Mostly Mary [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Voices [0:22]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:36]

Thank you, Mary, and welcome to episode 77 of Risk Parity Radio. Today on Risk Parity Radio, we're going to have a special episode about brokerage accounts and taxes. I had a couple of emails that I wanted to address, but I thought that giving you a little bit of background on brokerage accounts and taxes would be helpful to a lot of people who who do not have experience or maybe just helping one of their children open up their first brokerage account. So, I am not a tax expert and I don't hold myself out as one but I will just give you some conventional wisdom from your Uncle Frank. Now, the subject of taxes is often exciting or triggering for some people.

Mostly Voices [1:24]

Fire and brimstone coming down from the skies. Rivers and seas boiling. 40 years of darkness, earthquakes, volcanoes, the dead rising from the grave. Humans sacrifice dogs and cats living together, mass hysteria.

Mostly Uncle Frank [1:40]

Whereas for most of the rest of us, it just kind of puts us to sleep. Forget about it. And it is a problem to be managed, but it's not too difficult to manage if you take the time to look at the rules and understand how they apply to your situation. We had the tools, we had the talent. You don't need to know how the rules apply to everyone else's situation, just your own. So when I was growing up, my parents sat me down and they said, Fat, drunk, and stupid is no way to go through life, son. Well, I actually only resembled one of those remarks. I'll let you guess which one. But really, that's not where I was going here.

Mostly Voices [2:25]

I'm funny how? I mean, funny like I'm a clown? I amuse you?

Mostly Uncle Frank [2:29]

What I am thinking though is that in the day we live in, it is a good idea or part of adulting I think for everyone to be opening up an ordinary brokerage account. There are three accounts that an 18 year old ought to have who's beginning to earn some money or has earned some money and those accounts would be a checking account, a Roth IRA, and an ordinary brokerage account. The reason that ordinary brokerage accounts are important now is that they are so accessible to everyone given no fee trading and the possibility of buying fractional shares at places like M1 or Fidelity. So you don't need much money to actually invest in a taxable brokerage account anymore. You don't need thousands of dollars. You won't be paying lots of commissions. Everybody can do it and just about everybody should do it so that they are financially competent and ready to go as their finances expand and they're looking for places to put other assets. So let's talk about this from the very basics. How do you open up one of these brokerage accounts? Well, it's pretty easy. You get on the interwebs and you go to a site like Fidelity or a Vanguard or Schwab. I would use one of the big established discount brokerages and not one of the social media type platforms, which seem to be having problems and scandals these days. But if you go to one of those websites, there will be a tab that says open an account. And then you open that up and you go in and it'll ask you what kind of account you want to open. and you will say brokerage account, which is the same thing as when people say taxable brokerage account. It's the same thing. It's actually barely taxed if you managed it properly and we're going to talk about that. We have the tools, we have the talent. Now once you have that, there are essentially five things or transaction types that can happen with one of these brokerage accounts. First you hook it up to your checking account. and then you can deposit money into that account. You can withdraw money from that account. You can buy things in that account, those things generally being exchange traded funds, ETFs, or mutual funds. These days you might as well just buy the exchange traded fund versions because you could do it with no fee trading and buy fractional shares if you need to. mutual funds are becoming obsolete after that has changed. So you can still buy mutual funds, but I would focus on learning how to handle ETFs for the future. So you can buy funds or stocks, you can buy individual stocks too, you can sell those individual stocks or funds, the ones you hold, and the only other transaction that occurs in these accounts is if you hold something that pays an interest payment or a dividend, whenever that happens, that will be the fifth kind of transaction. Okay, now how are these transactions taxed? How does this taxation work in an ordinary brokerage account? Well, I think I'd like to, like I usually like to, is invert the question. We'll take those five transactions and talk about which ones are not taxable events. These ones do not cause you to have to record or pay any taxes. You are not taxed by putting money into a taxable brokerage account. You can put money in there, you can leave it in there as long as you like. It will never be taxed by the very act of putting it in there or leaving it in there. Unfortunately, there are some people who believe that if you put money in a taxable brokerage account, you're going to get taxed on it every year. and that is not the case, putting money in a taxable brokerage account does not cause you to incur any taxes. The next transaction that does not cause you to incur any taxes is taking money out of a taxable brokerage account. You can remove money from a taxable brokerage account to your heart's content, and that is how it differs from an IRA. If you take money out of an IRA, that is a taxable event that does not apply to an ordinary brokerage account. So if you take money out of a brokerage account, there is no taxation associated with that. And the third transaction that does not cause you to have a taxable event is buying something. If you buy a stock or an ETF or anything in your taxable brokerage account, that does not cause a taxable event. So there is no taxation caused by buying something in your taxable brokerage account. So that's three out of the five, which leaves only two left that, and these are the two that can cause a taxable event. And one of those is if you sell something in your taxable brokerage account, if you had bought a fund or a stock and then later on you sell it, that is what is called a taxable event. And we'll talk about what those taxes are in a minute. The other taxable event in your brokerage account is if one of your funds or stocks pays a dividend or some kind of interest. And when that happens, that is a taxable event for that year. Now, it doesn't matter what you do with that money. It doesn't matter if you withdraw it, if you reinvest it, if you buy something else. The very fact of it paying a dividend or the interest is the taxable event. So that cannot be avoided in that circumstance. Some people think that if they reinvest the dividends, it's not taxable and that's just not true. Alright, now let's talk about the kind of taxes that you will possibly incur in one of these accounts for one of those two transactions. And there are two schedules that matter. One is your ordinary income schedule. So the same thing that you pay taxes in connection with from your job and if it qualifies for that treatment, it will simply be added on to that income and that's the rate you will pay at the marginal rate you are at. If you're in the 12% bracket, you'd be paying 12% on it. If you were in the 22% bracket, you'd be paying 22% on it. Now, there are another set of transactions that we're going to discuss. that fall under what is called the long-term capital gains tax rates. And that is a completely separate schedule from your ordinary capital gains tax rates. And those tax rates on that schedule are 0%, 15%, and 20%. Now, there are some other excise taxes and other things that apply to very high incomes, but we are just going to Keep it to the most simple explanation for the purpose of this episode. So what goes into the ordinary income? Let's start with that. There are two things that get taxed as ordinary income. One is if you buy something and then sell it within the same year. If you buy something and sell it within the same year that is called short-term capital gains assuming you made a gain on it. and you would pay tax on the gain that you made. So if you bought it for $1,000 and if you sold it for $1,100 the tax you would pay would be on the $100 and so if you're in the 12% tax bracket and you made that transaction that would cause you a tax of $12. It would be $22 if you were in the 22% bracket. Now this also applies to income that comes from bonds and from some asset classes like REITs. They pay what's called ordinary income. So what are the transactions that go in this separate schedule, this long-term capital gains tax schedule. If you hold something for more than a year, you bought a fund and you hold it for more than a year and then you sell it, it is taxed on the long-term capital gains tax schedule. So if you bought a fund for $1,000 and the next year after one year you sold it for $1,100, your gain from that is $100. if you were on the 0% tax bracket for long-term capital gains, you would pay zero for that. If you were on the 15% tax bracket for long-term capital gains, you would pay $15 on that. If you were in the 20% bracket for long-term capital gains, you would pay $20 on that. The other thing this applies to is what are called qualified dividends. and most common stocks and most common stock funds like VTI, when they pay dividends, they are qualified dividends. And if something is a qualified dividend, then the long-term capital gains tax rates apply. So if you received $10 in qualified dividends from your fund and you were in the zero percent tax bracket, you would pay zero tax on that Dividend. If you're in the 15% bracket, you're going to pay $1.50. And if you're in the 20% long-term capital gains tax bracket, you're going to pay $2 on that. And now we get to the question is how do you know which tax bracket you're in for each one of these categories, the ordinary income and the long-term capital gains? Well, for the ordinary income, you're just going to look at your basic tax schedule, which tells you what tax bracket you are in. And the 12% bracket goes up to about $40,000 these days for a single person and about $80,000 for a married couple. And you can look at the other brackets. I will link to something in the show notes to show you those. But there is a separate schedule. for the long-term capital gains, which has that 0%, 15%, and 20% brackets on it. This is the confusing thing about that. That schedule is also tied to your other income for the year. So, for example, if you are single and you make under $40,000 for the year in your ordinary income, you would be in the 0% long-term capital gains tax bracket. If you make over $40,000 for the year, you're in the 15% capital gains tax bracket. And then if you go all the way up to something like $450,000 or something close to that, after that you get into the 20% capital gains tax bracket. As you can see, most people are in the 0% or the 15% capital gains tax bracket. And I will link to that schedule in the show notes. So then this leads to capital gains tax management. And this can be a funny or unusual topic because when you get to retirement and if your income for a married couple is less than $100,000, you can almost jigger this so you're never paying any taxes or hardly paying any taxes. because think of it this way. If you retired and had no outside income, no W-2 income, and you were single, that would mean that the first $40,000 in capital gains you incurred for that year would be taxed at a zero percent rate. So you'd be paying no taxes on $40,000 worth of long-term capital gains if you can Manage to manage your account so it only is giving you long-term capital gains. For a married couple, if for instance you had a year when you had zero income from other sources, you could take up to $80,000 in long-term capital gains and not pay any taxes on it. And if you had income over that, it would be taxed at the 15% long-term capital gains tax rate. Which leads to a funny thing for lower income people that are subject to only that 0% bracket. If you're in the 0% bracket, you want to sell and incur those gains every time there are long-term capital gains to be incurred. And simply sell it, incur the gain, and then buy back the stocks or the shares the same day or the next day. And you can buy the exact same thing if you're taking a gain. There's no worry about 30 days for wash sales. That's for losses. We're just talking about gains here. So if you are on the 0% tax bracket, it behooves you every year to look at it and say, where can I incur or get long-term gains and take them? Because you're paying 0% on them that year. Now, once you are in the 15% marginal bracket for capital gains, or you're in the 20%, then you need to think about something that is called tax loss harvesting. And what is that? If you look at your holdings in your portfolio, in your brokerage account, some of them will have gains usually, and some of them will have losses. And if you sell something at a loss, you actually get to subtract that from your net gains for the year or you carry it over to another year if you have too many losses one year and you can't use them all. So you get to offset those two things. So if you had two things in your account, two funds and one, you bought them each at for $1,000 and you had one that went up to $1,100 and you had another one that went down to $900. and you sold both of those, you would offset the gain with the loss, so you'd end up with zero for the net gain, and that would give you 0% taxes for that year. Now all of these things are recorded on what is called Schedule D of your tax form, and you should take a look at that so you can understand how these things are separated out. into short and long-term capital gains. Alright, I hope that didn't put most of you to sleep. It was kind of a very rudimentary explanation of the workings of taxable brokerage accounts and their taxation. I'm going to also direct you and link you to an episode from the Bogleheads on Investing podcast with Rick Ferri. He interviewed somebody named Phil DeMuth this past month, episode 32 of that podcast on April 4th. And that has lots and lots more information about lots of tax issues that affect all kinds of different people. But I didn't want to make it that complicated. I wanted to keep it as simple as possible because now we're going to turn to these emails that we received about some of these issues. And so here we go. Here I go once again with the email. First one is from Brian R. Brian R asked the question, you have mentioned your child saving for some intermediate term purchases in a taxable account using the golden butterfly. The thing I understand the least about investing is tax strategy. Have you spoken in the past about this? Compared to doing a two index equity bond portfolio, does holding a golden butterfly have a tax drag for someone in the 22% bracket? that should make them avoid it. Thank you for all your work, Brian. Okay, I have talked about these issues in a few other episodes, mostly with regard to specific situations. I think in episode 68 we were talking about Chuck H's portfolios and how to allocate some things there, and so you can have a look at that. And just for clarification, my son actually uses the golden ratio for the purpose of this investing for intermediate term purchases. But these portfolios are not that much different. They're both sample portfolios on our portfolios page at www.riskparityradio.com. Okay, the taxation of that kind of portfolio is really not any different from a two index equity bond portfolio. Because the same taxation rules apply to all of these things. I should say with the exception of gold, which has a 28% capital gains tax attached to it. But the way this works and the way you can easily tax manage this is this. If you are saving for some intermediate goal, money will be going in periodically as there is savings that are available for my son. It's a sporadic thing. There's more some months than other months. It's just the excess of what is not already saved away up front in the retirement accounts or used for expenses. There are some left over at the end of the month, and that goes into this. So the way you would want to do this is use that money to allocate to keep the portfolio in balance. So you're effectively doing a kind of a mini rebalancing every time you put money in there. The reason you want to do it this way is because of what I told you before. There is no tax consequences to buying something in your account. So as long as you're never selling anything in there, you're not going to have any tax consequences to it, at least on the buy sell side. With the idea that if you're going to hold this for some period of years, eventually when you sell the various parts of the account out, you will incur long-term capital gains because you've held them for long enough. and then you will pay the tax on that at your long-term capital gains tax rate. And so that is the same regardless of whether you're using one of those portfolios or a two index equity bond portfolio, you would still be paying the same kind of taxes on whatever gains you have in the account. So there's really no difference there. And the same is really true for the income that's coming out of the account. Because if you have a two index equity bond portfolio, you're going to have some qualified dividends from the equity fund and you're going to have some ordinary income from the bond fund. And the same thing will be true of the elements in a risk parity style portfolio, whether it's golden butterfly or golden ratio. You're going to have some qualified dividends and some ordinary income. And so when you get that, you will pay taxes on it in that year. And I should say you'll pay your ordinary income rate on the ordinary income and you will pay the long-term capital gains rate on the qualified dividends. So the basic answer to the question is no, there isn't really too much different overall. If you are in the 22% bracket for ordinary income, you're going to be in the 15% bracket as far as long-term capital. gains are concerned. One thing that you are more likely to be able to do though with a risk parity style portfolio is to tax loss harvest with it. Because there is a good chance that in any given year you will have something that has gone down in value and something that has gone up in value. And as I mentioned before, if you sell something at a loss, you sell something else at a gain, those things cancel out and so you're not paying anything on the capital gains. Now you do have to be mindful on the sale side of what is called the wash sale rule. So if you sell something at a loss, you can't buy it back right away. The rule is you have to wait 30 days. But there's an easy way to get around that rule and the way to get around that rule is you buy something that is very similar but not the same. So if you were selling a total stock market fund at a loss one year, you could buy a S&P 500 fund the same day and that would not trigger the wash sale rule. And so that's how you get around dealing with that rule. You just look for another asset ETF that is similar but not exactly the same. and these days it's very easy to do because there are so many ETFs out there that are so similar, but they're just slightly different based on slightly different indexes. If you want to figure out whether something is similar or not, go to that asset correlation analyzer@portfoliovisualizer, put those assets in there, see how correlated they are. Oftentimes you'll find things that are 99% or 100% correlated and then look at what their other return characteristics are and standard deviation characteristics are. And you'll get a good idea as to whether one thing is a good substitute for another for wash sale purposes. So in a sense, if you manage it properly, having a risk parity style portfolio allows you more options in terms of tax management. All right, question two comes from Jamie E. Jamie E writes, hi Frank, I discovered your show through Choose FI and I'm really enjoying it. I have a question for you. I am trying to retire early by accumulating funds in an account that is taxable. When I do this, the account's purpose is to have a shorter term lifespan of five to ten years. That said, I seem to be incentivized by the tax code at least to ensure that this is stock heavy and growth stock heavy in particular. How do you recommend dealing with taxable and tax deferred accounts from a holdings perspective, optimizing for taxes, but also risk parity for folks like me who will need to the taxable accounts earlier? I hope this crazy question makes sense. Thank you, Jamie. Thank you, Jamie. And yeah, we did deal with this back, I believe, in episode 68, but we'll talk about it again. Whenever you're having to manage a portfolio, it's always better to have more transactions on the deferred retirement accounts and rejigger those around because that is the difference between an ordinary brokerage account which gets taxed on those transactions when they occur in your deferred or retirement account. You can make as many transactions as you want and there's never any tax consequences to those. And so you're only going to get taxed on that when the money comes out of it. Now, this other basic question is your tax location question. And yes, it is generally better to have your stock funds on the taxable side and then keep your bonds and REITs in particular in that tax deferred or retirement account. because you don't want to be paying taxes on that ordinary income there. And then you also, if you have any qualified dividends, those will be taxed at long-term capital gains rates, and so that keeps you wanting to have most of your stocks in the taxable side of the account. So in terms of priority, you would put the highest income stuff in the tax-deferred account. which would be your REITs probably at the top. You could also, if you had other things that are paying lots of income bonds and other things like that, they generally go in that account as well. You keep the stock funds outside. And then when you are drawing down, you try to minimize those transactions on the outside, so you're just selling a bit of those stock funds at a time and then you can rebalance by doing transactions inside of the tax deferred account. The one thing you want to do is just treat all of these assets as one big portfolio because that allows you to do the transactions where they're not going to cause you taxable events and minimize the transactions on the outside in your taxable account. Of course this is always subject to how much you have in each place because obviously if you're having one big risk parity style portfolio, if your taxable account is 110th the size of your tax deferred account, you're going to end up with lots of stocks in the tax deferred account. If your taxable account were 10 times the size of the tax deferred account, then you would be ending up with bonds and other payers potentially in the taxable side of the account. Most people are more balanced than that and so it becomes relatively easy when you're talking about divisions in your allocations in your portfolio that are more in the lines of 20% of this or 15% of that can easily be located on the right or left side of this divide here. So I hope that answers your question. This does end up being a very personalized question for most people because you need to kind of take an inventory as to what accounts that you have and what your specific situation is as to when you're going to get access to those tax deferred accounts. But now I see our signal is beginning to fade. I want to thank all of our listeners. We seem to be getting over a thousand downloads a day on these podcasts now and I very much appreciate the attention you have paid and all of the comments and interest and questions that have been raised. We will proceed next time to finish our analysis of that corporate bond fund, SPLB, that we started last week. If you have questions or comments for me, you can send them to frank@riskparityradio.com that email is frank@riskparityradio.com or you can go to the website www.riskparityradio.com and put in your message in the contact form and I will get it that way. Thank you once again for tuning in.

Mostly Voices [30:16]

This is Frank Vasquez with Risk Parity Radio signing off. The Risk Parity Radio show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here. making sure to take into account your own personal circumstances.