I Set Up An Account Yesterday To Check It Out, And I Have To Say, It’s Pretty Slick
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This is a question a lot of people have. It is really one of those unfortunate things about taxable accounts. If you screw it up at the beginning, you're kind of stuck with it in a lot of ways, or it's going to cost you some money to get out, unless the funds are really terrible. If the funds are really terrible, you'll get a capital loss when you get out of them. But here is the way you should look at this as far as whether to have some legacy holdings in your portfolio, or whether to just get invested into what you actually want to own.
I have a multimillion-dollar taxable mutual fund account, and I don't pay capital gains taxes on it, period. I mean, I guess we get the distributions whenever they distribute to me each year. The qualified dividends and the longterm capital gain distributions, I pay taxes on that, but I don't sell them. The ones that have appreciated, I use for my charitable contributions, and I hold the rest. Obviously, the only time I sell them is when I have a loss in them, and I tax loss harvest the loss, so I'm getting these tax losses, and then I'm never paying the gains because I'm using those for my charitable contributions. It's really a pretty slick trick with a taxable account.
But realize about this exit tax, the way this works is when you leave the country, you're basically taxed on everything. So if you have a taxable account, you're basically updating your basis in that to what the value is on the date of expatriation. Obviously, you want those to be longterm capital gains taxes, but it's unfortunate you have to pay them at all. If you just stayed in the US you wouldn't have to pay those taxes. Bear in mind that this also applies to IRAs. If you are a covered expatriate, you pay taxes if your IRA was fully distributed to you on the day you expatriate. It's interesting, though, that you don't have to actually get rid of the IRA. You can leave the money in the IRA, you don't have to pull it out, but you do have to pay taxes on it. So essentially what you've done is turned your IRA from being tax deferred money, to being a nondeductible IRA, which now has basis. And so that basis now when you pull it out, you won't pay taxes on it cause you've already paid taxes once, but all the earnings, will be fully taxable going forward when you pull them out of the account.
So their idea is rather than just investing this in a taxable account, what if we use it to pay off our mortgage since that money is asset protected? I think that's fine. The nice thing about paying down a mortgage is its guaranteed rate of return. It's usually not a very high rate of return, it'd only be three or four or 5%, but it's guaranteed, and that's a pretty good guaranteed return these days when you're looking at treasury bonds paying 2%. That is certainly fine if that is what you would like to do. Are you likely to come out ahead investing it in the market, because you'll likely make more than three or four or 5% in the long run? Yeah, probably, that is an easy argument to make. But once you add in the guaranteed nature, and the asset protection nature, this is not an unreasonable decision to make. So go ahead and use that to pay down your mortgage. And then if something happens to public service loan forgiveness, you can borrow against the mortgage if you'd like to pay off the student loans, or you can just cash flow it going forward, but you have options.
Dr. Jim Dahle: Well, this is a question a lot of people have, and it's really one of those kind of unfortunate things about taxable accounts. If you screw it up at the beginning, you're kind of stuck with it in a lot of ways, or it's going to cost you some money to get out, unless the funds are really terrible. If the funds are really terrible, you'll get a capital loss when you get out of them. But here's the way you should look at this as far as whether to have some legacy holdings in your portfolio, or whether to just get invested into what you actually want to own. Step number one is figuring out the basis on everything in your taxable account. If you have something with a loss, sell it now. You want to change investments, and you've got a loss, it's going to cost you nothing, and in fact, lower your taxes to get rid of that investment.
Speaker 3: hygiene. I am an attending physician three years out of residency and I've been working with my financial advisor for the last five years. I currently have a taxable investment account that's being managed by his firm. We've only been contributing to it for the last 12 months, or so as our advisor wouldn't even let us think about opening up a taxable account until all of my loans were paid off, that being about $160,000 in two years. We were maximizing our retirement accounts and had purchased, and have been settled in our new house.Speaker 3: He currently has about $40,000 in it, and we contribute $2,500 per month. The AUM fee is pretty standard 1%, and all of the funds are Vanguard funds, which range from three to 35 basis points for their expense ratio. I want to put the investments into a more simple Boglehead style portfolio, which mirrors my retirement assets, because I don't like the complexity of having these other 12 funds, some of which I don't really understand, and don't want to take the time to learn.Speaker 3: I also don't want to continue to pay that 1% fee as it gets larger every year. For context, we pay our financial advisor about a hundred dollars per month flat rate. So can I transfer those assets in kind to another account without realizing capital gains, and two, what should I do with those funds once I have them in my own account and don't want them anymore? Should I sell them for simplicity's sake, and pay the taxes on the gains, which now is about $2,500 in a mix of short and longterm gains, or wait for them to lose value first so I can count the losses against my taxes. Thanks for everything you do, Jim.
Dr. Jim Dahle: In Canada, an MER is a common term, and what that means is a management expense ratio. We don't really use that term in the US, but they do in Canada, and that's an annual fee charged to your portfolio. It consists of a mix of management fees, operating expenses, and trailing commissions. You can look at the prospectus of the fund and figure out what that is. I guess the best thing to think about for a mutual fund, we have an expense ratio, same kind of thing, but for a separate account, this would be like a wrap fee is what we would call it in the US. So this demonstrates again that you've got to be careful what you buy in a taxable account, because you might be stuck with it for the rest of your life unless you're a tither, or some other person that gives a bunch of money to charity each year, and then you can just flush out those capital gains.Dr. Jim Dahle: I have a multimillion dollar taxable mutual fund account, and I don't pay capital gains taxes on it, period. I don't pay it. I mean, I guess we get the distributions whenever they distribute to me each year. The qualified dividends and the longterm capital gain distributions, I pay taxes on that, but I don't sell them. The ones that have appreciated, I use for my charitable contributions, and I hold the rest. Obviously, the only time I sell them is when I have a loss in them, and I tax loss harvest the loss, so I'm getting these tax losses, and then I'm never paying the gains because I'm using those for my charitable contributions. It's really a pretty slick trick with a taxable account.Dr. Jim Dahle: All right, our next question comes from Sam. Let's take a listen
Dr. Jim Dahle: Oh boy. You guys are really giving me the hard questions now. Should you choose an S-Corp to try to get at a 199A deduction? How do I figure out what the right balance of salary to pay myself is? How do I even decide whether to go S-Corp? I mean, this is like a two hour discussion I could have with Sam over dinner about all the implications of these decisions, and he's asking me to dumb it down on the podcast. No, I really can't dumb it down, and let's remember that I'm a blogger, not an accountant, so it's hard enough for me to get all these details right when I'm writing a blog post, and I can sit down and pour over it, and double check it, and check my resources. But to do it off the cuff for a podcast is really tough. I'm going to try though, but it's possible I may botch it a little bit.
Dr. Jim Dahle: So if you hear something that doesn't sound right, make sure you double check it. So this particular person, Sam, is married, filing jointly, and under the phase out limits, and making somewhere between 70 and $200,000 in 1099 income, plus has a W-2 income on the side. He wants to know, do I count the accounts receivable and the employer contribution? Well, accounts receivable really depend whether you count those in your books, it depends on how you do your bookkeeping. If you do it on a cash basis like I do, then accounts receivable are nothing. They're neither income, nor an expense. Employer contributions to 401(k)s are business expenses, so they decrease your ordinary business income, or profit, and thus your 199A deduction, which is the pass through business deduction for pass through businesses like partnerships, and sole proprietorships, and S-Corps.Dr. Jim Dahle: So if Sam is below the phase out limits for 2020, married filing jointly, those phase out limits start at $326,600. But if you're below that limit, you don't have to deal with the salary. You don't need an S-Corp like people above the upper limit do in order to pay yourself a salary to maximize your 199A deduction. If you're below those limits, you don't need that salary. So there's really no reason to form an S-Corp for that issue. The deduction is just 20% of your qualified business income. So if your qualified business income is $100,000 your deduction is $20,000. So if you're in the 40% bracket, that's worth maybe $8,000 off your taxes. But the only reason to form an S Corp in this situation is to try to save on Medicare tax by declaring some of your income salary, and some distribution. But remember that whatever you call salary reduces your qualified business income amount, and thus your 199A deduction.Dr. Jim Dahle: So if I were in this situation, I'd just be a sole proprietor. That way, that would max out with my 199A deduction. I wouldn't have to hassle with form 941 each quarter. For an S-Corp, your taxes would be a lot simpler. You'd save those costs. You wouldn't save anything on Medicare taxes, but you would certainly be able to maximize your 199A deduction. You know what another thing that you could do in this situation is rather than using a standard individual 401(k), and making tax deferred employer contributions, which would reduce your 199A deduction, you could do mega backdoor Roth IRA contributions. Obviously, you have to get a solo 401(k) that allows those contributions, but we're really getting off into the weeds now. You can see there's just no way to dumb this stuff down. 2b1af7f3a8