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.
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.
- 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 income which is a combination of both your earned income AND investment income.) We paid 15% on our investment income most years.
- After I quit working, our dividend income plus our inadvertent long term capital gains (more about this later) 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 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.
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.
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]