Start a taxable investment account

This is the eight piece in a 8 part series on getting your financial house in order. Here are the rest of the posts. Please read them sequentially and hopefully it will help you on your path to financial independence.

1. Setting up a budget/expense report: Ever wonder what should be included in a budget? We cover what you may want to consider. You can also sign up for our email list and  download our free Budget crushing tool!
2. Determining net worth: Do you know how to calculate your net worth? We discuss how to do it and if things like your home or cars should be included? Check it out to see what I do.
3. Get you some insurance: Here we discuss what insurance you need for your family? Is an umbrella policy really necessary?
4. Setting up a will or living trust and What to place in a living trust: How do you protect your family with a living trust? Why would you want one and how much will this cost? How do you do it? Check out these posts to figure it out.
5. Max out the 401K, 403b, 457, or Government TSP: Ever wonder what these different accounts are? How much can you put into one versus the other? Is a Traditional or Roth plan right for you?
6. Start an IRA: What is an IRA? Should you have one?  How do you do a backdoor Roth?
7. Pay down debt: As Dave Ramsey says, debt is bad. Still which debt should you pay down first and when can you consider paying down debt versus investing.
8. Start tax advantaged accounts: Once you have done the above, what is the next thing to do with your money?

Taxable investment accounts

Once you have gotten your financial house in order, including funding your 401K to obtain your company’s match, paying down high interest debt, starting a Roth IRA, and saving an emergency fund then it is time to start thinking about taxable accounts.

Taxable accounts act differently then money that goes into 401k and IRAs. Every time you sell a stock in a taxable account you pay  taxes on the capital gains or plan on tax loss harvesting. Let’s talk briefly about both before we get into how you may want to allocate your taxable accounts.

 

Capital gains tax

Capital gain tax comes into play when you sell an asset (in this case a stock) and realize gains. For instance, if you bought a stock for $100 and sold it for $120, you will have to pay taxes on the $20 profit. If you do not sell the stock and let the $20 continue to grow with the stock, then you do not have to pay taxes until you actually sell the stock.

You have to report gains on all assets sold, not just stocks. This includes selling your personal home, collectibles, etc. There is an exclusion though. If the gains (profits) from selling your primary residence is less than $250,000 for a single people and less than $500,000 for a married couples then no taxes are paid on the gains. Determining if a home is your primary residence includes facts such as how long you have lived there and for what portion of the time as described by this exciting IRS document.

Consider short term versus long term gains. There is a difference and it impacts your taxes. Long-term assets are considered anything held for over 1 year and are typically taxed at a lower rate (see below) for stocks. Short-term assets are investments less than 1 year and taxed at a higher rate based on your income.

 

Tax loss harvesting

What if you lose money on a stock . Let’s say you buy $100 of stock and sell it for $80. That is a $20 loss. With “Tax loss harvest” you use that money and deduct it from your gains. You can not use losses from property to do this, only investments.

For example, if you have 2 stocks both purchased for $100. Let’s call them “getting lucky” because let’s be honest, stock picking is about luck in the short term, and “losing”. Sometime in the future you decide to sell both stocks. Stock “getting lucky” is now worth $120 and stock “losing” is worth $80. If you sell both stocks you can use the $20 loss of the “losing” stock to decrease  your capital gains on the “getting lucky” stock by $20. That means the total capital gains owed for the year will be $0. This term is called “net capital gains”. This takes into account all of the funds sold for a given calendar year.

Additionally if the losses are more than the gains you can deduct up to $3,000 from ordinary income. For example, let’s say you have multiple stocks that you sell. At the end of calculating the profits and losses the total “net capital gains” is a loss of $2,000. You can take that loss and deduct it from your ordinary income (that’s right, deduct $3,000 right from your take home pay!). So if your income was $100,000, you only have to pay income taxes on $98,000.

Rolling over the losses

The beauty of this process is that capital losses are rolled over. If you have a $20,000 loss on stocks (it was a rough year), you can claim $3,000 of the losses on this years tax return (decreasing the income tax you own), and then still have $17,000 of losses to use in future years to either offset capital gains or income. You can use these in the future to offset capital gains or if you get out of the stock business, deduct another $3k per year for almost 6 years from your income.

From my understanding this is how President Trump has avoided paying any significant taxes in years as written here. He took a $916 million loss in 1995 and carried it forward for years! Kudos for him on working the system, but man that is a big loss.

The smart thing to do with tax loss harvesting is take an asset that has decreased in value/price and trade it for an equivalent item/stock. Something with high correlation. So swap small-cap domestic funds for small-cap domestic funds, etc. Your asset allocation doesn’t change. You still own a similar asset but can take the loss for “tax loss harvesting” and use it towards your income or save it for when you sell stocks for a profit. This way you maximize your tax advantage while maintaining the same asset allocation in your portfolio.

 

Capital gains tax rates

Ok so we have talked about some important things like capital gains, capital losses, net capital gains, and tax loss harvesting. Let’s now quickly spell out what the tax brackets are for dividends.

Gains on long-term assets (Stocks held for over 1 year)

• If your tax bracket is less than or equal to 15% (so 10 or 15%), then you pay no capital gains at all.
• If your tax bracket is 25% or greater (so 25, 28, 33, or 35%) then you pay 15% capital gains tax.
• If you are rich enough to be in the 39.6% tax bracket then you will pay 20% in capital gains tax. If you make that kind of cash ($418,400 as a single adult or $470,700 as a married couple) then you should find ways to decrease your adjusted gross income. 

Gains on short-term assets (Stocks held for less than 1 year)

• These gains are unfortunately taxed as ordinary income. So you can see the tax benefit of holding on to assets for more than a year.
• Here is a graph with the income tax brackets for 2017.

Finally, there is a 3.8% tax on net investment income for high earners; defined as single with an adjusted gross income of over $200,000 or married filing jointly with an adjusted gross income of over $250,000.

 

Asset allocation

Okay now let’s talk about asset allocation. This has been done at length and you can find some good references on my post here.

If you want to know my personal philosophy, I follow the mantra of KISS (Keep it simple stupid). I use a 3 fund portfolio. I prefer Vanguard for my personal investments, but also use Fidelity for my 401k. Use either for your taxable accounts. 

The three fund portfolio from Vanguard includes:

• Vanguard Total Stock Market Index Fund (VTSMX)
• Vanguard Total International Stock Index Fund (VGTSX)
• Vanguard Total Bond Market Fund (VBMFX)

Your allocation will depend on how aggressive you want to be, but to start I would recommend doing the following:

• 80% VTSMX
• 10% VGTSX
• 10% VBMFX

There are many other ways to go about buying individual stocks, but remember KISS and rest easy at night.

So there you have it. That is the basics of what you need to know to start a taxable account.

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Also published on Medium.