contributions to these retirement accounts, you effectively avoid (albeit only temporarily) paying income tax on those earnings. So your tax bill in the current year is reduced.

The money you contribute as well as its growth will ultimately be taxed as income when it is taken out. Therein lies the key benefit; most people will be in lower tax brackets during retirement since they are no longer working. So the tax rate on this income will very likely be lower than if it were paid in the year it was earned.

This can often result in a 10-20% lower tax rate – especially when optimized during retirement (see the section below on Roth conversions). This strategy helps to level one’s income (and hence income tax) throughout their lifetime and follows the logic of the example highlighted above.

Another benefit of using retirement accounts is that they impose no taxes any dividends, interest, or portfolio rebalancing (i.e., capital gains). If the same investments were made in a normal, taxable brokerage account, then these types of taxes would have applied – thus reducing the benefit of compounding and overall growth rate.

Maximizing retirement accounts

Given the significant benefits described above, why would any choose not to defer more their taxes until retirement? Unfortunately, one common reason is people wanting or needing the money now. Even when someone wants to contribute more to their retirement accounts, there is another reason: contribution limits.

Depending upon what type of retirement plan you have (e.g., 401K, 403B, IRA, etc.), there will be limits on how much you can contribute. For example, the maximum contribution to a standard 401K is $19,500 in 2021 for workers aged 49 and under. It is also worth noting that employers often match some or all of their employees’ contributions and this makes the economics on retirement contributions even more compelling.

Many prudent savers max out their contributions to their 401K but it is also worth noting that you may also make contributions to (individual retirement accounts (IRAs) outside of their employer plans. However, income limits may apply and impact the deductibility of those contributions. So you should check to make sure your retirement contribution strategy makes sense for your situation. The next section touches on one special case: high earners.

Roth accounts and high earners

Roth retirement accounts are another option available to many of us. These are similar to the retirement accounts above except:

  • These contributions are still taxed in the current year
  • Money grows tax free (i.e., no tax when money is taken out – unless the tax code changes!)
  • Required minimum distributions do not apply
  • Different limitations apply

The discussion above involved deferring income tax until you are in a lower tax bracket during retirement. However, if you are a higher earner and the math works out a certain way, then Roth accounts may be sensible. For example, if you are stuck in higher brackets even during retirement, then there may be no benefit to deferring income tax.

In this case, you might consider how the tax rates (not tax brackets) might be different down the road. In my experience, most people (including myself) expect taxes to go up – especially relative to the current (2021) rates we enjoy now on the back of Trump’s Tax Cuts and Jobs Act (TCJA).  However, it is also important to consider the potential benefits stemming from no RMDs. I find this is an often-ignored topic. So I have devoted much research to this topic (e.g., the articles here and here).

Note: Income limits prohibit many of the people who would benefit most from using Roth contributions. However, under current (2021) tax law, there is another way for higher earners to get money into Roth accounts. The method is called the backdoor Roth strategy. While I will not go into the details, the basic idea is to make nondeductible contributions to retirement accounts and soon after convert them to Roth accounts.

Optimizing further: Roth conversions

Some people think it is best to leave their IRAs alone for as long as possible to maximize tax benefits. However, this is often not the optimal strategy. There is another powerful strategy we may be able to use in order to level one’s income further during retirement.

For many, there is a period between when someone retires or semi-retires (i.e., stops or reduces their earning) and when they start taking their full Social Security benefits or are required to distribute money from their retirement accounts (i.e., RMDs). In other words, there may be a period where they temporarily find themselves in lower tax brackets.

These situations open the door to making Roth conversions. That is, one can pay taxes and convert parts of their traditional retirement accounts to Roth retirement accounts (e.g., traditional IRA to Roth IRA). This allows them to pay taxes on some of their retirement balances in lower brackets but not lose out on the other retirement account benefits (i.e., no tax on dividends, interest, or capital gains from rebalancing). Again, this facilitates the general idea of leveling out their income throughout retirement in order to minimize poking up into higher tax brackets.

Determining the optimal amount of Roth conversions is a complicated task that involves many variables:

  • Size of retirement accounts
  • Spending needs
  • Current + future tax rates
  • Beneficiary tax brackets
  • Longevity expectations
  • Social Security elections
  • Tax credits + eligibility for various subsidies (e.g., affordable care)
  • IRMMA (investment-related monthly Medicare adjustments)
  • NIIT (net investment income tax)
  • Taxation of Social Security (watch out for the torpedo!)

Accordingly, I strongly advise utilizing a financial planner who uses financial planning software that is devoted to this purpose. I prefer Income Solver due to its superior calculation engine even if its interface and reports are less glamorous than other packages.

Unfortunately, I find many advisors opt for planning software packages that are easier to use and create more aesthetic (interactive) reports to show to their clients. Moreover, I believe it is also important for financial planners to augment software output to address areas the software does not (e.g., disclaiming and beneficiary strategies – see my video discussion of this topic on my videos page).

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