The Bogleheads' Guide to Retirement Planning (9 page)

Taxes are complicated, confusing, frustrating, and a necessary evil. This chapter highlights that portion of the tax code that is particularly significant to the retiree. The amount you pay in taxes has a direct impact on your standard of living. Only by understanding taxes and their implications for your particular situation can you plan properly to minimize the amount you pay.

Several web sites can help you estimate your total tax liability based on where you live and how much income you have. There are many tools available on those web sites for doing an annual tax analysis. Time spent studying how taxes affect you will lead to better retirement planning decisions.

A taxable account is funded with after-tax savings. You are taxed on the income and capital gains from taxable accounts when you submit your personal tax returns in April. Investors open taxable accounts for different purposes: from saving for a house down payment to saving for retirement.

A taxable savings account is the most straightforward way of holding investments, though often not the best way because of tax considerations. As a general rule for retirement investing, taxable accounts should be your last resort if you are in a high income tax bracket. Tax-advantaged accounts help lower the amount of your money that you will pay in income taxes each year, and those tax savings compound in your account. Less tax today earns more for your retirement even after you withdraw the funds and pay income taxes on those withdrawals. Consult your tax advisor for your best savings account option.

The main types of taxable accounts are personal, joint, and trust. When you set up a new account, the first question is whether you want to set up a retirement account, an account for general investing, or an account to save for college and children. General investing refers to a taxable account. The next question is whether you want a personal, joint, or trust account.

A personal account is an account for a single person. There is one name and one Social Security number on the account, and one person makes all the investment decisions. A personal account is the simplest account you can set up.

Joint accounts are for investors with a spouse, domestic partner, or significant others. Joint account registration designates that two or more individuals share ownership of the funds equally. The most common joint account is a joint tenancy with right of survivorship. Upon the death of an owner in this kind of account, the shares pass to the remaining owner.

The advantage of a joint account is that when one of the joint holders dies, the surviving account holder automatically inherits the assets. There is no probate or legal proceeding required to transfer the assets to the surviving account holder. Probate, the legal process of distributing a deceased person’s property, can be expensive and time consuming. Joint accounts are a great option for ensuring that assets are immediately available to a surviving spouse, child, or partner.

Of course, there are also special reasons why a married couple might not want to have a joint account. Perhaps one or both are in a second marriage. In that case, trust accounts may be more appropriate. Trust accounts are designed for more complex situations. Generally, their purpose is to reduce estate taxes, to provide more control over how assets are transferred to survivors, or both.

An example of a trust is an AB Disclaimer trust. It provides a way to reduce your estate taxes when you have more assets than the federal estate tax exemption ($3.5 million in 2009). Before setting up a trust account with your mutual fund company, bank, or brokerage firm, you’ll need to first set up the trust. This means you will need to visit an estate-planning attorney who understands trust law and can word the document correctly. Trusts can be tricky business. Don’t try to write one on your own.

There are many different types of trust accounts, and they are discussed in more detail in Chapter 16.

An advantage of taxable accounts is the ability to use the losses that inevitably occur in some years to lower your tax bill. This is called tax loss harvesting. There are three benefits. First, tax losses represent an interest-free loan that defers capital gains taxes you would otherwise owe into the distant future and can even eliminate them entirely when you die. Second, you can use remaining tax losses to deduct $3,000 from your regular income taxes each year, which can mean an extra $750 or more in your pocket if you are in the 25 percent federal tax bracket. Third, any remaining losses are carried over into the subsequent years, so each year until your losses are used up, you can defer your capital gains and apply up to $3,000 against your income.

Suppose that you had invested $10,000 into a mutual fund in a taxable account and that with the steep decline in 2008, your holdings are now worth only $6,000. Since you plan to continue holding that fund, you might be inclined to ignore the losses and wait for the fund to eventually recover. Instead, using tax loss harvesting, you’d sell the fund and then buy it back 31 days later. In the meantime, you can either hold the cash in a money market fund or invest it in a similar, but not identical fund. This has the effect of booking a $4,000 capital loss, while returning you to your original position 31 days later.

The capital loss is valuable in several ways. Before you pay any capital gains taxes each year, you use your capital losses to offset any capital gains, and you pay taxes only if you have more gains than losses. If you have more losses than gains, you can apply up to $3,000 of your remaining capital losses against your regular income. And whatever capital losses are still left over (in this case, $1,000, which is the $4,000 in losses minus the $3,000 deduction) can be carried forward indefinitely into future years. Each year, you get to first apply the carried-forward losses against capital gains and then use any remainder (up to $3,000) to reduce your ordinary income.

Using tax loss harvesting to offset capital gains doesn’t actually eliminate the capital gains taxes you would have paid. Instead, it defers those taxes into the future. (In our example, you will owe more capital gains taxes in the future because you bought back the fund at a cost basis that is $4,000 lower.) However, because future money is worth less than money today, there’s a saying in public finance that a tax deferred is a tax avoided. Using tax loss harvesting to defer capital gains taxes is like receiving an interest-free loan from the IRS. Also, if you (and your spouse) are still holding the shares when you die, your heirs will receive a stepped-up basis, and you will have gotten the up-front benefit from tax loss harvesting while avoiding the taxes on the back end entirely. Finally, the extra capital gains you owe in the (possibly distant) future will be at the (lower) capital gains rate, while the benefit you receive today of the $3,000 deduction is at your (higher) marginal income tax rate.

If you buy the same security that you sold at a loss within 31 days, the IRS considers it to be a wash sale, and you will not be able to claim the tax loss. Even if you buy a security that is, according to tax law, substantially identical within 31 days, the IRS considers that to be a tax wash. For example, if you buy options on a stock to replicate the action of a stock you sold, the IRS sees this as a synthetic security that is substantially identical to the stock, and the loss will be disallowed. The IRS also counts wash sales across accounts, so you cannot sell a fund from your IRA and buy the identical fund in your joint taxable account.

The IRS has not defined
substantially identical
very well, but there are some reasonable guidelines to follow. The stock of one issuer isn’t substantially identical to stock of a different issuer, even if they are in the same industry. For example, Dell Computer (Ticker: DELL) isn’t substantially identical to Hewlett-Packard (Ticker: HP). If you have a loss on one of these companies, you can buy the other one without having a wash sale. However, an index fund that tracks the S&P 500 Index may be found to be substantially identical to another index fund that tracks the S&P 500 even though different fund companies manage the two funds.

It is probably fine to move between funds that track different indexes, such as Vanguard Total Stock Market and Vanguard Large Cap Index. These funds track different indexes, but the returns are similar, so they are good alternatives for domestic holdings. Vanguard Total International Stock Market and Vanguard FTSE All-World ex-US also have similar performance while tracking different indexes.

If you hold ETFs, iShares Dow Jones U.S. Index (Ticker: IYY) is a good substitute for Vanguard Total Stock Market ETF (Ticker: VTI), and SPDR MSCI ACWI ex-US (Ticker: CWI) is a good substitute for Vanguard FTSE All-World ex-US ETF (Ticker: VEU). These non-Vanguard ETFs have higher expense ratios and track different indexes than Vanguard ETFs, but their performance should be nearly identical to their Vanguard equivalents.

There has been ample opportunity to tax swap over the past several years. Even in an up year, there are occasional down months when you could decide to sell the specific shares that have losses (generally, the newest shares that you purchased) to book the loss.

An alternative to swapping into a similar fund is to hold cash. Simply place the sale proceeds in a money market fund for 31 days and then buy back the original holding. The downside to this approach is that you could be out of the stock market during a month when there is a large rally.

To maximize the return of your taxable account, you want to minimize the taxes you pay. That means using tax-efficient mutual funds and exchange-traded funds.

There are several advantages to holding tax-efficient equity mutual funds in your taxable account. First, when you eventually begin to sell these funds in retirement, you will pay the lower capital gains tax rate on funds you hold in your taxable account. If you held those same funds in a tax-deferred account such as an IRA, you would pay ordinary income taxes at a potentially higher marginal tax rate. Second, your heirs will receive a stepped-up cost basis on your taxable holdings after your death. That means neither you nor your heirs will owe taxes on the appreciation that occurred in the securities. There is no stepped-up basis for funds in a tax-deferred account.

Avoid using stock mutual funds that have a high portfolio turnover of securities unless it is in an exchange-traded fund, which has a different tax structure. Funds that have a high turnover of stocks generally distribute the most capital gains each year. You can identify funds that have high turnover by reading that turnover ratio listed in the fund prospectus. The lower the turnover ratio in the fund, the less churning of securities and the more tax efficient it is.

Perhaps the most tax-efficient domestic stock holding for taxable accounts is a total stock market index fund. This fund holds essentially all U.S. publicly traded companies. This means that the fund is not churning between different holdings, so capital gains are rarely generated.