The John C. Bogle Center is pleased to announce the seventeenth episode of Bogleheads® Live. This episode with Steven Fox answers questions on taxes for millennials.
Steven Fox, CFP®, EA is the founder of Next Gen Financial Planning, a Registered Investment Advisor in the state of California.
Bogleheads Live with Steven Fox
Jon Luskin: Bogleheads® Live is a weekly Twitter Space where the Bogleheads® community asks questions to financial experts live. You can ask your questions by joining us live on Twitter each week. Get the dates and times for the next Bogleheads® Live by following the John C. Bogle Center for Financial Literacy on Twitter. That's @Bogleheads. For those that can't make the live events, episodes are recorded and turned into a podcast. This is that podcast.
Thank you for joining us for the 17th episode of Bogleheads® Live, where the Bogleheads® community asks questions to financial experts live. My name is Joe Luskin, and I'm your host. Our guest for today is Stephen Fox. Today, we'll be answering your questions about tax planning for millennials. We'll rotate between asking Steve questions that I got beforehand from the Bogleheads® forums at Bogleheads.org and taking live audience questions from the folks here today.
Let's start by talking about the Bogleheads®, a community of investors who believe in keeping it simple, following a small number of tried and true investing principles. You can learn more at the John C. Bogle Center for Financial Literacy at boglecenter.net.
The annual Boglehead conference is on October 12 through 14th in the Chicago area. Speakers include Eric Balchunas, author of The Bogle Effect, economist Bert Malkiel, Jason Zweig of the Wall Street Journal, Rick Ferri, host of the Bogleheads® on Investing podcast, Christine Benz, Director of Personal Finance at Morningstar and much more. You can find a link to register at the top of the Investment Theory & News in the general forum at Bogleheads®.org.
Mark your calendar is for future episodes of Bogleheads® Live. Next week we'll have a very special guest, Barry Ritholtz, host of the Bloomberg podcast Masters in Business. The following week we’ll have JL Collins, author of The Simple Path to Wealth, and the week after that we'll have Jim Dahle, aka The White Coat Investor.
We are looking for editors, transcribers and for help with grouping transcriptions to help spread the message of low cost investing. Shoot me a DM @Jon Luskin on Twitter.
Before we get started on today's show, a disclaimer. This is for informational and entertainment purposes only and should not be relied upon as a basis for investment, tax or other financial planning decisions.
Thank you for everyone who has any questions ahead of time on the Bogleheads® forum. We might not have enough time to answer all those questions.
Let's get started on today's show with Stephen Fox. Steven Fox CERTIFIED FINANCIAL PLANNERTM, EA [Enrolled Agent], is the founder of NextGen Financial Planning, a registered investment adviser in the state of California, providing comprehensive fee only financial planning services for young professionals.
Steven, thanks for joining us today on Bogleheads® Live. Let me jump into the first question that I have from FiveK from the Bogleheads® forums. He writes, “How do I plan so that there are no surprises when I file my taxes next year?”
Stephen Fox: You need to be proactive about it. Everybody should be doing an estimate every year of what their total tax liabilities go for the year, and comparing that against the sum of withholding from their paychecks if they're employed, or for estimated payments if you're self-employed. The IRS has on the website a Tax Withholding Estimator. You put in the different types of income that you have and the amount that's being withheld or paid in quarterly payments. Then it will tell you how much you should be withholding, and you can get a pretty good estimate there.
There are a number of other online calculators, like TurboTax offers one, pretty much every major tax prep software will have one. If you hire a tax preparer every year, they should definitely be able to do this for you pretty easily using the same tool that they use to file your returns or a related one. But the only way to not be surprised is to be proactive about it.
David: Jonathan Clemens has a wonderful blog called Humble Dollar, recommended you hold your value stocks in tax favored accounts, growth stocks in taxable accounts. What investment products do you recommend as the optimal portfolio from a tax perspective? Where do you park those funds? Thank you.
Stephen Fox: He asked a great question, thanks for asking. Like anything else with tax planning, it's going to be highly situational independent. Worth looking into is asset location. You put different types of assets inside accounts with different types of tax treatments. Let's say you want to have a portion of your portfolio in small cap value and you're expecting that to appreciate more rapidly over a long period of time than other asset classes that you're investing in. You might want to put that small cap value fund inside of a Roth account.
Another example of asset location, usually you would not want to have a target date fund or any type of fund-of-funds inside of a taxable account. Same with if you have an asset that is expected to pay a high amount of dividends or interest and you're in a high marginal bracket right now, you probably don't want to have that inside of a taxable account. Those are some basic examples of the idea of asset location.
In terms of specific products, ETFs are generally going to be more tax-advantaged than mutual funds because you have control over when you realize income from the investments, whereas mutual funds have distributions pass straight through over to you, sometimes even when you have a loss in the fund. So, ETFs over mutual funds inside taxable accounts if you care about taxes.
In terms of other financial products that might make sense from a tax-efficiency perspective, sometimes annuities or different types of permanent life insurance policies can have real tax advantages there and opportunities to defer taxes on it. But you should never buy a financial product in those categories just for that purpose. Only buy it if they otherwise make sense to do so. Imagine I'm preaching to the choir a little bit there. I'm talking to a bunch of Bogleheads®, but never buy a financial product just for that reason.
One of the things that comes to mind is a lot of people fail to consider an idea that's called tax diversification. Look at the portion of your overall investments that you have inside different tax treatments. Maybe you have 10% inside taxable investment accounts, and 50% in Roth and the remainder inside pre-tax accounts. Looking at that balance across those categories, the idea of tax diversification is that you might consider shifting some proportion of your net worth into a category that you might be underweight in, similarly to how you would consider asset classes that you're over or under invested in.
Because if you're 20, 30, 40 years old, you're dealing with a really long time horizon. There could be future tax law changes that are unfavorable. You have no idea what the tax code is going to look like in the year 2050. You have more broad tax diversification there. Then you're increasing the flexibility of tax planning options that you have available and you're also increasing the options that you have for distribution and tax planning.
Jon Luskin: With respect to splitting growth and value, I caution folks, think about if this is going to be worth the additional ongoing management. There's a gentleman that I worked with recently, he was a Boglehead® using all sorts of low cost index funds, but he was taking a pretty extreme slice and dice approach with large cap, small cap, mid cap, large international, small, etc, etc. And he came to me to do a portfolio second opinion, and he said to me, “I regret so many funds because now I have to rebalance them all.”
So, theoretically splitting value and growth sounds nice from the tax efficiency perspective. But remember, you're going to have to manage it not just this year or next year and every year thereafter, but you have to manage it well into those years of your life when your ability to manage complex spreadsheets starts to fade. That's to say, our mental capacity over time fades as we get older. You're 75, you're staring at a spreadsheet where you've got to balance value or growth. That might be more of a challenge than you're up for. So yes, you can add this complexity to your portfolio, but is it really necessary?
Stephen Fox: A couple of things I like to add there, Jon. It reminds me of an old saying a lot of you may have heard: don't let the tax tail wag the investment dog. You shouldn't make your investment decisions primarily based on tax application. You make your investment decisions based primarily on your expected risk return profile, and what makes sense for you to have as an investment. And then tax implications are always secondary to that.
And on this topic of having many individual holdings versus few individual holdings, I generally have a strong preference for simplicity, like Jon was mentioning there. But, I think there are some times opportunities in having a greater number of holdings within a tax planning context.
For example, the idea of direct indexing is becoming much more popular now. And that's one of the reasons why, is because if you're holding hundreds of individual securities, some of them went up over time, some of them went down over time. That opens up opportunities for tax savings. And yes, it can be much more complicated to manage. But, if you are using technology to make that process easier and if you are dealing with a long time horizon and you are in a high marginal bracket, you're dealing with high expected returns over a long period of time, it could absolutely be worth it.
David: I just wanted to follow up on your comment. Yes, everybody is different, but I would argue that in a taxable account, the base case should be start with the broadest possible index fund you can buy and probably now in the form of an ETF, because it's very, very difficult to find anything that's more tax efficient than broad based index fund in an ETF wrapper.
Steven Fox: Yeah, I agree with you 100% that the far majority of people should be using very broad index funds as a primary investment vehicle for personal financial planning, whether that's in a taxable account or in any type of retirement account. As far as investment strategy goes, I’m definitely a Boglehead® in that regard. I think the far majority of people should take that approach.
In terms of tax efficiency, I think you're generally right with some exceptions. A couple of exceptions that come to mind would be one, if it is a very broad based index fund, generally there's going to be some amount of dividends that are paid out every year, and if holding bonds some out of interest is going to be paid out every year. And so that may be one factor to consider, is do you want to be taking out that income amount every year from it and do you want to be doing so during this stage of your life?
And then another consideration is sometimes people open the taxable account with the specific intent of passing it along to heirs or to charity someday. If you're passing it along to heirs, there's going to be that step-up in basis later in life. In that case, you might want to focus on that class that has the highest expected appreciation over time, so that the taxes end up not getting paid at all with that step-up in basis. Similarly, you wouldn't want to have a dividend yield either in that case. But I think generally you're definitely right.
Jon Luskin: I would certainly agree. It's hard to go wrong with an ultra low cost, broadly diversified, tax efficient ETF in a taxable account.
Jon Luskin: Jon Luskin, your Bogleheads® Live host jumping in for a podcast edit. In the show notes, for our podcast listeners, I'll link to a couple of resources where folks can learn more about the value of tax loss harvesting. The first resource is the Bogleheads® on Investing podcast episode 32, where host Rick Ferri interviews Phil Demuth. The two discuss how tax loss harvesting can mean a small short term tax benefit for a lifetime of additional investment expenses. The second resource is from the Rational Reminder podcast, episode 158. That is a deep dive into the subject. In the episode about tax loss harvesting, they make the point that tax loss harvesting can mean changing your investment exposure, adding risk to your portfolio.
Therefore, one report suggests that tax loss harvesting may make sense if you can do so yourself at low cost using broadly diversified index funds. That means avoiding the high fees that can come from professional tax-loss harvesting services and avoiding the investment risk that comes from deviating from the low cost, broadly diversified portfolio.
Steven this question is from username Picasso from the Bogleheads® forum who writes, “For millennials with self-employment income in addition to their regular W-2 wage income, are there short or long term tax impacts of contributing to a SEP IRA in addition to contributing to a Roth IRA?
Steven Fox: First and foremost, we should be considering the total amount that you're saving and then the types of investments that you're buying within those accounts. And then the next consideration is what amount do you want to have inside accounts, each of those different types of tax treatments. Overall, somebody definitely should consider investing in each of those. And the biggest determining factor in which one makes sense for you now is going to be what is your current marginal tax rate. That is the tax rate you're going to pay on the next dollar of income versus what you're expecting your marginal tax rate to be in the future.
And your marginal tax rate is going to change quite a bit from one year to the next. If you are on maternity leave this year and you're taking time off work, maybe you’re in a low bracket. If you get a big bonus, or the sale of a property, or something like that, you're going to be in a higher marginal rate this year. It's just about impossible for anybody to know exactly what your marginal rate is going to be in the future when you're taking distributions from these accounts.
But we can look at some clues to try and get a rough idea. Let's say you are a federal government employee or teacher and you have a reasonable expectation of a fairly high pension in the future that's going to increase your marginal rate. If you know that you're going to be getting an inheritance of an IRA that you're going to have to take a lot of our RMDs from and distribute the entire account within ten years. That would raise your marginal bracket during that period.
You’ve got to look at a lifetime scale. What reasonable expectations do you have about future versus present marginal tax rates? Then of course, we've also got to deal with all the rules about contribution limits, timing for each of those types of accounts. There are other considerations around estate planning, inheritance. Also, you need to consider the topic I brought up earlier about which category are you currently overweight or underweight in relative to the others, with an eye towards trying to increase tax diversification so you have greater flexibility later in life.
Jon Luskin: I like how Jim Dahle of The White Coat Investor frames it. He says, “never a SEP IRA, always an individual 401(k).” That's going to give you some better options when it comes to tax planning. Now, it's going to take a little bit more work to set up an individual 401(k), next to an SEP IRA. But again, it's going to be worth those additional tax planning opportunities.
For those who want to get really on the tax planning front, so that we are making that contribution to that individual 401(k), you may run into the issue of the qualified business deduction reduction. There are some great posts on this topic by Sean Mullaney, who has been a previous guest on the Bogleheads® Live series. I'll make sure to link to that for our podcast listeners.
Now, if you've got a lot of stuff, you might consider setting up your individual 401(k) to make mega backdoor Roth contributions. That's going to let you put extra $40,500 into that individual 401(k). Even if you don't have hundreds of thousands of dollars of income. You can contribute more money to an individual 401(k) by setting up a special individual 401(k) capable of doing a mega backdoor Roth 401(k) contributions. Now you'll have to do some extra work to be able to get that individual 401(k) capable of making those extra contributions. You have to work with a third party to create some trust documents and set up multiple accounts to be able to move across those different types of individual 401(k) accounts.
Harry Sit has written about this. I'll link to that in the show notes for our podcast listeners.
Twitter Live audience member: When would you recommend to use the child tax credit versus the child care dependent tax credit? Thank you so much.
Steven Fox: The answer there is just whichever gives you the greatest benefit to you this tax year. And you don't have to take the same choice year after year, either, it’s on a year by year basis. The only way to know for sure is by doing the math. Doing that is sometimes a little bit difficult. You’ve got to look through the rules or ask the tax preparer about it. Whichever one gives you the greatest benefit is the simple answer.
Twitter Live audience member: I was wondering if you could speak on considerations when doing the calculations for someone who may expect a pension in retirement, like a government employee, specifically for Roth versus traditional contributions to the retirement account, whether it's a TSP per government employee or a 401(k).
Steven Fox: Good question, because that could help you determine what type of account you should be contributing to now, right? Or other things too, like you should be accelerating depreciation or take advantage of other opportunities. The first thing that comes to mind there is that you don't want to get buried in the weeds too much, making too many assumptions about what's going to happen. The only thing that we know now is what the tax bill looks like for 2022.
And we can make some reasonable guesses about what's going to change over the coming years, but they're really just going to be guesses. None of us know for sure. We can't even predict if Congress is going to pass a law tomorrow or not that they're considering right now, let alone decades from now. First thing is don't focus too much on precision. I'd rather be roughly right than very very precisely wrong. Think about general principles.
And besides trying to only do math about what an expected tax liability would be on income now versus in the future, you can also think how much risk are you willing to take that this specific tax thing you're considering is going to be the same, or more or less advantageous.
Let's say that you have highly appreciated stock and you're considering selling it and paying the capital gains now, but you think that later in life you're going to be in a higher rates, higher marginal bracket. So, it makes sense to sell it now instead of later. Let's say you think that over time, it's likely that the people who are calling for it will succeed in getting the law changed so the capital gains are taxed as ordinary income. You might choose to sell that now instead of selling it after that law has passed, just for reducing risk that we have that change in the future.
I wouldn't get too far into the weeds of looking at the current limits and amounts for all of the various deductions and credits and types of income and everything and trying to project that years out in the future because it's going to be changed completely.
You're saying that we calculate makes me think that you may be going a little bit too far on that. Just think in general principles. Don't worry too much about high precision on this over a long period of time.
Twitter Live audience member: Okay. Thank you. I guess one follow up to that, I thought I'd not be too precise, rough estimates, but thinking about like 50/50 Roth/traditional split and what considerations?
Steven Fox: Factors that I would consider there would be: one, how tight are you going to be and the amount that you have saved up over time versus what you're going to need to be taking in distributions. How much room is there for margin for error? That's one factor to consider.
Another is what changes you might want to make to your asset allocation over time. Maybe another factor is how likely you think it is that you're going to have other sources of income later in life, whether that's pension or amount of Social Security, or inheritance or other factors like that, or they change your tax situation later.
Maybe another factor to consider is how important is it to you to hedge against the risk of something like Roth accounts being taxable over a certain threshold later in your life. What do you think the likelihood of that is and how damaging to you would it be if a change like that were to be made? Other considerations might be your spouse and the types of investment accounts that they have.
Twitter Live audience member: Great. Thank you.
Jon Luskin: This is a great question. Should I do Traditional or should I do Roth contributions? Maybe I should do a 50/50 split.
One consideration is you can have this pension income that's going to be taxable in the future. Eventually, that means contributing to a traditional tax deferred account, at least with respect to, “Hey, I'm going to have distributions from the traditional tax deferred account in the future that's going to generate taxable income, making me in possibly a higher tax bracket than I otherwise would be if I didn't have this traditional tax deferred pension income in retirement.”
So that suggests making Roth contributions because if that pension income is going to be big enough, it's going to push us into those higher tax brackets. At that point, we might necessarily not want to have our required minimum distributions (RMDs) in the future driving us up into future tax brackets.
Now, all that assumes we're going to be in some sort of really punitive tax bracket in the future, which is completely unknowable to plan today to say, “Hey, I'm going to make Roth contributions in my account today because naturally I'm going to be in a higher tax bracket.” Or to say the inverse “I'm going to be in a lower tax bracket in the future” is arguably ridiculous because we don't know what tax rates are going to be 20, 30, 40 years from now.
Generally, I tell folks when it comes to this decision, “hey do I do Roth? Do I do traditional?” I say, “don't worry about it too much. Just contribute the maximum you can to these tax advantaged accounts. That's going to put you in the best spot. If you feel strongly one way or the other, quick, go for it.”
There's a couple of folks I worked with recently. They were very highly compensated. They were in that top federal tax bracket. They were making Roth contributions because they felt taxes were going to be higher in the future. That is a very reasonable approach since we can't know what the future holds.
Again, Roth versus traditional. It's not as important as making that maximum contribution. That's going to let you take advantage of that tax treatment.
Steven Fox: I think it's also important to keep this in mind, the broader context of your overall financial plan in your situation. For example, if you are trying to maximize cash flow right now because let's say you have high interest credit card debt to pay off, or you're saving for a big short term goal. Maybe, it makes sense to go to pre-tax contributions instead of Roth, for example, because putting $5,000 into a pre-tax account, there's a lower impact on short term cash flow than putting $5,000 into a Roth because you don't have to pay the taxes on that amount.
Jon Luskin: I'm going to jump to a question I got from the Bogleheads® forum. Username Flobes writes, “How do taxes on inheritances work?
Steven Fox: There aren't really any direct taxes on inheritances in our country. There is what's called an estate tax, which is paid by the estate that the person leaves behind. It's not paid by you as the person who inherits the money.
Most people don't have to worry about estate tax because there's a threshold, it changes every year. It's just over 12 million right now, and under that threshold, you don't have to worry about the estate taxes at all. It's only amounts above that that are subject to an estate tax.
Also, some states do have an estate tax, but most of them don't. I know Washington, for example, does, a few others. But most people aren't going to have to worry about estate taxes. As far as the taxes that you will pay on it, in most cases, it's going to be zero. If you have a taxable account that you're inheriting, there's a step-up in basis where your cost basis is as the person who inherits it is going to be whatever the value was of that asset on the date the person died.
If they bought shares of stock for $2 a share back in 1975, and it's now $30 a share on the day that they die, your cost basis is $30 a share, not the $2 that they paid back in the day. You don't pay taxes on the inheritance in that sense either. You can sell it and your taxable income would be zero unless it's gone up or down, since that person had the step-up basis.
Jon Luskin: Steve mentioned cost basis. Let's break that down for folks who aren't tax planning nerds.
Your cost basis is what the IRS considers the amount that you purchased an investment for. And using Steve's example, the heir inherits the stock and now has a cost basis of $30. The cost basis matters because it determines how much of the investment is taxable when you sell it.
Going back to this example, if the original owner of the stock sold it, they would have a realized gain of $28. That's the difference between the value of the stock that they sold at $30 versus their cost basis of $2. That realized gain, $28, is what they must pay taxes on.
If you inherit a stock worth $30 and you immediately sell it, then your cost basis is the same price that you sell it at, making for an unrealized gain of $0. That's why letting heirs inherit taxable accounts can be a tax efficient strategy. The heir gets to inherit the account and receive the cost basis of the present market value. They can then sell the positions tax-free.
Steven Fox: One exception is Inherited IRAs. Assuming the person died in 2020 or later--there was a change with a law called the Secure Act a few years ago. But if they died in 2020 or later, then if it's a non-spousal IRA, you will have to take out the full value of the account in a ten-year period. Sometimes that can open up tax planning opportunities for you, too, if you know that you're going to have over the next ten years some periods that are particularly high or low income, you might want to consider taking the higher distributions when you're going to have lower income. For the most part, with that exception, there aren't really direct taxes on.
Jon Luskin: I'll add that Health Savings Accounts, HSAs, for non-spouses are fully taxable in the year they're received by a beneficiary.
This question is from Quiet Seas from the Bogleheads® forum, who asks about 401-k contributions, to make Roth pay taxes now, or traditional pay taxes later.
I feel like we've tackled this one, Steven, unless there's anything else you want to add on the topic of “hey, should I make a Roth contribution or should I make a traditional contribution to my workplace 401(k)?”
Steven Fox: Just a reminder that this is all highly individualized. It may be a good place to start with not just this question but broader tax planning in general is to start with a balance sheet and a cash flow statement. That's going to be a really good starting point for finding potential tax planning opportunities, including something like this question of should you do Roth or traditional? It all depends on your circumstances.
If you're a small business owner, maybe you can change the timing of incoming expenses, or you can consider a tax that has changed, like an S-Corp, or take 179 bonus depreciation if that's your circumstance if you're a small business owner. If you own a rental property, you can do 1031 exchanges or a cost segregation study or something like that. If you are a tech worker with incentive stock options, maybe you can spread out those exercises into multiple years so you don't have to pay AMT [Alternative Minimum Tax]. Whatever your situation is, is going to be the starting point for finding potential opportunities there, including this question of what type of retirement account should you be contributing to. Think much more broadly on tax planning, than only what type of retirement account.
Jon Luskin: There's an interesting suffix to the question that I'll add, and maybe that was a little more talking points here. They asked Roth versus traditional, traditional being you pay taxes later, or maybe your kids pay taxes after your death. Any thoughts you want to add on that last suffix?
Steven Fox: But the retirement account, yeah, they would be paying out whatever their marginal rate is in the year that they're taking those distributions. One factor there is to consider how important is it to you to leave money to your kids? Some people think that's highly important. Some people don't care about that at all. They want to spend every penny they can.
Maybe another factor to consider is what is your tax bracket versus your kids? If you're a physician and your kid works for a nonprofit, they're probably not ever going to have a high income in their life. or vice versa, then that might change your views. If you're paying a higher amount of taxes, it's less total money available for the family as a whole.
It's really situational depending on how much do you care about either one. Do you want to maximize the amount available for yourself because you're worried about having enough to sustain your needs over your lifetime? Do you really care about maximizing the amount that goes to your kids because you think that that's part of your duty as a parent? Do you want to minimize the total amount that goes to the government, in general, so your family as a whole has more to be able to spend? You’ve got to figure out what your goal is first and then you have to match with that.
Jon Luskin: To add a little bit to that, this is the same question we had before. Roth or traditional, but now I'm not looking at my future tax rate, but my kids' future tax rate. And if you're relatively younger, you're a millennial guessing what your kids' future tax rate, what your future tax rate is going to be at the end of life. It's arguably ridiculous. So I tell folks again, “don't worry so much, just make the full contribution to either account.”
Now there are going to be some tax planning strategies that you want to consider as you get closer to ultimately bequesting your accounts. Usually, and to add a little bit to what Steven said, “Hey, if I've got an heir and they're working in a non-profit, they’re not in a high tax bracket, then ideally it makes more sense to contribute traditional, because then they’ll inherit traditional and they'll be able to pay taxes at a lower bracket compared to what I'm in.”
Alternatively, if you've got multiple heirs with heirs in different tax brackets--and this is more of a boomer tax planning strategy, so forgive me while I digress here – for our millennials listening today, they can talk to their boomer parents about this – if you are a millennial and you're in a different tax bracket from your sibling, consider which accounts your parents leave to you – Roth versus traditional – should depend upon your tax bracket compared to your sibling. That's to say, the sibling in the higher tax bracket should get more dollars from Roth accounts, and the heir in the lower tax bracket should get more money from traditional accounts. That's going to be a more tax-efficient way to leave money to heirs. There again, I'm digressing into boomer tax planning. Let's bring it back to millennial tax planning.
This one is from Financially Fit, who writes, “Something I've struggled with is what you need to report, and how to report adjusted income, and there might be a different term for it in community property states, when filing married filing separately, it is not obvious to me in TurboTax or H&R Block software, but both indicate that it needs to be reported. The reason for filing for married filing separately is for public service loan forgiveness purposes. If you live in a community property state, you can request that your PSLF payments are based on just your income if Married filed separately. But first you need to file correctly.”
Steven Fox: First thing I'll point out there, is that if you file a federal tax return separately – you filed married filing separately-–you have to report half of all community income and all of your separate income.
For most people, it's not going to work out to be advantageous to do married filing separately. In almost all cases, you're going to pay a higher total tax bill for your household by doing that, not just because of the way the tax brackets work, but also the threshold for deductions and credits and such. So you should only do that if you have a very specific reason for doing it.
One example of a specific reason why somebody might file separately, even knowing that if it's the case where they would be paying more taxes, is for what you mentioned here of lowering student loan payments if you're on an income driven plan. To clarify, it's not that you're enrolled in PSLF that determines what your income is for the payment purposes, the payment amount purposes. It's determined by which of the income-driven plans you're enrolled in. Are you in ICR [Income Contingent Repayment]1 or Revised Pay As You Earn (REPAYE)2 That's what determines what your payment amount is, from your income on your tax return, not the fact that you're enrolled in PSLF. So just one thing to make clear there.
The other thing is for student loans in particular, sometimes it's worth paying more in taxes by filing separately if it lowers your student loan amount by a greater number. If you're paying an extra $3,000 per year in taxes by filing separately from your spouse, but your student loan payments are going to go down by $8,000 a year for doing that, well, then that's probably a good deal if you don't have your balance of your student loan increasing over time with the lower amount, you don't care what it is because it's going to be forgiven anyway. That is something we're considering for anybody with a high student loan balance that's enrolled in income driven plans. Do we want to pay more in taxes to lower our student loan payment?
Jon Luskin: This one is from user Else 22, who writes, ”Could you talk about the child tax credit for 2022? Is the assumption that it will revert to the pre 2021 levels? When will we know what to expect?”
Steven Fox: The child tax credit, it is a little bit different now for last year and this year than it is for most years. And in terms of what Congress is going to do about 2022 when it reverted back to the lower amount, I have no idea. As far as I understand right now, that's up to Congress. And if nothing changes, then it’s going to revert to the prior lower version.
But you shouldn't assume that Congress is going to do anything on this question or any others. And most people who are eligible for the child tax credit, were receiving those monthly advance payments for the last six months of last year. That has stopped now. I wouldn't count on it ever resuming again. It's up to Congress at this point.
Jon Luskin: How can I pay less taxes?
Steven Fox: It's highly dependent on the individual situation. I gave a few examples earlier. Some other ones would be trying to find opportunities to shift the timing of income or deductions, if you're able to. That's always kind of a broad catch all thing to be looking out for.
Or looking for opportunities to shift the tax burden to another entity. Maybe if you do regularly file separately from your spouse for some reason, there are opportunities to shift income or deductions to one of you or the other that might make sense. Or to a business that you own, or vice versa, from the business to yourself. Opportunities exist there sometimes.
You can also shift the timing of when you make payments for things that are deductible. For example, let's say you are pretty close to the threshold where it makes sense to take itemized deductions instead of the standard deduction. You might want to consider stacking all of your deductions into alternating years. If you have control over in your area when you pay property taxes, or if you can change the timing of when you pay for big medical expenses or charitable contributions or something like that, you can stack all those. So let's say in even number of years, you try and do all those deductible expenses at once, and then you take the itemized deductions on schedule A. And let's say in the odd number of years, you take the standard deduction and you try and minimize the amount you're paying. That's trying to shift the timing of deductions. That is probably more applicable to a broader range of people than some of the other stuff I mentioned earlier.
Maybe another example that we haven't talked about yet: let's say you have a large charitable contribution that you want to make and you're trying to maximize the impact and also receive some tax benefits. For that, you consider which types of assets it makes sense to donate. You might choose to donate those that are highly appreciated, that are way above your cost basis now, or you might choose to do a donor advised fund.
But all of these types of things are dependent on your situation. We really have to make sure that we're not just minimizing taxes now, or over your lifetime, but that you're trying to fit this tax planning within your broader financial plan.
Jon Luskin: For those folks who aren't tax planners, can you tell us a little bit about what a donor advised fund is and how that works?
Steven Fox: A donor advised fund is a way to receive a large tax benefit now so that you can have control over the assets still, over how the money is used to be distributed to other charities. It doesn't actually have to go over to charities on day one. It goes into this separate fund that you maintain control over and you get immediate tax benefit for it.
One example of when somebody might want to do that is if you have a year that's particularly high income from sale of a business or rental property, something like that, and you need to get as large a tax benefit as possible over the short term instead of spreading that out with charitable deductions over time.
Jon Luskin: To recap what Steven said a little bit differently, I want to contribute to charity. What's the most tax-efficient way I can do it? Well, let's say you bought some Apple stock a long time ago and it's appreciated a lot. Instead of selling that, paying taxes on it, you can contribute that security to the charity directly. Avoid that unrealized capital gain, if the charity doesn't accept donations of free security, you can contribute that security, that Apple stock, to a donor advised fund that you set up for yourself.
Now you do not want to sell the position and then put that cash into the donor advised fund. You want to contribute that position directly. Then with that money in the donor advised fund, you can dole it out to qualifying charities of your choice on whatever schedule works for you. And if you're in a high income tax year, that can be the year to make that large outright charitable contribution, helping to decrease your income taxes for the year.
For some folks that I've worked with recently, they've either gotten a large one-time pension distribution, taxable not transferred over to an IRA. Or they've sold a business, or they're doing Roth conversions. These are years where you are all going to have additional taxable income. That would be a good time to make that large contribution to a charity, helping to offset that income.
Another question, Steven: My portfolio is down. Should I be tax loss harvesting?
Steven Fox: Possibly. But I think more young people should be considering just the opposite actually, which seems to get a lot less attention. The idea of tax gain harvesting, where you're trying to take advantage of the fact that you have these needs right now to step up your basis over time and you don't care as much about the short-term tax savings. And that usually makes sense for people with very long time horizons and/or have a reasonable expectation of being in higher marginal brackets later in life.
Whether you should be tax-loss harvesting just depends on expectations of marginal bracket now versus later. You should not be tax-loss harvesting if doing so would require you to take on positions, or you would end up taking positions that are very different from what you want your overall investment allocation to be in the first place.
Remember, we don't ever make decisions just for tax purposes, so that it impacts other things more negatively. But don't necessarily assume that reducing taxes over the short term through tax harvesting is the thing you should be doing, or even a positive impact overall. Sometimes, it makes sense to do just the opposite.
Jon Luskin: Well said. Investments first, taxes second.
Twitter Live audience member: Any tax things to lookout for potential first time home buyers?
Steven Fox: The first thing that comes to mind is around property taxes rather than income taxes. Here in California, it's a particularly big issue, but I've also seen this come up to varying degrees in other places as well, where somebody needs to pay property taxes at a very different rate than what they were expecting. Probably the reason this matters a lot in California is because we have this law called Prop 13 that was passed back in the ‘70s that limits the rate at which your taxable base value for your home can increase. What happens is over time we've had a lot of houses in California go way up in value over the last few decades, and if somebody's been living there the whole time, they have a much lower property tax rate than what I would be paying if I were to buy the house and live there today.
When you have your escrow account with your mortgage that is paying your taxes on your behalf, since the home hasn't yet been reassessed by the local government and to determine the new taxable value, the initial amount going into that escrow account will be based on the old property tax rate, which is very different from what you're going to be paying. Over and over again, people are hit with unexpected supplemental property tax bills that are not reflected in their escrow account that had been the amount that had been going there before. And so they end up having to pay obscene ten to $15,000 before, within the first year after buying a home, that they weren't expecting to pay because there wasn't enough being withheld. Watch out for those types of issues. Of course, that's going to be a local thing, depending on how property taxes work in your area.
Other tax considerations for buying a home in general: one, buying a home is the single most common reason why people have to start or get the opportunity to start itemizing deductions rather than taking standard deduction. That's because of the sum of being able to take property tax deduction as well as mortgage interest. It's a little bit less common now the last few years since the Tax Cuts And Jobs Act increased the standard deduction by a lot, doubled it. But still, that's the most common reason why people would be doing that, or start itemizing.
Another thing to keep in mind: the tax benefits of buying a home with the itemized deduction:. it's often misunderstood and overstated. A lot of people think that the full amount that you're paying in mortgage interest is able to be written off, but effectively it's actually much less than that because you have to account for that first $24,000 or so that you would have gotten in a standard deduction anyway. If you have enough in other deductions, itemized deductions that you would already be itemizing outside the home, then yes, it's reasonable to include the full amount there. But really you're taking, let's say $27,000 in total itemized deductions, It's only that last few thousand that really counts for anything. So don't make that common mistake of overestimating that tax benefit of buying a home that your realtor and your mortgage broker are going to try and push on you.
Jon Luskin: Here Steven mentions that the value of deducting mortgage interest is highly overrated. Let's break that down.
The standard deduction for married filing jointly is $25,900 for 2022. This is for folks who aren't blind and were under age 65. Imagine you hadn't yet purchased a home and are considering purchasing one. When doing your annual tax return you know that the $10,000 limit for state and local taxes, and your charitable contribution of $7,000, perhaps to a donor advised fund tallies to $17,000. This is less than the $25,900 standard deduction. Therefore, it doesn't make sense to itemize. You'll save more money on your taxes by taking a standard deduction.
But now you become a homeowner and now you're also deducting your mortgage interest. Let's say you're paying $9,000 in mortgage interest each year. Adding that $9,000 to a total of $10,000 for state and local taxes and $7,000 for charitable contributions brings you to a total of $26,000. That $26,000 is just $100 more than the $25,900 standard deduction. In that case, you would itemize, allowing you to deduct an additional $100 on your taxes. That is, you spent $9,000 on interest and you'll save just a fraction of $100 on your taxes.
Where would itemizing mortgage interest truly have you come out ahead? if you were already itemizing. For example, if you had $10,000 in state and local taxes and $20,000 in charitable contributions. At that point, you're already itemizing. Therefore, you're able to fully deduct any mortgage interest at that point. However, most folks aren't already itemizing before their mortgage interest. Therefore, the savings available from deducting mortgage interest is quite limited and often overstated.
Steven Fox: Make sure you're taking advantage of whatever types of credits and deductions you might be eligible for. In some states, for example, they have state specific credits or deductions for things like home efficiency improvements or water efficiency, stuff like that. There's still a federal credit for solar panels and other similar types of equipment. And that's by the way, another example of tax planning opportunity, is if you're buying solar panels make sure you do so in a year that you're going to be able to take full advantage of it. I don't think that credit in particular expires but lots of credits do expire. I know the electric vehicle credit does expire if you don't use it. So just make sure you're watching out for the timing of credits to make sure you actually have enough of a tax liability to take advantage of it if it doesn't carry forward, or if it doesn't, if it's not a refundable credit.
Another one that comes to mind is a house can be a significant proportion of inheritance going to your kids. So remember that step-up in basis issue that we talked about before. That that's cost saving opportunities as you can pass it along to them and they won't have to pay taxes on the gain if they were to sell it. And if they were to continue to live there, then their basis, if they ever needed to later in life, they wouldn't pay taxes on the full amount of the gain ever since the day you had bought it.
Anything you see related to taxes on rental properties--so like about 1031 exchanges and depreciation schedules and all that, that does not apply to your primary home. That stuff is only for rental properties. So don't get mixed up. You're looking into it, you see those kinds of issues, make sure you know what type of property they're talking about.
And then the other thing that comes to mind I should probably mention is the capital gain exclusion. If you sell a property that is your primary home and that you've owned for two out of the last five years, then you qualify for $500,000 exclusion of capital gains if you're filing joint and $250,000 if you're not. You don't pay capital gains on full amount.
Jon Luskin: When we bought our home several years ago, we updated the windows to some more energy efficient windows and we're able to save a little bit of taxes on that.
Steven, any final thoughts on tax money for millennials before I let you go?
Steven Fox: I'll finish this by reminding everybody that taxes really are for most people, that the biggest expense of our lifetimes or very close to it. This really is worth looking at and paying more attention to it than most people do. Usually when you file your return it's too late because stuff has already happened in the past. There are only a few things that you can control to shift your tax liability for a year after the year is over. That list of options is pretty small once the year is done. So be proactive about this, pay attention to it.
If you're thinking about the time that you spend trying to learn more about this and look into stuff as being a burden or not being worth it, one thing that kind of helps me think about it and be a lot more happy to do so, is thinking about it in terms of per hour. If I spend 2 hours researching something and it gives me a credit for a $1,000 that I wouldn’t otherwise realize, that's $500 an hour, that's probably worth my time to figure it out. That can really help put in perspective for you.
The other thing is a lot of tax preparers don't really do any proactive tax planning stuff. They just file all the forms and report on things after the fact. Unless your tax preparer or financial planner, whoever, is proactively helping you with tax planning, the burden is going to fall on you. Make sure that you're doing that to the extent possible.
One of the things that holds people back from doing any kind of tax planning sometimes is feeling a little bit guilty about it, that they're doing something wrong. And there I think maybe it's helpful to distinguish between two concepts. They're often called tax avoidance or tax evasion. That is not the same. Avoidance is both ethical and legal. Tax evasion is when you are lying or hiding information. That is definitely illegal, it’ll get you in a lot of trouble, it's not worth it.
Simple examples of avoidance are things like contributing to your 401(k) to avoid the taxes that you pay. That's a simple example of tax avoidance, totally legal and ethical. And other more advanced tax planning strategies are really just extensions of that same principle. You're not doing outright tax evasion where you are hiding cash income or failing to pay employment taxes for a nanny or not reporting crypto transactions that have capital gains, things like that. Those are all tax avoidance which is illegal and most people would probably say unethical. But tax avoidance is both legal and ethical and very much worth it. Pay attention to this more than most people do. It's going to pay off for you.
Jon Luskin: Steven, great points. That's well said about don't feel guilty about doing tax planning moves. We're going to use the tax code to the best of our ability. We're not going to break any laws, but we're certainly going to take advantage of tax planning opportunities.
Well Steven, thank you for joining us today, and thank you for everyone who joined us for today's Bogleheads® Live. That is all the time we have for today. Our next Bogleheads® Live will have a very special guest, Barry Ritholtz, host of the Bloomberg podcast Masters in Business. The week after that, we'll have J. L. Collins, author of FIRE-favorite The Simple Path to Wealth.
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Thank you again, everyone. Look forward to seeing you all again next week where we'll have a very special guest, Barry Ritholtz, answering your questions. Until then, have a great week.
- See Income Contingent Repayment, finaid. [↩]
- See the October 2015 Federal Register Vol.80 No, 210. [↩]