Spreadsheet Goodness
This is part 2 of a 3-part series.
Download the spreadsheet as:
Previously, we looked at samples of the usual assortment of retirement accounts. The standard retirement options are actually the easiest model since the math behind the taxes is straightforward -- either apply taxes before, after or never. Now let's look at taxable investments.
401K versus Taxable Index funds
I have seen the question asked before -- my employer does not offer matching, should I instead put my money into taxable investments and pay 15% tax on gains? Well head over to the Taxable section and give it a test. Now we have another variable to look at. Yr Distrib is the portion of gains that are distributed every year as a taxable event. For example, if you own a diversified portfolio with an average 2% dividend yield and 0.5% turnover, that would be a 25% yearly distribution based on a 10% annual return (2.5 / 10 = .25). We then put tax as 15% long-term capital gains + dividends, 25% regular income, 5% state income for a total of 22.5% as the effective tax rate.
At $30.5K after taxes, it's quite a beat-down from 401Ks. For a taxable account to break even, income tax rates would have increase up to 44% ((54666-30581)/54666) after you stop contributing while LTCG/QDIV rates remained constant.
Taxable Accounts: Growth Index Funds
Let's say you put decided to put everything into just Growth Index funds where average yields+turnover is about 5%? Does that improve the situation?
About 4.7% better -- certainly some potential for splitting assets across low yield and high yield categories if you invest more than the 401K+Roth IRA annual limits.
Taxable Accounts: Systems Trading
What if you prefer system trading where you turnover your portfolio every year? (Examples: Magic Formula, Dogs of the Dow, etc.)
Looks to be a 11%+ drag compared to the growth index option, 7%+ compared to total stock indexes. Do systems trading under tax-advantaged accounts if possible.
Taxable Accounts: Income Tax Rate
What if we have taxable investments/strategies at regular income tax rates -- say bonds or day trading. (For this exercise to isolate the tax consequences, assume bonds return 10%.)
Ouch, quite a big tax hit. We just went from $38K for 401Ks/Roth IRAs to $32K for Growth Index Funds to $24K in this case. Absolutely the top priority for sheltering under some type of retirement account (or to avoid completely in the case of day trading).
Taxable Accounts: REITs
With REITs, the yearly dividend distributions are taxed at income rates. However, the capital gains are at qualified rates. To get a close projection, set the yearly distribution to 40% (4% yield / 10% total return = 40%) and the default tax rate to 30%. At year 20, set yearly distribution to 0% (assume you sell before the big end of year distributions) and then the tax rate to 20%.
At these tax rates, it's about par with systems trading tax drag. At higher tax rates, the impact will be higher.
Taxable Accounts: Different Tax Rates?
Something to keep in mind -- we have historically low LTCG/QDIV tax rates. LTCG rates used to be 28% and there was no concept of QDIVs. And from the rumblings, it's possible qualified gains might have to be bumped up to 20% or 25% as part of fixing the AMT package. We are also at historic low dividend yields -- before the 90s boom period, 4%-4.5% was the average yield. Let's see what happens when we change these parameters.
So investments in an 80's like environment incur a 9% tax drag compared to the tax rates today.
Taxable Accounts: Cost Basis
One last variable to look at. Suppose you invested $5000 over the years and it has grown to $10,000 now. In addition, there has been about $1,000 in taxable distributions. So to account for only $4,000 of the starting balance being taxable, we would enter $6,000 in the Cost Basis field.
To be continued in part 3 (variable annuities, variable universal life) ...
This is part 2 of a 3-part series.
Download the spreadsheet as:
- OpenDocument: InvestmentTaxSummary.ods
- Excel: InvestmentTaxSummary.xls
Previously, we looked at samples of the usual assortment of retirement accounts. The standard retirement options are actually the easiest model since the math behind the taxes is straightforward -- either apply taxes before, after or never. Now let's look at taxable investments.
401K versus Taxable Index funds
I have seen the question asked before -- my employer does not offer matching, should I instead put my money into taxable investments and pay 15% tax on gains? Well head over to the Taxable section and give it a test. Now we have another variable to look at. Yr Distrib is the portion of gains that are distributed every year as a taxable event. For example, if you own a diversified portfolio with an average 2% dividend yield and 0.5% turnover, that would be a 25% yearly distribution based on a 10% annual return (2.5 / 10 = .25). We then put tax as 15% long-term capital gains + dividends, 25% regular income, 5% state income for a total of 22.5% as the effective tax rate.
At $30.5K after taxes, it's quite a beat-down from 401Ks. For a taxable account to break even, income tax rates would have increase up to 44% ((54666-30581)/54666) after you stop contributing while LTCG/QDIV rates remained constant.
Taxable Accounts: Growth Index Funds
Let's say you put decided to put everything into just Growth Index funds where average yields+turnover is about 5%? Does that improve the situation?
About 4.7% better -- certainly some potential for splitting assets across low yield and high yield categories if you invest more than the 401K+Roth IRA annual limits.
Taxable Accounts: Systems Trading
What if you prefer system trading where you turnover your portfolio every year? (Examples: Magic Formula, Dogs of the Dow, etc.)
Looks to be a 11%+ drag compared to the growth index option, 7%+ compared to total stock indexes. Do systems trading under tax-advantaged accounts if possible.
Taxable Accounts: Income Tax Rate
What if we have taxable investments/strategies at regular income tax rates -- say bonds or day trading. (For this exercise to isolate the tax consequences, assume bonds return 10%.)
Ouch, quite a big tax hit. We just went from $38K for 401Ks/Roth IRAs to $32K for Growth Index Funds to $24K in this case. Absolutely the top priority for sheltering under some type of retirement account (or to avoid completely in the case of day trading).
Taxable Accounts: REITs
With REITs, the yearly dividend distributions are taxed at income rates. However, the capital gains are at qualified rates. To get a close projection, set the yearly distribution to 40% (4% yield / 10% total return = 40%) and the default tax rate to 30%. At year 20, set yearly distribution to 0% (assume you sell before the big end of year distributions) and then the tax rate to 20%.
At these tax rates, it's about par with systems trading tax drag. At higher tax rates, the impact will be higher.
Taxable Accounts: Different Tax Rates?
Something to keep in mind -- we have historically low LTCG/QDIV tax rates. LTCG rates used to be 28% and there was no concept of QDIVs. And from the rumblings, it's possible qualified gains might have to be bumped up to 20% or 25% as part of fixing the AMT package. We are also at historic low dividend yields -- before the 90s boom period, 4%-4.5% was the average yield. Let's see what happens when we change these parameters.
So investments in an 80's like environment incur a 9% tax drag compared to the tax rates today.
Taxable Accounts: Cost Basis
One last variable to look at. Suppose you invested $5000 over the years and it has grown to $10,000 now. In addition, there has been about $1,000 in taxable distributions. So to account for only $4,000 of the starting balance being taxable, we would enter $6,000 in the Cost Basis field.
To be continued in part 3 (variable annuities, variable universal life) ...
Subscribe
Leave a comment