Where The Tax-Tail Meets The Investing Dog


This is going to be one of those posts where I write about the reality of living off investment income.  You know… one of those posts where I write the truth instead of blowing a bunch of sunshine up your ass.

It might not be comfortable to hear this, but trust me — I think it’s better for both of us this way.

Not so long ago I mentioned something along the lines of, “The tax tail should not wag the investing dog“…. but I didn’t really go into a whole heck of a lot of detail about it.  Clearly investments are not dogs and taxes are no joke.  So what exactly did I mean by this rather odd jumble of verbal diarrhea?

I meant this — Avoiding taxes should not be the primary aim of any investor who intends to live off their portfolio returns.  Compounding at good rates of return should be the primary aim.

For today’s post, I thought we might cover why I believe this is important.

First, let’s take an instructive visit to the really-real world where people like me actually pay taxes and why tax avoidance isn’t necessarily in your best interest as an investor.

 

That Sweet-Sweet Tax Free Income

If you live in the United States and you invest, you’ve probably heard that our current tax laws allow a sizeable chunk of investment income completely tax free — As long as your investment income is in the form of qualified dividends and long term capital gains AND your total income is within certain tax bracket levels.

In 2017 the 0% investment income tax bracket allowed up to $75,900  (if married and filing jointly) tax free.  This number was raised a little for 2018, and now you can earn up to $77,200 of taxable income and still qualify for 0% taxes if you qualify.

2018 tax brackets
2018 Investment income tax brackets, courtesy of Corporate Monkey CPA.

Pretty sweet, right?  For retirees and the financially independent without ordinary income, this 0% tax bracket provides a very comfortable level of income in most areas of the United States. (Unless of course you live in New York, San Francisco, Honolulu, or one of the more expensive cities in the U.S.)

If you geo-arbitrage and find affordable locations to live outside the U.S., this tax free money can go even further!  It’s a huge boon for retirees and the investor class, and one of the best parts of the U.S. tax code.

That’s the bedtime story anyway.  Early retirement bloggers love to brag about this little tax loophole and how they “don’t pay any taxes”.  But how real is it?

Well, I can’t speak for other bloggers, but I can tell you about my experience — I live off my investment income (mostly) and I pay taxes on my investment income too.  A LOT of freaking taxes.

Here’s why:

  1. When I was still working, Mrs. Tako and I easily surpassed the 0% tax bracket with our taxable income from both our jobs and our investments.  (Remember: investment income tax brackets are based upon taxable earned income)  We paid 15% on our investment income most years.
  2. After I quit working, our dividend income plus our inadvertent long term capital gains (more about this later) plus earned income still exceeds the $77,200 amount. In other words, we still pay 15% taxes on our investment income.

Based upon our dividend growth plan for 2018, Mrs. Tako and I expect to receive dividend income of $53k in 2018.  On those dividends alone we would seemingly to fall into the 0% investment income bracket…  but that’s not the whole story.

Subtracting that $53,000 from the allowed earned income level of $77,200 and leaves us with $24,200 in available “space” for capital gains.

Sounds like plenty of room for capital gains, right?

Except it’s not.  That $24k in capital gains is a mere 1.2% of our portfolio.  If i’m not extremely careful we end-up blowing right through the 0% tax bracket level and into 15% land very easily.

In 2017 for example, we realized $116,523 in capital gains and that happened through no action of my own.  Nearly all of these capital gains came from ‘called’ preferred shares.  There was nothing I could have done to avert these capital gains.  Because I bought those preferred shares at prices far under par value, I realized considerable capital gains on those investments when they were called (in addition to very nice dividend yields).

This is what I mean by inadvertent capital gains — I didn’t have a choice in the matter.

In most cases, even if I’m only $1 dollar over the 0% taxable bracket — I’ll really be looking at $65,620 to spend after taxes.

 

Optimizing For Taxes

Given the choice, I think most people would probably choose $77k over $65.  Right?  There’s lots more fun to be had in life with another $12k!  With just a little tax optimization!

Maybe.  Or, maybe not…

Let’s imagine these same tax-savvy investors start to look for ways to lower dividend income or carefully control capital gains so that they’ll continuously come in under the 15% bracket every year.  They do this by moving to low-dividend paying ‘growth’ investments and then avoid selling assets until they need that spending cash.

There’s a number of reasons why this strategy of optimizing for taxes can be problematic, but here’s the ones that stand-out the most to me:

1. By forgoing higher dividend payments you might actually be creating lower investment returns for yourself.  Long-term studies have shown that over long periods dividends make-up roughly 50% of all investor returns.  Trying to lower dividend income may not be the best idea.

2.  Moving your assets into lower-dividend paying “growth” investments could mean your overpaying for growth.  It’s a well known fact that investors usually overpay for growth investments.  Overpaying means lower real returns for investors.  (You might want to read my post Is Growth Hurting Your Investing Returns for further thoughts on this topic)

3. Trying to avoid capital gains by not selling assets can also cause investors to hold onto underperforming assets far too long.  If you get stuck holding underperforming assets you might be missing out on considerable portfolio growth.

4. By controlling investing income to meet annual spending levels, you give-up external compounding — which is a tragic mistake to make.  I feel strongly that investors should seek both internal and external compounding.

5. You may not be able to control capital gains all the time.  Say for example, your shares get purchased by another company.  Buyouts happen.  Or, your bonds/preferred shares get called like mine did last year.  You might be forced to take extra capital gains.  This has happened to me multiple times.

6. Accidents, medical issues, or natural disasters may also require extra withdrawals at inopportune times.  This can easily force savvy investors into the 15% bracket.

7. Tax laws are always changing.  What works this year to avert taxes may not work next year.  Making big changes every year to take advantage of new tax laws is not an efficient way to run a portfolio.

For all of these reasons, I’ve come to the conclusion that smart investing decisions and smart tax decisions are not necessarily the same thing.  Optimizing a portfolio to minimize taxes does not optimize for maximum returns.

Instead, I try to make smart investing decisions that will maximize returns and then let the taxes fall where they may.

dominos
Like the game of standing up dominos and knocking them over, it’s reaching the goal at the end that matters, not the perfect placement of each domino. Total returns at the end matter more than tax free returns in any given year.

 

Planning For 15% Taxes

In a sense, hitting the 15% tax rate is going to be inevitable for the Tako family.  With $2 million in taxable investments, we’re already getting close to that income level with just dividends (completely ignoring ordinary income and capital gains here).

Once our taxable portfolio grows to about $2.6 million in taxable investments we’ll easily be blowing past $77,200 every stinking year from dividends alone.  Furthermore, if I assume a 6% annual return, that $2.6 million is only 5 years away!

Given this reality, we might as well just plan on having 15% taxes every year for our “investment income only” budget.  This has been my strategy for the past few years and we’ve been budgeting assuming the 15% rate.

(Note: The 15% bracket has plenty of room for higher investment income before we hit 20%.)

Now that I’m freed from thinking I must forever maintain a 0% tax rate, I’m open to making smart investing decisions that will maximize my long-term returns.

This doesn’t mean I completely ignore taxes either — It’s important to be cognisant of my required rate of return after taxes.  If I can invest in a low-risk tax-free bond fund earning 4%, this means I must earn a taxable return exceeding 4.7% before it’s worth investing in a taxable investment.  Every new investment should be measured against this yardstick.

 

Caveats

OK, so I’m the first to admit that everyone’s tax situation is going to be different.  Taxes in the US are extremely complex, and there are many variables that can alter the tax equation.  I obviously don’t have the time to cover every scenario and contingency here.

My real-world scenario of constantly bumping into the top of the 0% bracket is very real for my personal situation, but it might not be a problem for people with smaller-sized portfolios.

Maybe there is a scenario where you can minimize your taxable income and keep earning high rates of return without overpaying for growth stocks or inadvertently lowering your returns.  If you know how to do this, I’d love to hear about it in the comments

However, I suspect if you intend to live a middle-class lifestyle you’ll probably spend somewhere around the national average of $58k annually.  If that’s the case, you might be bumping into those higher tax brackets sooner than you think.

Welcome to the really-real world my friends.

 

[Image Credit: Dominos]

22 thoughts on “Where The Tax-Tail Meets The Investing Dog

  • June 30, 2018 at 7:15 AM
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    I agree. Tax decisions are a consideration but their minor opposed to expenses, returns, volatility, and liquidity.

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  • June 30, 2018 at 7:19 AM
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    Very nice post! Trying to keep income down for tax reasons seems a lot like trying to get a health insurance subsidy even though you’ve got millions. I wanted some enjoyable side gigs in early retirement and the fact that they make enough money to blow past any of the income limits for ACA and capital gains by themselves is kind of a blessing because I don’t have to go through all the income hacking gyrations, I just pay my taxes and my $16,000 health insurance and stay at a zero withdrawal rate. Does seem wierd to have been frugal my whole life and to have saved up so much and now to not be spending any of it.

    Reply
  • June 30, 2018 at 7:50 AM
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    Hi Mr. Tako,

    You are right- you are probably going to have some bite coming out of taxes?

    Have you ever thought of moving abroad? Then there may be a way to convert any earned income under the exclusion of the the first 103K USD which will be tax free. You will still need to account for the dividend income but can offset this tax liability against any foreign taxes paid on passive income.

    It’s pretty hard to get away without paying taxes but you can certainly minimize them.

    If you have any investments that are below your basis price you can also tax loss harvest to offset the gains from your preferred that got called.

    -Mike

    Reply
    • June 30, 2018 at 2:24 PM
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      I do some tax loss harvesting but traveling abroad on occasion makes me prefer living in the states, partly due to our hobbies and grown kids. I could potentially incorporate my consulting into a business and pay the lower corporate rate on that income but at the end of the day it would only be a few thousand dollars saved and that just isn’t worth the time and effort now.

      Reply
    • July 4, 2018 at 12:07 AM
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      We’ve considered moving abroad, but the idea of moving around every 90 days isn’t terribly appealing. The places where we could live longer than on just a tourist visa aren’t really our style. But it’s something we’ve considered.

      For our family it’s really about quality of life, not just minimizing spending.

      Reply
  • June 30, 2018 at 8:20 AM
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    Tax laws are always changing. What works this year to avert taxes may not work next year.

    Good stuff. The above is what I’m waiting for. I do my taxes manually so I can learn what’s actually happening behind the numbers and with the new tax law it’s basically going to be a wait/see game until I file next year to see how all the changes affect things. Being the geek that I am, I’m actually looking forward to doing next years taxes!

    Reply
    • July 4, 2018 at 12:08 AM
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      I’ve got a fair idea of how our taxes are going to turn out next year, but until I fill out the tax forms it’s all a big (educated) guess! 🙂

      Reply
  • June 30, 2018 at 9:46 AM
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    Thank you so much for taking the time to post this. This very concern has been on my mind recently as I started figuring out that how I have constructed my portfolio is going to cause a lot of problems tax wise as my passive income streams alone are putting me into the higher tax bracket (I’m currently single so it’s lower limits but do plan on getting married prior to retiring so it should be a moot point then).

    I just rationalize it that whatever money comes in, I will still be paying far less taxes than I do now (I’m well into the 37% tax bracket). Biggest concerns are if there will be tax law changes in future that start attacking investment income more.

    Reply
    • July 4, 2018 at 12:09 AM
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      Well, the current tax system is setup to tax workers the most. Investors see comparatively little in taxes.

      Call that unfair, but it’s been that way for a very long time. I don’t expect it will change soon.

      Reply
  • June 30, 2018 at 1:47 PM
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    This is a topic we have explored quite a bit but will pay to pay more attention as we get closer to living off our portfolio. A good thing is that we have RRSP and TFSA which are tax advantaged. With TFSA we don’t have an age restriction on when you can take out the money.

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    • July 1, 2018 at 1:01 AM
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      Sounds like a very good plan to have. We did a mix of investing in both tax advantaged and taxable plans over the years, so we’ve got some tax advantaged money, but most of it is pretax money in 401k’s and IRAs. At some point when we withdraw that cash we’ll just have to pay taxes on that too.

      Sooner or later the tax man gets his cut!

      Reply
  • June 30, 2018 at 7:44 PM
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    Why has no one mentioned how absolutely adorable the photo of the baby and doggy is?

    I try to avoid as many taxes after we are retired as possible but my husband thinks it’s weird. If your going to be able to side hustle and make money, you always should because you’ll still keep more in the end. The house gets their cut but no one died from making some easy money if it’s there.

    I’ve been obsessed with returns. I mean it doesn’t matter how much we earn and save in the next 7 years. A .5% difference in returns is much more important. Kinda makes me crazy how little everything else we do matters now. Not sure if I like that feeling, not much control here…

    Reply
    • July 1, 2018 at 12:55 AM
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      Hehe, thanks. My son was a little younger than 1 year old in that photo. One of my favorite pictures ever.

      I know a lot of older investors in the 60+ age range that try to reduce taxes, and they do some incredibly stupid stuff that kills their returns… but they think they’re getting somewhere because they “reduced taxes”.

      But the reality is exactly like you said — higher returns (and consistent returns) are much more important.

      Reply
  • July 1, 2018 at 2:10 PM
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    I love the photo too!! Your son is ADORABLE.

    This is my favourite quote of this post:

    I write the truth instead of blowing a bunch of sunshine up your ass.

    Looolll!

    We have TFSAs and RRSPs (as Tawcan mentioned) but maxed those out and now my non-registered accounts are kind of a mess. I still invest in US and international stocks even though the taxes will be up the wazoo but better than keeping too much home bias which will sag my portfolio.

    Double edged sword I guess.

    Reply
  • July 2, 2018 at 11:04 PM
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    Nice post, Mr. Tako. We’ve been quite satisfied living in the 15% bracket with my wife working FT still. I can imagine working to stay within the 0% could be time-consuming and at times frustrating. But, sounds like you’ve got it figured out given your situation and you’re not sweatin’ the fluctuations you can’t control.

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    • July 4, 2018 at 12:02 AM
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      Yeah, it’s unlikely we’ll see many 0% years in the future. Might as well get used to paying 15% all the time.

      Reply
  • July 3, 2018 at 11:50 AM
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    I have it on very good authority that the market will solve the problem for you in many of the upcoming years. A long bull market makes perspective fade.

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    • July 4, 2018 at 12:02 AM
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      So are you suggesting that a bear market is coming and my investment returns will be minimal in the near future?

      Need I remind you that capital gains like those I had last year can happen even in bear markets.

      Reply
  • July 5, 2018 at 7:07 AM
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    Hmmm, I’m worried I misunderstand tax brackets after reading this post. If you go over the $77k cutoff by $1 of qualified dividends or long term cap gains, I thought your additional tax due is $0.15. (and not $~12k in taxes on that single dollar off additional taxable income).

    Am I missing something? Aren’t tax brackets applicable to marginal income?

    Reply
    • July 5, 2018 at 8:46 AM
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      Yes, you are missing something. Regular income might work that way, but investment income doesn’t work that way. I suggest studying the irs tax spreadsheets further.

      Reply
  • July 7, 2018 at 3:04 AM
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    We were planning on get money out of our RRSPs (Canadian equivalent of 401Ks) in retirement and paying no tax, but due to unexpected income (blog and book advance) in retirement we’ll probably end up paying tax this year. Champagne problems, right? Penalizing yourself just to save on taxes never made sense to me, so I’ll happily continue doing work I love and paying taxes, should the unexpected income continue.

    Reply

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