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  • Bogleheads on Investing with Kaye Thomas on income taxes and how to lower them: Episode 67

Bogleheads on Investing with Kaye Thomas on income taxes and how to lower them: Episode 67

Post on: February 20, 2024 by Jon Luskin

If you hate paying taxes, then you should love learning about taxes because that’s the way to reduce them. Host Rick Ferri interviews Kaye Thomas, who received his law degree from Harvard Law School in 1980 and then began his career as a tax attorney, dealing with complex tax matters related to business transactions, finance, and compensation.

Kaye now spends his time as a writer, publisher, public speaker, and consultant on topics relating to taxation and investments. He has written several books, including Capital Gains…Minimum TaxesGo Roth! A guide to the Roth IRA and other Roth accounts, and Consider Your Options, a plain language guide to company stock and stock option compensation plans. His website, Fairmark.com, provides free plain-language guidance on the taxation of investments, taxes in retirement, kids and taxes, taxes on stock-based compensation, and much more.

This podcast is hosted by Rick Ferri, CFA, a long-time Boglehead and investment adviser. The Bogleheads are a group of like-minded individual investors who follow the general investment and business beliefs of John C. Bogle, founder and former CEO of the Vanguard Group. It is a conflict-free community where individual investors reach out and provide education, assistance, and relevant information to other investors of all experience levels at no cost. The organization supports a free forum at Bogleheads.org, and the wiki site is Bogleheads® wiki.

Since 2000, the Bogleheads’ have held national conferences in major cities nationwide. There are also many Local Chapters in the US and even a few Foreign Chapters that meet regularly. New Chapters are being added regularly. All Bogleheads activities are coordinated by volunteers who contribute their time and talent.

This podcast is supported by the John C. Bogle Center for Financial Literacy, a non-profit organization approved by the IRS as a 501(c)(3) public charity on February 6, 2012. Your tax-deductible donation to the Bogle Center is appreciated.

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00:00:10 Rick Ferri: Welcome everyone to Bogleheads® on Investing, Episode #67. Today our topic is taxes. And our special guest is Kaye Thomas. Kaye is a longtime tax attorney who has written several books including the book we will focus on today, “Capital Gains, Minimal Taxes.”

Hi everyone. My name is Rick Ferri, and I am the host of Bogleheads® on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is building a world of well informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net, where you will find a treasure trove of information, including transcripts of these podcasts.

Today’s episode is about taxes, and I have a saying. If you hate paying taxes, then you should love learning about taxes because that’s the way you reduce your taxes. My guest today is Kaye Thomas, and he knows a lot about taxes. Kaye’s law degree is from Harvard University, where he served on the Harvard Law Review and graduated cum laude in 1980.

He spent his career as a tax attorney, dealing with complex matters relating to business transactions, finance, and compensation. Kaye now spends his time as a writer, publisher, public speaker, and consultant on topics relating to taxation and investments. He has written several books, including, “Capital Gains, Minimal Taxes” (the book will be focusing on today) as well as other books include “Go Roth: A Guide to the Roth IRA and Other Roth Accounts and, “Consider Your Options: A Plain Language Guide to Company Stock and Stock Option Compensation Plans. Kaye also maintains a website, https://fairmark.com/, where he provides free plain language guidance on the taxation of investments, taxes in retirement accounts, kids and taxes, taxes on stock option compensation, and much more. So, with no further ado let me welcome Kaye Thomas.

00:02:29 Kaye Thomas: Thank you so much for having me. It’s an honor to be here.

00:02:33 Rick Ferri: You’ve done a fantastic job writing about taxes in plain English. It’s really difficult to find good investment tax books.

So, I want to thank you for being on the show today. Can you tell our listeners a little bit more about you and your books?

00:02:50 Kaye Thomas: First of all, I got into taxes. That’s a little bit of a nerdy area among lawyers. In the tax area, I tended to gravitate toward the investment side of things. And so, I found myself doing quite a lot of that, both for partnerships and individual investors and people who had stock options.

So, that created a locus of interesting topics for me to write about. And I became interested in the internet at a fairly early time in the 1990s. I was trying to figure out how I could start a website and just doing it as a hobby. I was still a full-time lawyer at that time, and I started thinking about what are things that I’m knowledgeable about that people do not have very good guidance about them. And so, I started writing it and at that time there was very little competition for this kind of thing. The website became fairly successful. As I had written a number of topics on the website, I started to think about putting out my first book. One of the things I had written about quite a bit was employee stock options. And that’s what I chose for my first book, which was called, “Consider Your Options.”

And that came out in the year 2000. Those of us who are old enough will remember that the year 2000 was a heyday for the internet boom. And at that time there was so much interest in stock options that this book just took off like crazy. And it also happened to be the time when Amazon was just really becoming very popular and early adopters of Amazon tended to be people who had stock options. And so, the book was one of one of the best sellers on Amazon for a time.

And honestly, I thought publishing was very easy. I couldn’t understand why people thought oh it’s hard to make money writing books. I’d heard that many times, and I couldn’t understand it because it just seemed like printing money. All you do, you write the book, you put it out there and it sells like crazy. Then I learned it was a little bit harder. My second book was the capital gains book and that was successful, but nothing like the stock options book.

And I learned that I had to work for a living. It is a lot of work to explain taxes in non-technical language, make it readable, not just understandable but readable, so that people don’t have to slog through it in order to get to the main points. That was a challenge, but I thought I was fairly good at it. And the book has done reasonably well over the years.

00:05:43 Rick Ferri: The edition that I read was 2023 with all of the new tax information in it.

00:05:47 Kaye Thomas: Yes, I try to update all of my books. My books are tax-related, and people don’t really trust a tax book that’s been written many years earlier.

00:05:57 Rick Ferri: And when did you write the Roth book? “Go Roth.” What enticed you to write that? And why did you write about it?

00:06:02 Kaye Thomas: The Roth originated about the time when I was really trying to get my website going, and initially there was not a tremendous amount of information about the Roth. I thought that a book about Roth would be helpful. Initially I had another book, a more limited book about Roth IRA’s. I called it the Fairmark Guide to Roth IRAs. But then I wrote this book, “Go Roth” to go right through the lifespan of a Roth from creation of it to making contributions to managing while it’s in place and then taking distributions from it.

00:06:42 Rick Ferri: Well, we’re going to get to some of this later on, but the focus today is going to be on “Capital Gains, Minimal Taxes,” the updated edition 2023. And just to make sure we’re all on the same sheet of music, we do have to begin with the basics of taxation.

And so, I am the government. I love to collect taxes, and I, the government, have come up with many, many ways to collect taxes. Income tax, capital gains tax, net investment income tax, alternative minimum tax. So, I want to go through them very quickly. Let’s say we start with just income tax.

00:07:24 Kaye Thomas: All right. We have since 2017 tax brackets that go from 10% up to 37%. Those are the basic federal income tax brackets, 10% for people with very modest income, but 12% gets you into a more substantial amount. Then it’s 24%, 32%, 35% and 37%. And the break points that are most interesting there, you go from 12% to 22%. That’s a huge difference in tax rate. If you happen to be at the border between those two tax rates, you’ve got a 10% difference.

And you need to be really paying attention to anything that you can do to avoid going up into the 22% bracket or keeping yourself down as much as possible into the 12% bracket. We also have a break between the 24% and 32% brackets. So that’s eight percentage points. Another really big one. And that’s an area where, once again, you want to be paying very close attention to whether you can manage your income. Can you make an additional 401(k) contribution to avoid paying that 32% rate as opposed to having all of your income taxed at 24% or less? Those are the two important ones. The other ones are much smaller, obviously 22% to 24%. It’s not completely negligible, but it’s not anywhere near as important. And similarly for the other differences in tax brackets.

00:09:11 Rick Ferri: If we have capital gains or we have dividends that are treated as capital gains, that’s a completely different set of brackets.

00:09:18 Kaye Thomas: Yes, it is. And we have the 0%, 15%, and 20% brackets for capital gains. 0% roughly corresponds to – used to exactly correspond to – and now it very closely corresponds to the 10% and 12% brackets for ordinary income. The 15% bracket takes you up into a fairly high level of income and doesn’t correspond exactly to a tax bracket, but in a pretty high income level is where you start paying the 20% rate.

00:09:55 Rick Ferri: And then there’s another tax on top of that. Well, if you’re single and you make more than $200,000 a year, or if you’re married filing jointly and you make more than $250,000, and this is a kind of a stealthy tax, it’s called a net investment income tax. What is that?

00:10:09 Kaye Thomas: Net investment income tax was put in as part of the way to pay for the Affordable Care Act. What some of us call Obamacare. It really matches up with Medicare tax that you would otherwise pay on other kinds of income. And so, it’s trying to make sure almost all kinds of income are going to contribute in one way or another toward healthcare. And this tax at 3.8% can hit capital gains. It can hit dividends, it can hit interest income, short-term capital gains, and long-term capital gains.

This is why people will say that capital gain taxes go up to 23.8% instead of just up to 20%. One point about this is that $200,000 break point that you mentioned where the net investment income tax kicks in for single investors and $250,000 for married filing jointly, those are not indexed for inflation. And so that’s something that wears away every year a little bit and brings more people into paying it.

00:11:18 Rick Ferri: And let’s get into another tax, and this is called the alternative minimum tax, and this can hit people who have very large capital gains or perhaps had stock option compensation. So, what is this tax?

00:11:31 Kaye Thomas: This tax originally came into existence out of the notion that there were people with very high incomes who pay either nothing or very little in the way of taxes. It seemed unfair to some in Congress that there would be this disparity where people with very modest incomes would be paying a substantial portion of that income in the form of taxes. And yet people with much higher incomes would pay little or nothing.

And so, this tax was instituted as a way to require that everyone will pay at least some minimum amount of tax. That’s where the word minimum comes from in here, and the word alternative has to do with the notion that we figure out how much tax you should have to pay under how much your minimum amount of tax that would be by using an alternative calculation. And so, we step aside into a not entirely different but quite different set of rules for determining what your tax is.

The tax rates here are 26% and 28%. You have a special deduction called the minimum tax exemption, but at the same time you are denied many of the tax deductions and benefits that you would otherwise get under the regular income tax. And the notion being, those are the deductions and credits that are allowing people who are very wealthy to avoid paying alternative minimum tax.

Now this used to be a very big problem for a large number of people because the alternative minimum tax did away with certain items that were claimed by many people, such as personal exemptions. The state and local income tax deduction. And so, people who have a lot of those kinds of deductions would be paying alternative minimum tax, even though they were not necessarily very wealthy. This was substantially changed in the 2017 tax law where the minimum tax exemption amount became much larger and the place where that starts to phase out happens at a much higher income tax level.

Now the alternative minimum tax affects a much smaller number of people. It tends to be mainly people who exercise a kind of stock option called incentive stock options. If you have that type of option and exercise it for a very large profit, then you do need to deal with the alternative minimum tax. And my book, “Consider Your Options” talks about how to plan for that. Other types of people generally don’t have to concern themselves with alternative minimum tax for the most part.

Although it’s still possible with certain types of tax benefits, and particularly a large capital gain can bring someone into paying alternative minimum tax. And the reason for that is that it causes a phasing out of this minimum tax exemption, and I know all this is kind of abstract. It’s kind of hard to talk about and understand, but that’s the picture.

00:15:04 Rick Ferri: All these different taxes, the income tax, capital gain tax, net investment income tax, alternative minimum tax, there’s a lot of different ways the government can tax us directly. But there’s also backdoor ways and that is phase outs. As you make more money, your tax credits that you may get are phased out. The tax deductions that you may have get phased out.

You’re a business owner and you’re getting the qualified business income deduction, that gets phased out. Also, if you make more money and you’re retired, more of your Social Security becomes taxable, and you end up paying more in Medicare costs through IRMAA. So, could you talk about these back door ways in which you can end up paying taxes?

00:15:50 Kaye Thomas: Right. The IRMAA, of course, is not exactly a tax. But it’s something that plays off of, actually, your adjusted gross income, and causes you to pay a potentially significant amount of additional premium. So, your Medicare premium can be substantially larger as a result of this. And if your income is just very large every year, there’s nothing you can do about paying this additional amount.

But if you have a very large amount of additional income in a particular year, for example, you decided to do a Roth conversion. A Roth conversion can be a wonderful planning device, but can cause you to run into the additional premium that you pay under Medicare as a result of IRMAA. Now you can deal with that by going to the Medicare website, obtaining the forms that you need to file and say, look, my income for this one year was higher, but now my income has gone back, and it’s a normal income, and I shouldn’t be paying this higher premium because it doesn’t reflect the income that I have right now.

There’s this two-year lag in IRMAA, and the reason for that is that they need to have your tax information before they figure that out. The only tax information they have for you right now in 2024 is your tax return from 2022. So, it’s two years ago that they have your tax information.

So, there is this two-year lag you can deal with the situation if your income was very high for one year and it has gone down by the time the higher IRMAA Medicare premium has kicked into effect. But very often you simply want to try to do planning to avoid having that happen in the first place.

00:17:49 Rick Ferri: That form is SSA-44. Just type SSA-44 into an internet search engine and the form will come up. You fill it out, you send it to the Social Security Office, and within a few months, hopefully, they will revert back to the lower premium amount.

00:18:10 Kaye Thomas: Yes, thank you for that. As to the other phase outs, there are really too many of them to comprehensively cover here. But the thing that I would mention is that most of them play off against what’s called modified adjusted gross income.

And there are different modifications for different rules, but almost all of them involve foreign income. If you have foreign income that has been excluded for one reason or another, then you have to include that back in for purposes of that phase out. A few of them, like the Social Security taxation, we also include tax exempt income. But for the most part, we’re talking about adjusted gross income, which is your income before itemized deductions. And you can think about if you’re running into one of these phase outs, whether there’s something you can do to your adjusted gross income. And of course, retirement savings, boosting your retirement savings is one of the ways to do that.

Obviously, that would have to be in a traditional retirement account and not a Roth because the Roth provides no deduction.

00:19:16 Rick Ferri: Well, let’s go ahead and get into that. The different types of ways you could save where you do get a tax benefit either now or ongoing or in the future.

And what I’m talking about is there are different types of retirement accounts. One that you can invest in pretax and you get tax deferral and then you when you take the money out you’re taxed. The others are putting money in pretax and getting tax free gains when you take the money out later on tax free. Basically, I’m speaking about an HSA account. And then there are after tax accounts you could put money into where it’s either tax deferred or tax free and at the end when you take the money out non-taxable or only the interest portion is taxable.

Just go over quickly the different types of accounts that people can put money into to either reduce their current taxes or reduce taxes ongoing on investment gains or reduce taxes at the end when they take the money out.

00:20:20 Kaye Thomas: Yeah, there are five different potential models for taxation of investment accounts. The simplest ones to understand, first of all, the fully taxable account. Your income that you have in there, income and capital gains, are going to be currently taxable.

The Roth account. You get no deduction for the money going in, but it’s entirely tax free. If you follow the rules, all your investment gains will be tax free.

We have the traditional retirement account that we’re used to. That’s the one where you get a deduction when the money comes in, it grows tax deferred, but it’s going to be taxable when the money comes out.

And we have the HSA, which as you mentioned, that’s the gold standard, but it has somewhat limited reach right now. But anyone who has it available should really give some thought to studying up on it and whether they want to be in it, because it provides that unique situation where you get a deduction for the money going in, tax deferred growth, and then the opportunity to take that money out tax free at the end as well. Again, all subject to limitations. But that is the one and only type of account for that.

Now I’ve mentioned four and the fifth model is when you make a nondeductible contribution to a traditional retirement account. That produces its own set of results. I think one of the key things to understand here is that the taxable account isn’t as bad as it might seem compared to the tax favored account. Because you can actually get a lower tax rate with a buy and hold strategy, which I know is what many Bogleheads® are looking for.

That long term deferral of capital gains as you grow your capital gains over a period of many years in a taxable account in effect lowers the tax rate that you’re going to pay on those capital gains. In the end, you may pay the same actual rate at 20% rate. Let’s say if you’re at the top bracket. But deferring that tax over a period of many years can have the effect of lowering that as an effective rate to 18% or 16% or lower depending on how long you held that stock or other investment and how well that investment performed over that period of time.

00:23:07 Rick Ferri: One of the investments that we often highlight to go into a taxable account is a simple total stock market index fund, which if it’s in an ETF format (and the one I’m thinking of is the Vanguard Total Stock Market ETF) the ticker is VTI.

If this goes into a taxable account, there are no capital gain distributions in the fund. The dividends on it are only about 1.5%, and most of that dividend is a qualified dividend which as we’ll talk about in a minute, is treated as a long-term capital gain. So, this is a very tax efficient, broadly diversified index fund for a taxable account. And usually when we’re talking about investing on the Bogleheads® Forum and we’re talking about taxable accounts, this fund often comes up.

00:24:06 Kaye Thomas: I have to admit, because I got into investing at a time when ETFs were really just coming out, I don’t have ETFs as part of my own main investments. But I do understand the advantage here because of the way they operate when people cash out of ETFs, the ETF does not have to sell its own investments and create gains for its investors. Whereas an index fund and especially a managed one would have to incur capital gains that have to be distributed to investors whenever their investors start cashing out.

00:24:45 Rick Ferri: And fortunately for Vanguard investors, the ETF and the mutual fund are the same. They are just share classes of the one fund, so the tax benefits extend to the open-end index funds as well. And that’s not true for almost all other fund companies. They have a separation between their index mutual funds and their index ETFs. And theoretically, the index mutual fund could actually create a capital gain tax.

Whereas if that same company, same fund company, had an ETF following the same index, it typically wouldn’t happen. But with Vanguard it just happens to be that both the ETF and the fund, it’s a unique structure, they’re all taxed the same and so the open-end index fund gets the tax benefit of the ETF.

And if you bought funds that had low dividend yield, that works even better. And of course, in the end too, if you own these funds when you passed away right now, we get a stepped-up basis on death. So, all of that capital gain goes on to the next generation or whomever is going to inherit the stock or the ETF at no tax. So, let’s just talk about that for the step up on death.

00:25:57 Kaye Thomas: That is a huge benefit for people who do hold assets that are going to pass to the next generation that are highly appreciated. This has been in place for many years. There was one attempt to do away with it and for one year they did away with it.

I think it was the year 1979. And it was such a disaster that Congress immediately did an about face and went back to having this stepped-up basis at death. For many years afterward, we had to say, well, did this person die in 79 and deal with whatever problems came up as a result of that one year repeal. And there’s still some talk about trying to do something that would rein in this tax benefit because it is such a huge benefit.

So, this is one of the ways of completely avoiding capital gain tax. Another is donating appreciated assets to charity. And those two are really major ways of benefiting from special treatment of long-term capital gains.

00:27:08 Rick Ferri: We mentioned doing Roth conversions. I want to talk about why it’s more beneficial to do Roth conversions before taking Social Security and before getting to Required Minimum Distribution age on your pretax retirement funds. Can you talk first about what Roth conversions are, and then when you should do them and when maybe you should not do them?

00:27:30 Kaye Thomas: Roth conversion is the transfer of money or assets from a traditional retirement account into a Roth account. Now, in the traditional account, you received a deduction when the money went in. So, when that money goes to a Roth, you need to pay tax on those dollars. And the general rule is you don’t want to pay tax any sooner than necessary. And so, some people are immediately skeptical of even considering the idea of a Roth conversion.

We’ve just talked about the benefit of avoiding paying tax earlier than necessary on a capital gain for all the benefits that you get from deferring that capital gain. So why would you do a Roth conversion? This kind of starts from what I call the parity principle. Which is that a Roth can produce exactly the same results as a traditional retirement account if certain things are true.

And those things are that the tax rate remains the same at all times, the dollar amount that goes into the Roth is the same dollar amount that was in the traditional account, reduced by the amount of tax that is imposed on that conversion, the amount of time invested remains the same, and the fourth thing that has to be the same is the investment results are the same. If you do all those four things together, you get exact parity between those two.

And the tendency has been to focus on the tax rates and saying, well, the tax rate that is imposed on the Roth conversion should not be higher than the tax rate that you would have on withdrawal of those assets during retirement.

And that’s generally true. It’s a pretty good rule of thumb, but it’s not the whole story. The second one that I mentioned was that the dollars going into the Roth in order to achieve this exact parity have to be the same number of dollars reduced by the amount of tax. And yet you’re not required to reduce those dollars by the amount of tax.

So, to make this simple, if you have $100,000 in a traditional retirement account and $100,000 in a Roth retirement account, that $100,000 in the Roth is worth more. You’re going to take that out tax free during retirement, or your heirs will. That $100,000 in the traditional retirement account is going to bear some tax when it comes out, and so it’s worth less.

And so, the Roth account is actually larger. It may have the same dollar amount in it, but in terms of usable assets that’s larger than the traditional retirement account. And that’s where we start thinking about all the benefits of a Roth conversion.

00:30:41 Rick Ferri: But we would want to do these before we start taking RMDs because the RMDs you cannot put that into a Roth. And maybe before you start taking Social Security because that closes the window a little bit because Social Security becomes taxable and anything that you take out of a retirement account just increases your ordinary income, which could make more of your Social Security taxable.

So, could you talk about, say you retired early, should you start then?

00:31:07 Kaye Thomas: It’s one of these very forward-looking planning ideas of taking making the Roth conversion as you said before Social Security.

I do want to mention though that there are circumstances where you can do a Roth conversion even in retirement, and it can be beneficial even after you’ve started RMDs and you’re into that whole later years of your retirement. You can still potentially benefit from a Roth conversion. You do have to be careful. The first dollars that come out of your traditional account are going to be treated as your RMD, and so if you make a mistake and convert the first dollars that you take out to do the conversion before taking your RMD.

That’s a mistake I’ve seen fairly often. Then you’ve got a bad conversion because you have converted dollars that you’re not allowed to convert because you cannot convert RMD dollars. However, after you get beyond that, you’ve taken your RMD, now you take your Roth conversion.

What you’re doing, if you can pay tax on that conversion with dollars that you have otherwise sitting in a taxable account, now in effect you’ve moved dollars out of your taxable account and into a Roth IRA. And that of course is a very beneficial thing to be doing. The impact may not be huge, but again, it’s one of those little tax planning scenarios that people tend to overlook because they’re getting into those years when they think, oh, Roth conversion is no longer for me.

00:32:53 Rick Ferri: I want to take a moment here to talk about Qualified Charitable Distributions. And this is where if you’re 70.5, you can take up to $100,000 per year per person from your IRA and donate directly to a charity. It can’t go to a donor advised fund. It has to go directly to a charity, and you’re not taxed on this money. Now, when you hit RMD age at either 73 to 75, then the amount that you gave to charity as a Qualified Charitable Distribution is deducted from your RMD amount. So, if you gave $25,000 to a charity directly from your IRA and your RMD was $35,000, you would only have to take a $10,000 RMD. Now, the trick here though is you have to make the contribution to the charity first and then you make the RMD second. You can’t do it the other way around. You can’t do the RMD first and then the charitable contribution second.

Which is, by the way, the exact opposite of what we just talked about. Which is if you’re going to do a Roth conversion from your IRA, you have to do that after doing your RMD, not before. So, remember, QCDs must be done before you do your RMD, whereas Roth conversions are done after you do your RMD. Clear as mud as we used to say in the Marine Corps.

I’ve got one other, Kaye. Let’s say that you are past Required Minimum Distribution age, but you’re still working for a company. This is a company that you do not own more than 5% of. Could be a nonprofit, and it’s a 403(b). They could have a 401(k). But you are working for this company and you’re participating in their 401(k) or their 403(b).

You do not have to take Required Minimum Distributions from that 401(k) or 403(b) for as long as you work there. So, if you work there until you’re 85, you don’t have to do RMDs from that account. Now the IRS also allows you to take IRA money and hold 401(k) or 403(b) money and roll it into your current employer’s 401(k). So technically, any money that you roll into that 401(k) also, you wouldn’t have to take an RMD from.

00:35:21 Kaye Thomas: That’s right, Rick. And you’re making it sound attractive for me to go back to work in a law firm. But the prospect of doing all those billable hours just makes that hard.

00:35:34 Rick Ferri: Oh, and I have to mention here that anything we talk about on this podcast is strictly informational. You need to check with your tax advisor to see if these strategies work for you. Alright. Let’s get into the title of your book, “Capital Gains.”

And here it can get complicated. We have long-term capital gains, short-term capital gains. How do the taxes work?

00:35:56 Kaye Thomas: So short and long-term, capital gains are basically the differences between whether you’ve held your investment for more than a year. And we have to be specific about saying it is more than a year and not just one year. You have to sell no sooner than the anniversary of the day after you acquired your asset in order to have a long-term capital gain.

There are various circumstances that can cause an adjustment in your holding period, but that’s the basic rule. Now, generally speaking, a long-term capital gain is going to be more favorable than a short-term capital gain because of the favorable tax rates that we spoke about earlier for long-term capital gains. Short-term capital gains are going to be taxed at the same rates as ordinary income.

But there are various rules that cause these to interact. If you have a combination of short-term and long-term capital gains and capital losses, then you’re going to net the long-term capital gains against your long-term capital losses.

And this is why a capital loss is actually more favorable if it’s short-term, whereas a capital gain is more favorable if it’s long-term. Now, once you’ve done all that netting out, if you have a net long-term capital gain, that’s when you get the favorable tax result. And if you have a capital loss, it’s going to be deductible. But only to the extent of $3,000. And this, by the way, is one of those strange items that is not indexed for inflation. Almost all of the dollar amounts that are in the tax law are indexed for inflation.

But this one is not, and so we’ve had this $3,000 going back to the Reagan administration. And if you adjusted this for inflation since then, I don’t know what the dollar amount is now, it’s probably $15,000 or more. But we’re still stuck with only $3,000 as a potential deduction for capital loss.

That’s an important fact for people who have variation in their capital gains and losses that they recognize each year. Because if you have a large capital gain one year and a large capital loss the next year, there’s no carry back. You’ve already paid tax on your capital gain and this capital loss, you’re only going to deduct $3,000 of it. And so, this is what we call a capital loss whipsaw. And it’s a very unfavorable situation.

The opposite is not as much of a problem. If you have a large capital loss one year, you do carry it forward and you can use that against capital gain in the next year. So, it’s very important if you have these kinds of variations in your capital gains and capital losses to keep this in mind that you can only deduct $3,000 of your loss.

00:39:07 Rick Ferri: Now, a lot of people think, and incorrectly, that the dividends you get from stock, which are treated as long-term capital gains, some of them, the qualified dividends that you get are treated as long-term capital gain for tax purposes. But they don’t get offset by capital losses, correct?

00:39:24 Kaye Thomas: Yes, that’s absolutely right. Long-term capital gains do get offset by capital losses, including even short-term capital losses if they exceed your short-term capital gains. But none of that will offset a qualified dividend. Qualified dividend benefits from the long-term capital gain rates, but not the full capital loss treatment.

00:39:48 Rick Ferri: So, I want to get into something that would help if you had capital gains. And that is to have done tax loss harvesting, which is basically if something goes down in value and you’ve got a capital loss, you sell it and replace it with something that is close but not substantially identical. So, could you cover tax loss harvesting and what substantially identical actually means?

00:40:12 Kaye Thomas: Well, the concept of tax loss harvesting is as you describe. Something has gone down in value. You’re going to sell it. And a lot of people think about doing this just at the end of the year.

They’re reviewing their investments. Should I sell something before the end of the year in order to get a deduction? But the reality is that tax loss harvesting that is done throughout the year can be more beneficial. I’ve seen some research on this where they did the projections and worked out that a portfolio in which tax loss harvesting is done at reasonable intervals (you don’t want to be doing it every day) can outperform a simple buy and hold portfolio for a number of years by up to one percentage point. 100 basis points.

That gradually wears away over a number of years, and that’s for the simple reason that the stock market over many years will go up in value, and most of what you have in your portfolio will be the stocks that have gone up. And so, your opportunity to be benefiting from tax loss harvesting does kind of wear away over a period of time.

But on a brand-new portfolio, tax loss harvesting can produce a very substantial benefit. And Bogleheads® certainly know that one percentage point or 100 basis points is a really big deal. And to be able to do that over several years can be highly beneficial to your long-term financial health.

So that’s basically the idea. Now what constrains this primarily is something called the wash sale rule. And in simple terms, the wash sale rule says that if you sell a security at a loss and buy a substantially identical security within 30 days before or after, then you don’t get to claim that loss. The loss gets added to the basis of whatever you bought as a replacement, but you don’t get to claim that loss on your tax return.

So, this creates something of a stumbling block for the people who are into tax loss harvesting. We have a 61-day period. It’s the day of the sale, 30 days before and 30 days after. So, you have to be very careful about measuring that if what you’re looking to do is sell and then go back to the same exact investment or something that is substantially identical.

00:42:53 Rick Ferri: In your book, you gave March 31st as a good example. If you sold it on March 31st, it means you couldn’t have bought it in March or you couldn’t have bought it in April, which is only 30 days. And I thought it was a great example.

00:43:05 Kaye Thomas: Right. Well, thank you for that.

00:43:06 Rick Ferri: So substantially identical.

00:43:08 Kaye Thomas: Yeah, substantially identical is something that has not been fully defined ever. And there is one ruling out there where the IRS talks about a situation where a takeover is pending, and it has not yet closed, and the two stocks that are involved in the takeover are going to trade exactly in tandem.

They say that even though these are different stocks, they are going to be treated as substantially identical. And that that makes a lot of sense that you shouldn’t be able to sell one at a loss and buy the other one when you are really trading into the same situation that you traded out of.

The place where questions come up a lot is mutual funds and particular index funds. Can I sell one total market index fund and buy a different one from a different company? And will those be considered substantially identical? And the IRS has never ruled on this. And of course, there are related questions about overlapping index funds or if you take a total market fund and replace it with a small cap and a large cap index fund that together add up to that that total market fund. There are no rulings on this.

What I say in my book is that unless you want to be a wise guy and play loose with the rules, you’re going to treat it as substantially identical if the two investments, once you lay one on top of the other, they are going to perform exactly the same. If you know the investments are going to perform the same, that was the basis for that one ruling that I mentioned by the IRS. And so those are what are going to be or should be treated as a wash sale situation.

The IRS doesn’t have a way of tracking this realistically, but if you know if your return gets audited for some other reason and they see that you were a kind of a wise guy about this, they may decide to go after you.

00:45:20 Rick Ferri: OK, well, I’m a wise guy. If I sell the Vanguard Total Stock Market Index fund, which is run by Vanguard and tracks the CRSP total stock market index (which is the Center for Research and Security Prices, an affiliate of the University of Chicago) and I take a loss and I buy the Fidelity Total Stock Market Index Fund, which tracks the Dow Jones Total Stock Market Index, which is owned by Standard and Poor’s, neither the index provider nor the index fund provider are affiliated. And to me that means they’re not substantially identical, but again, I’m a wise guy.

00:46:08 Kaye Thomas: Yeah. And I have no problem with that. And I perhaps use the wise guy. I mean that’s sort of characterization that.

00:46:14 Rick Ferri: Forget about it, forget about it.

00:46:19 Kaye Thomas: I don’t mean to imply that means you’re cheating. You’re playing in an area where the IRS probably wouldn’t like. I’ll put it that way. If they took a close look at it.

00:46:31 Rick Ferri: As you said, the IRS has never said anything about mutual funds or particularly index funds, which have been around now for 45 years. I wish they would say something and just get it over with, but so far, we’ve heard nothing. So, it’s up to each person to make their own decision with the help of their tax advisor, of course.

In the last few minutes we have left, I want to talk about dividends. There are different types of dividends. We’re all getting our 1099’s. We already got them.

1099-DIV or 1099-INT, which is for interest. And there are ordinary dividends. There are capital gain distributions, non-qualified dividends, qualified dividends, exempt dividends. I mean all kinds of different dividends. Could you give us a kind of litany of what this is all about?

00:47:10 Kaye Thomas: For the most part, individual stocks are going to pay ordinary dividends, which will be qualified if you hold the stock for 61 days. You don’t have to hold it for 61 days before the dividend, but you have to hold it for a total of 61 days in order to get that qualified dividend treatment.

Mutual funds, their dividends can include a variety of items. If the mutual fund has interest income, that will come out as an ordinary non-qualified dividend. So technically it’s not interest, but it is treated essentially the same as interest. It’s ordinary income, and it’s going to be taxed at ordinary rates. If the mutual fund has received qualified dividends, then that qualified dividend can be passed through to the shareholders of the mutual fund. Those shareholders again have to hold for 61 days in order to get the qualified treatment.

We get into more interesting aspects with, for example, if you have a mutual fund that pays out tax-exempt income. If the mutual fund invests in municipals, then it’s going to have tax-exempt interest. It can pass that through as tax-exempt interest, and that interest can be tax-exempt federal, it can be tax-exempt on your state income tax if that’s applicable. Depending on the rules of your state and what state’s municipals that the mutual fund invests in.

So those are other possibilities. There’s a special rule for mutual funds that says that if you have invested in that mutual fund for a period of less than six months and you receive a capital gain distribution from that fund, you can treat that capital gain distribution as capital gain on your tax return. But if you sell that mutual fund within six months and you sell it for a loss, then that part of that dividend is going to be converted into a short-term capital gain instead of a long-term capital gain.

Now the reason for this is imagine that if you have a clever wise guy, let’s say, who is investing in mutual funds and selling and trying to get a tax advantage. You buy the mutual fund immediately before it pays out a capital gain dividend. You treat that as long-term capital gain and then you immediately sell that mutual fund for a loss. And it would be a loss immediately after the dividend pays out because that dividend payout reduces the net asset value of the mutual fund. So, you sell it for a loss, and you claim it’s short-term capital loss because you held it for less than a year.

Well, that would create an artificial advantage for someone who did that. They’re getting a long-term capital gain and immediately turning around and getting a corresponding short-term capital loss.

So now we have a rule that says you don’t have to wait a year, but if you wait less than six months before selling that mutual fund at a loss, you’re going to get this corresponding treatment that wipes out the benefit you would get from that. And the same thing happens to a tax-exempt payout from a mutual fund if you sell at a loss within six months after receiving one of those. Then you’re going to get a treatment that wipes out that loss up to the extent of the tax-exempt dividend that you received.

00:50:57 Rick Ferri: Well, the very last thing I’d like to talk about is gifting. Gifting of appreciated stock, giving it to charity, or gifting it to say your children. The benefits of that or the disadvantages of gifting of appreciated assets.

00:51:14 Kaye Thomas: Well, when you gift appreciated assets, long-term appreciated assets, to a charity, then you can (subject to limitations) treat the value of that gift as a charitable contribution deduction without having recognized any gain. So, you’re getting the same deduction that you would get as if you sold the stock or other investment and then gifted the proceeds. But you’re getting that benefit in terms of charitable contribution deduction without having to report gain on a sale.

So that’s a very beneficial way of dealing with substantial charitable contributions. I say substantial because nowadays small ones don’t produce benefit for most people because most of us are not itemizing anymore.

00:52:08 Rick Ferri: That’s a really important point. Because a lot of people, they might only have their state and local taxes as a deduction, and that’s limited to $10,000. And maybe their house is paid off, so they don’t have any interest mortgage expense in their house. And maybe they don’t have high medical expenses. So, the only other thing is a charitable contribution, and so if you’re married filing jointly your standard deduction this year is almost $30,000. And so, the first $20,000 that you would donate to charity wouldn’t be a tax deduction because you’re not going to be itemizing. You have to get over that amount.

00:52:43 Kaye Thomas: Yeah, that’s correct. Massive increase in the standard deduction. Again, this goes back to the 2017 tax law, a huge reduction in the number of people who itemize. And it is, in a sense, a great benefit for those people who you’d rather take a $30,000 standard deduction, than a $20,000 itemized deduction. But it also means that deductions of this kind, like charitable deductions, are of no benefit to a large number of people.

00:53:18 Rick Ferri: But what we do talk about a lot with the Bogleheads® is bunching of these charitable deductions and putting them into a Donor Advised Fund. And I don’t have a lot of time to get into what Donor Advised Fund is, but if you’re going to be giving $20,000 to charity every year and you’re going to be giving appreciated stock, that it’s better to give $100,000 in one year and put it in a Donor Advised Fund.

You get a $100,000 tax deduction on that, because now you’re above the standard deduction. Plus, your state and local taxes, so call it $110,000. And so, you’ll be able to take all of the amount of the deduction above the original $20,000 that you donated can get a tax deduction. This is if you’re in a high tax bracket, because only 30% of your AGI would qualify for this.

And then you put it in a Donor Advised Fund and then over the next five years, you just dole out the money from the Donor Advised Fund, $20,000 a year to the charity that you want to give to. Now you don’t give it to get a deduction in the following years, but you do get to deduct a large portion of that $100,000 rather than every single year, putting $20,000 to the charity and not getting any deduction for that $100,000.

00:54:26 Kaye Thomas: Yeah, the Donor Advised Fund has been a huge benefit for people who want to do bunching. Or simply just want to be putting money in it into a charitable vehicle, but without having chosen those charities yet and paid that money out. Yet it is in a sense kind of a workaround from the private foundation rules. Private foundation is another way of doing a similar thing, but at a far more expensive level. But with greater control by the individual who is setting it up.

00:55:00 Rick Ferri: This is all great for charity, giving appreciated property to charity, but it’s not something you may want to give to your children, correct?

00:55:08 Kaye Thomas: Well, they will still have to pay tax on the gain, so you’re not avoiding that gain and its property that you otherwise would be able to pass to your children at death if you hold on to it. And so, you know, I’ve seen people make this mistake. They’re in their later years and they think, oh, I should benefit my children by giving them this appreciated property. And of course, then they lose that step up in basis so it can be one of the classic mistakes that people make.

00:55:40 Rick Ferri: We could be talking about this for hours, if not days. All of the different things that we could do to lower our taxes. I do have a saying that if you hate paying taxes, then you should love to learn about taxes because that’s how you can reduce your taxes. So, with that in mind, I want to thank you so much for being with us today. I learned a lot and hopefully our listeners did also.

00:56:06 Kaye Thomas: It’s been a great pleasure being here. Thank you for having me.

00:56:08 Rick Ferri: This concludes this episode of Bogleheads® on Investing.

Join us each month as we interview a new guest on a new topic. In the meantime, visit boglecenter.net, bogleheads.org, the Bogleheads® Wiki, Bogleheads® Twitter, listen live to Bogleheads® Live on Twitter Spaces, the Bogleheads® YouTube channel, Bogleheads® Facebook, Bogleheads® Reddit, join one of your local Bogleheads® chapters, and get others to join.

Thanks for listening.

About the author 

Jon Luskin

Board member of the John C. Bogle Center for Financial Literacy


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