It's important to understand how the IRS categorizes (and taxes) different types of income. There are three major categories of income: ordinary income, capital income, and passive income.
To minimize taxes—and maximize what you actually get to keep—put your most tax-efficient investments (those that lose less of their return to taxes) in your taxable accounts and your least tax-efficient investments (those that lose more of their return to taxes) in your tax-deferred accounts.
Be tax-wise as you withdraw your income. To the extent that you rely on income from your portfolio, it's important to consider taxes as you sell investments and withdraw funds.
By the time you've been paying taxes for decades, you get it. The tax code is absurdly complicated and enough to make any of us (myself included) want to run for cover. On the other hand, like me, you probably want to be a good citizen and pay your fair share but not a penny more.
Unfortunately, these two realities don't fit together. Just completing your tax return every year can be a monumental task. And figuring out how to manage your tax bill takes even more work. It takes long-term planning, short-term decisions, and a solid understanding of tax concepts. I'll go over some basics here, but I also highly recommend that you enlist the ongoing help of a great CPA, particularly as you first move into retirement.
When it comes to taxes, there are both advantages and disadvantages to being a retiree. On the plus side, you may have more control over your income, and therefore more strategies for controlling your taxes. On the minus side, you may well have more at stake, and certainly more to think about.
Understand How Different Types of Income Are Taxed
Before I get into strategies, it's important to understand how the IRS categorizes (and taxes) different types of income. In the eyes of the IRS, there are three major categories of income, which are taxed as follows:
- Ordinary income—From wages, self-employment, interest, dividends, etc.
- Taxation—In 2020, ordinary income is taxed at a marginal rate ranging from 0 percent to 37 percent, with the highest earners paying the most. Note, though, that some interest income is tax-exempt (for example, interest from state and local municipal bonds), and some dividends are considered qualified and therefore receive special long-term capital gains tax treatment.
- Capital income—From the sale of property. Capital gains and losses can either be short-term (held for one year or less) or long-term (held for more than one year). There are also special categories for things such as collectibles.
- Taxation—Short-term capital gains are taxed as ordinary income.
- In 2020, long-term capital gains and qualified dividends are not taxable for single filers with up to $40,000 and married filers with less than $80,000 in taxable income.
- For married filers with taxable income between $80,001 and $496,600 and single filers who have taxable income between $40,001 and $441,450, long-term capital gains and dividends are taxed at 15 percent.
- For single filers with taxable income over $441,450 or $469,600 for married filing jointly, long-term capital gain and qualified dividend income over that amount is taxed at 20 percent.
- A 3.8 percent Net Investment Income Tax (NIIT) applies to individuals, estates, and trusts that have net investment income above applicable threshold amounts ($250,000 for married filing jointly or qualifying widow and $200,000 for single filers).
- Long-term capital gains on collectibles are taxed at 28 percent.
- Passive income—From investments in real estate, limited partnerships, or business activities where participation is "immaterial."
- Taxation—Ordinary income tax rate. Passive losses can usually only off set other passive income, not ordinary income.
Marginal vs. Effective (Or Average) Tax Rate
Because taxes are progressive, meaning that we pay a proportionately larger amount of taxes on higher levels of income, there are two tax rates that you need to be aware of: your marginal rate and your effective rate.
Your marginal tax rate is the amount of tax you pay on your last dollar of income. For example, in 2020 if you're married filing jointly and in the 22 percent tax bracket, you will pay $22 in taxes for every $100 of taxable income above $80,250 and up to $171,050. This is important, so that you will know, for example, how a bonus or other extra income is taxed.
Your effective tax rate is the average tax rate you pay when you take all of your income into account. This is important, for example, if you're figuring out the tax impact of an investment. Your effective rate (also known as the average rate) is most likely lower than your marginal rate.
At a Glance: How Retirement Income is Taxed
Social Security benefits—Up to 85 percent of benefits taxed at your ordinary income rate.
- Singles—Income less than $25,000, benefits not taxed; income $25,000–$34,000, 50 percent of benefits taxed; income over $34,000, 85 percent taxed.
- Married filing jointly—Income less than $32,000, benefits not taxed; income $32,000–$44,000, 50 percent of benefits taxed; over $44,000, 85 percent taxed.
Pension income—Fully or partially taxed as ordinary income, depending on whether contributions were tax-deferred.
Annuity income—Fully or partially taxed as ordinary income, depending on whether contributions were tax-deferred.
Traditional 401(k) Distributions—Fully taxable as ordinary income.
Traditional deductible IRA distributions—Fully taxable as ordinary income.
Traditional nondeductible IRA distributions—Withdrawals of contributions tax-free, earnings taxable as ordinary income.
Roth IRA and Roth 401(k) distributions—Tax-free provided you are 59½ and the funds have been in the account for at least five years.
Taxable account—Taxes are assessed annually based on the different kinds of income (ordinary, capital, passive) generated by the investments during the year. When an investment is sold, it is taxed as short- or long-term capital gains (or losses). Interest from municipal bonds is exempt from federal income tax, but gets added back for computing taxability of Social Security benefits (however, interest from "private activity" bonds could be included when computing the alternative minimum tax). Income from Treasury bills and bonds is exempt from state (but not federal) income tax.
Investment income from interest, dividends, royalties, gains and passive income may also be subject to the 3.8 percent Net Investment Income Tax for high earners.
Be Smart About Where You Place Your Investments
I've said it repeatedly: As an investor, your first priority is your asset allocation. Next comes diversification and your individual security selection. But paying attention to your taxes is important, too.
To minimize taxes, and therefore maximize what you actually get to keep, put your most tax-efficient investments (those that lose less of their return to taxes) in your taxable accounts and your least tax-efficient investments (those that lose more of their return to taxes) in your tax-deferred accounts—as shown in the following.
Taxable accounts are the best place for:
- Individual stocks you plan to hold for more than one year
- Tax-managed stock funds, index funds, exchange traded funds (ETFs) and low turnover stock funds
- Stocks or mutual funds that pay qualified dividends
- Municipal bonds and I Bonds
Tax deferred accounts such as traditional IRAs and 401(k)s are the best place for:
- Individual stocks you plan to hold one year or less
- Actively managed funds that may generate significant short-term capital gains
- Taxable bond funds, zero-coupon bonds, inflation-protected bonds (TIPS) and high-yield bond funds
- Real estate investment trusts (REITS)
Roth IRAs or Roth 401(k)s are the best place for:
- Assets that you believe have the greatest chance for the largest return
- Assets that are the least tax efficient
SMART MOVE: If you believe that you will be in a higher tax bracket at a later date (for example, if you're currently delaying Social Security or if you're expecting an inheritance), you can consider converting all or part of your IRA to a Roth IRA. Not only will your eventual withdrawals be tax-free, there also will be no RMDs. Plus, converting your account to a Roth can be a boon to your heirs. Keep in mind taxes are due at the time of conversion and there are other considerations, so check with a professional before doing a conversion.
Be Tax-Wise as You Withdraw Your Income
To the extent that you rely on income from your portfolio, it's important to consider taxes as you sell investments and withdraw funds. In a nutshell, it's generally best to:
- Sell from your taxable accounts before tapping your tax-deferred accounts.
- Sell securities from overweighted asset classes.
- Sell lower-rated securities before higher-rated securities. If you need to sell high-rated securities from your taxable accounts, sell those that will generate a loss before those that will generate a gain.
When it comes to taxes, it's essential to think long-term. But you can have an impact by thinking year-to-year as well. For example, if you've made a large charitable contribution or have paid extraordinary medical bills, you might be able to take a larger distribution without increasing your taxes. Conversely, you might want to reduce your distributions in a year with unusual income.
Harvest Your Losses from Your Taxable Accounts
No one wants their investments to lose money. But tax-loss harvesting can turn a loss into a plus, if not an out-and-out win. Here's how the process works:
When you sell your investments in a taxable account, you can reduce your taxable capital gain with a capital loss. Both capital gains and capital losses are categorized as either short-term (for an investment that you've owned for one year or less) or long-term (for an investment that you've owned for more than a year), which means that almost every sale will create one of the following four results:
- Long-term capital gain (LTCG)
- Long-term capital loss (LTCL)
- Short-term capital gain (STCG)
- Short-term capital loss (STCL)
You net these out with the following three steps:
- Net your LTCGs against your LTCLs
- Net your STCGs against your STCLs
- Net your long-term result against your short-term result to arrive at a single taxable figure
Example: In one year, Sam sold several investments in his taxable accounts, resulting in:
- LTCG: $11,000
- LTCL: $6,000
- STCG: $5,000
- STCL: $6,000
He nets them out as follows:
- LTCG $11,000 and LTCL $6,000 _ LTCG $5,000
- STCG $5,000 and STCL $6,000 _ STCL $1,000
- LTCG $4,000
This long-term gain then receives the preferential long-term capital gain rate. However, if the netting process resulted in a capital loss, up to $3,000 can be deducted against ordinary income. Any amount over $3,000 can be carried over as a deduction in future years.
CAUTION: If you decide to sell a stock or mutual fund to take a tax loss, but you know that you want to buy it back at a future date, watch out for the wash-sale rule. If you sell a security at a loss and buy the same or a "substantially identical" security within thirty days, the loss is generally disallowed for tax purposes.
SMART MOVE: If you make a partial sale, your broker is required to report the cost basis for stocks purchased after January 1, 2011. The default method is FIFO, or "first in, first out." Instead, you may be able to minimize taxes by specifying shares with a higher cost basis.
Plan Your Charitable Gifts with Taxes in Mind
As you plan charitable contributions, there's no harm in lowering your tax bill at the same time. For example, think about the following:
- You can deduct a percentage of your adjusted gross income for contributions to qualified charitable organizations above the standard deduction if you itemize. The amount depends on the type of asset you give and the type of institution you give. In 2020 under the CARES Act you can deduct up to $300 in cash to qualifying charities if you take the standard deduction.
- Giving appreciated stock instead of cash. If you donate appreciated stock that you've owned for more than a year, this can be a win-win for you and the recipient. If you sell appreciated stock, you will owe capital gains tax. But you can gift the stock tax-free to a qualified charity plus potentially receive a charitable tax deduction equal to its full market value. Caution, though: If you've owned the stock for one year or less, it's considered a short- term holding and you'll be able to deduct only the purchase price, not the full market value.
- Conversely, it's better to sell depreciated stock before you donate the proceeds. This way you can realize a capital loss, which you can either use on your current year's taxes or bank for future years. Plus, you can still claim the value of the gift as a charitable deduction.
If you're 70½ or older, you can make a direct contribution to a charitable organization from your IRA without paying any tax. The downside is that you can't also claim a charitable deduction for this donation. However, it can count toward your RMD.
Work with a tax professional and financial advisor for more customized advice based on your situation.
Have a personal finance question? Email us at . Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, Schwab.