Tax Efficient Investing for the Everyday American

Many billionaires get rich by avoiding taxes.  How can you employ some of their methods to increase your net worth and financial stability?

Long Term Capital Gains (LTCG) vs Short Term Capital Gains/Ordinary Income

We all know capital gains taxes are much lower than ordinary income in 2020.  According to the IRS, long term capital gains tax rates range from 0 to 20 percent, but most of us will fall in the 0 or 15 percent bracket.  Short term capital gains are treated as ORDINARY income, and it ranges from 10 to 37 percent.  The median US household income was 63,000 in 2017 according to the Census Bureau, so they will pay 0 percent for capital gains tax and 12 percent for ordinary income as a married couple.  This means that for every dollar that the median US household earns can have a 12% swing based on its tax treatment.

RateFor Single Individuals, Taxable Income OverFor Married Individuals Filing Joint Returns, Taxable Income OverFor Heads of Households, Taxable Income Over
10%$0$0$0
12%$9,875$19,750$14,100
22%$40,125$80,250$53,700
24%$85,525$171,050$85,500
32%$163,300$326,600$163,300
35%$207,350$414,700$207,350
37%$518,400$622,050$518,400
2020 Tax Brackets Source: IRS

Not all capital gains are treated equally.  Since we already know that long term capital gains rates are not treated as ordinary income, what qualifies as a long term capital gain?  In general to qualify, you will need a qualifying investment that is held for 12 months or longer at the time of sale.  A qualifying investment is an investment purchased with pre-tax income.  

To put this simply, you will need to hold onto your investment for 1 year before selling to qualify for the long term capital gains tax rate.

RateFor Single Individuals, Taxable Capital Gains OverFor Married Individuals Filing Joint Returns, Taxable Capital Gains OverFor Heads of Households, Taxable Capital Gains Over
0%$0$0$0
15%$40,000$80,000$53,600
20%$441,450$496,600$469,050
2020 Tax Brackets Source: IRS

How to optimize your taxes

Now you may be asking how do I optimize my taxes based on these tax differentials? The easiest way we can make our investing more efficient is by fully utilizing our taxable and tax advantaged accounts.  Examples of tax advantaged accounts are your 401k and IRA.  An example of a taxable account would be your after tax brokerage account, such as Robinhood.  Obviously, a tax advantaged account is always going to have a better tax treatment, but most people are realistically unable to store most of their investments in tax advantaged vehicles due to liquidity issues, contribution limits, among other reasons.  Therefore it is very useful to have a taxable account to hold your investments.

Since tax advantaged accounts are not taxed, it is advantageous to hold investments that may lose more of their return to taxes.  In other words, investments that would normally qualify as a short term capital gain would be better held in a tax advantaged account such as an IRA… rather than your brokerage account.

Conversely, if you have an investment that does not lose a large amount to taxes, AKA something that qualifies as a long term capital gain, it is good to hold in your taxable account.

Now the question is, which investments are best for each type of account?

Taxable accounts are better for holding individual stocks and passive mutual funds/ETFs that you plan to hold more than 1 year.  It is also better for holding stocks that pay qualified dividends.  Municipal bonds are also nice to hold in a taxable account since they are exempt from federal taxes.

Tax advantaged accounts are useful for holding everything, but for tax efficient investing, it is useful for individual stocks/etfs that you plan on holding for less than 1 year.  It is also useful if you want to hold an actively managed ETF/Mutual fund because these generally generate short term taxable events.  Bonds are nice to hold in tax advantaged accounts because the interest they generate are generally subject to income tax.  Lastly, investments that pay dividends that are unqualified, such as REITs (or Real Estate Investment Trusts), are great to hold in tax advantaged accounts since you will avoid paying ordinary income tax rates on them.

Common Types of SecuritiesTax Advantaged AccountTaxable Account
Individual Stocks✔ (held longer than a year)
Mutual Funds✔ (held longer than a year)
ETF✔ (held longer than a year)
REITs
Municipal Bonds
Corporate Bonds
Here are a few types of securities and what accounts could be useful for holding them

What I do to tax optimize my investment accounts

Hope that helps.  Obviously it is better to hold everything in a tax advantaged account, but it would be very difficult to live life without quick access to your investments.  Hopefully these guidelines will assist you in deciding what strategies to run in each of your different accounts.  

As for me, I hold individual stocks in my brokerage account for over a year, while I hold REITs and run some active strategies in my HSA and IRA.  

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