Allison Dubreuil, Wealthway Financial: While tax season may be over for most people, we thought we would revisit some tax issues. We get a lot of questions about people’s tax bills about unexpected tax bills, a lot of people owing. So we thought it’d be a good idea to give a rundown of why you might have owed. Why you can expect that, going forward. What you can do to plan for it so that you don’t get those unexpected surprises.
Kevin Zywna, Wealthway Financial: Not the immediate rushes over having to get your taxes prepared and filed by April 18 this year. Something we say in every tax-oriented show, is tax planning does not happen on April 14. It doesn’t even happen on December 30th of the prior year. Tax planning, good tax planning, is done year round. So here’s some things you can start thinking about and preparing for now to set yourself up for the best tax year that you can have for 2022.
Allison Dubreuil, Wealthway Financial: And so we want to go into a little bit about how capital gains tax works. Because I don’t think everybody’s aware of how capital gains taxes are applied to non-retirement investments. Major stock market indices ended the year near all-time highs. So a lot of people had built in capital gains in their investments. And if you sold at a gain, you may have owed taxes where you will have owed taxes. But even if you didn’t sell it’s possible that your investments created taxable gains. And that’s where I think people don’t realize that’ll owe tax on an ongoing basis.
Kevin Zywna, Wealthway Financial: Especially people who are new to investing. And there are a lot of people who were new to investing in 2021, because there were about 10 million new brokerage accounts that were opened last year. A lot of those were by younger people, first time investors and on apps or through companies that you create accounts online. And that encouraged sort of a gamification of investing or trading, I guess I should say. While it can seem fun, when the market is going up, if you are trading frequently, and you are incurring a profit, then you are also incurring capital gains. Capital gains are taxable. But, unlike your paycheck, where with taxes are automatically withheld by your employer and sent to the state or federal government. There is no withholding on your profit when it comes to investment taxes. So a lot of people were surprised this year, that they owed a lot of additional tax. Because they incurred some profit from trading activity last year. And they didn’t really understand how cost basis and capital gains taxes work. And how they’re calculated and how you can minimize them if you are thoughtful and plan with the investment strategy. So we’re going to talk a little bit more about that.
Allison Dubreuil, Wealthway Financial: Yes, so know that what we’re talking about does not apply to retirement accounts. So that’s one of the benefits of retirement accounts. That they grow tax deferred. We’re talking about investments outside of retirement accounts. That would almost always be in a brokerage account.
Kevin Zywna, Wealthway Financial: Right, with brokerage account not protected. The activity that occurs in their: dividends interest, capital gains distributions from mutual funds or exchange traded funds, or that occurred from sales, from investments. That is all subject to taxation. Now, lower tax rates than the withdrawals that come out of traditional IRA accounts, but if managed properly. So we’re going to get into a little bit more of that.
Allison Dubreuil, Wealthway Financial: Yes, capital gains tax. So when you buy a stock or an investment. And then you sell the investment for more than what you bought it for, that’s a gain and you are subject to capital gains tax on any of that gain. Conversely, if you sold it for less than what you bought it for, that would be a capital loss. You can deduct capital losses on your tax return. But there are limitations involved in that. So it’s pretty straightforward. I think most people understand that when you have a profit on an investment, and you sell it, you pay capital gains tax on the profit.
What I don’t think a lot of people realize are that when you’re investing in mutual funds, even if you don’t sell the mutual fund, the mutual fund could be distributing its own capital gains because they’re buying and selling within the mutual fund. So you may owe taxes on a mutual fund gain without ever having sold that fund.
Kevin Zywna, Wealthway Financial: Right. A Mutual Fund is like a basket. And in that basket is typically anywhere from 25 to over 500 individual securities, stocks, bonds, those types of instruments inside the mutual fund basket. And whether it’s actively managed, then there’s a manager there who is buying and selling within that mutual fund basket. That trading activity eventually works its way to the holder of the shares of the mutual fund at least once a year. Sometimes more frequently, sometimes quarterly, sometimes monthly. Mutual funds distribute capital gains, dividends and interest throughout the course of the year, but at least annually. And so without even selling the shares of the mutual fund, you can be subject to capital gains taxes due through the distributions of mutual funds.
Now, exchange traded funds or ETFs, are typically an unmanaged basket of stocks or securities or bonds. And while there can be some tax distributions that come from ETFs, they typically are much less than an actively managed mutual funds. Because there is not somebody who is routinely buying and selling. However, corporate activity can occur throughout the course a year. Companies merging, selling off, spinning off, divisions, those types of corporate activity also cause taxable distributions from the ETF. So even without selling those types of instruments, you can be subject to capital gains taxes.
Allison Dubreuil, Wealthway Financial: You may not realize until after the year is over, because a lot of this, it can happen throughout the year. But a lot of it is at the last minute in December. And then it takes a couple months for the reporting to all come in, and then you finally get your 1099 to file your taxes. And then, lo and behold, a surprise tax bill that you didn’t even know was coming,
Kevin Zywna, Wealthway Financial: Right, because there’s no withholding on that taxable activity.
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Allison Dubreuil, Wealthway Financial: So let’s talk about capital gains tax rates. They are more favorable than ordinary income tax rates based on current tax law. So just to give you an idea, if you are single, and have less than about $42,000, of taxable income, then you would pay 0% on your capital gains. So that’s not bad. If you’re married and have less than $83,000 of taxable income, you also pay 0% on your capital gains. So if you’re retired and your income is low, and you’re able to generate capital gains without paying tax. But for people above those limits, you’re most likely paying 15%. And then for high earning people, the you could be in the 20% tax bracket.
Kevin Zywna, Wealthway Financial: So your capital gains tax rate is dependent upon your taxable income. And the higher your taxable income, the higher the capital gains tax rate. But it is possible to have a 0% capital gains rate. If you can structure your affairs appropriately, then you might be able to manage your way to either a 0%, or a 15% tax rate. Now most people are going to pay 15% capital gains rate on their profits. So for planning purposes, that’s number you should kind of file away in the back of your head.
Allison Dubreuil, Wealthway Financial: I should just mention that this is for long-term capital gains. So that means investments held for longer than one year. If it’s a short-term capital gain or less than one year, then you’re taxed at ordinary income rates.
Kevin Zywna, Wealthway Financial: Yeah, so that’s what I was talking about at the beginning of the show. People who are new to investing and are much more frequent traders, as opposed to long-term investors tend to incur short-term capital gains. Though that is profit that you make on investment that you have held for less than one year. The profit on that type of capital gain is taxed at ordinary income tax rates, which are higher than capital gains rates. And for most people, might be in the 22% tax bracket could be in the 25, and then 32. So yeah, that type of profit is taxed at ordinary income tax rate, and it’s very inefficient. Rarely should individual accumulators who are trying to build long-term worth wealth. Rarely should they be trading that frequently. That’s sort of a mythology that should be left to people who are more experienced and know what they’re doing.
Allison Dubreuil, Wealthway Financial: And let’s not forget that while most people are not excited about an unexpected tax bill. Ultimately, at the end of the day, paying capital gains tax means your investments were profitable. That you have more money, more spendable income than you did when you started out. So current tax regime dictates that part of that is taxable. You do have to pay your tax, but ultimately, you are better off for having invested.
Kevin Zywna, Wealthway Financial: Right, we’ve got to reiterate that. Don’t let the tax tail wag the dog. When it comes to building net worth, taxes are a natural consequence under current tax law, natural consequence of successful investing. So if you invest successfully, then you are growing your net worth. You are growing your wealth, then you are ultimately going to pay some tax along the way. And so the goal is not to eliminate all taxes, that’s actually not hard to do. If you want to give away all your money, or if you want to lose all your money, then you are free to do that. And you will not have to pay any tax on your losses or on your charitable donations. But for most people, that’s not the end objective. It’s to grow their net worth over time. And so hence, we’re going to pay some taxes from time to time.
Allison Dubreuil, Wealthway Financial: And one other possible source of capital gains taxes that I want to bring up because it’s a very prevalent right now is the sale of real estate. So if you are selling real estate, for a profit, it’s possible that you could owe capital gains tax on that profit. Where people get confused, is there’s an exemption for your personal residence. So if you’re selling the home that you’ve lived in for at least two out of the past, five years, you are able to shelter some of that gain from capital gains tax. For single people, they can shelter up to $250,000 of gain from tax. Married filing jointly can shelter up to $500,000 of gain from tax. So if you sold your primary residence, and your gain was within those limits, you most likely have no tax – that’s tax free. Then any gain above that would be taxed at capital gains tax rates. But there are some things, if you keep good records on upgrades, and it’s not repairs.
Kevin Zywna, Wealthway Financial: Remodeling the kitchen and putting an addition on your house. Pool in the backyard, a sunroom. Those are capital appreciation, improvements to your house that can add to your cost basis. And I think we need to talk a little bit about cost basis after the break. But that gets added to your cost basis which ultimately lowers the amount of the capital gain. The profit that you would have to declare on the sale of the property and so it can reduce some of the taxes.
Allison Dubreuil, Wealthway Financial: If you’re like many people who are taking advantage of the real estate market…
Kevin Zywna, Wealthway Financial: You probably have a profit. And if you’re married filing joint and the profit is greater than $500,000, then you too are going to owe some capital gains tax that you might not be prepared for. So just remember to hold back some of that profit, come tax time. Don’t roll it over into your next new residence and try to pay cash on the present unless you got you know, cash sitting outside a bank account.
Allison Dubreuil, Wealthway Financial: And that’s a whole other discussion on mortgage strategies, which if you’ve listened to us for any amount of time, you’ve probably heard our theory on that.
Kevin Zywna, Wealthway Financial: We’re going to run up to Williamsburg and speak with Bill. Good evening, Bill. You’re on Dollars & Common Sense.
Caller: If you sell your home now and the price is high, and then you say, Okay, well, I’m going to buy another house now. But the price is all high with those houses, too. But does that make sense to be selling a home when the others are going up anyway, and you’re going to end up maybe being priced out of a home anyway?
Kevin Zywna, Wealthway Financial: So as it relates to the home purchase, rarely should someone be selling their home just to cash out. Your primary residence is first a home and an investment. Second, so live in the type of property that you want to live in. Now if you’re ready to move to another location, go down to Florida, or you’re ready to downsize from the house you raised your kids in and now you’ve got a four-bedroom house and six bathrooms and now it’s just the two of you, and you want to downsize that makes good sense to then sell your home. But to try to take advantage of the real estate market the way it is. That’s a risky proposition. And as you pointed out, while you might be selling high, if you’re buying comparable type property, you’re probably also buying high. So from a financial planning standpoint, it’ll either be a wash, or you could end up just with a more expensive house.
Caller: So there’s no tax advantage to that, either, apparently?
Allison Dubreuil, Wealthway Financial: Technically you would lock in that gain, and you would get that tax-free. But again, you know, you’re buying power is going to be more limited and interest rates are ticking up right now. So that would be making a tax decision, probably for the wrong reasons.
Caller: Okay. We appreciate your help.
Kevin Zywna, Wealthway Financial: Alright, Bill, thanks for the call.
Allison Dubreuil, Wealthway Financial: Yeah, I, I keep bringing this up. There’s two sides to the real estate equation. Because if you’re selling, you’d better have someplace to go or you better find your place to go before you sell. Because people are living in hotels right now trying to buy houses. It’s just wild.
Kevin Zywna, Wealthway Financial: Anecdotally, the real estate market is kind of flipped on its head. And in the past, you would try to sell your own house first. And once you had an offer, and you knew what you were dealing with how much you’re going to sell it for how much profit you are going to make, then you could make an informed decision on your next property and how much down payment money you would have to put on that. Well, now that seems to be reversed. It’s almost like you have to come qualified with a pre-qualified offer or cash offer, put it down on your next property, and then worry about selling your current house. And for most people that seems to be working out, okay, because properties are selling so quick. So just a unique period of time that we’re in a variety of reasons for that. But that’s the way home buying is these days.
Allison Dubreuil, Wealthway Financial: And so kind of along with that, back to our capital gains tax discussion, whether it’s selling an investment or selling a real estate property, you need to have a good handle on your cost basis. Which is the technical term for what you paid for the investment or the property.
Kevin Zywna, Wealthway Financial: It’s probably one of the biggest mistakes that we see investors make – not recording or capturing or remembering or saving cost basis. The date and amount that you purchased an investment for. And, you know, it’s relatively simple when it comes to stocks and mutual funds and exchange traded funds, that type of thing that is recorded somewhere. Now, within the last almost 10 years now, it’s been a requirement of the brokerage companies or the custodians, where you place your trade (Vanguard, Fidelity Schwab, TD Ameritrade) to record that information. But before that time, they were not capturing that. And still, even though they do it today it is still ultimately you the taxpayer, who is responsible for the proper record keeping on when and how much you purchased an investment for.
So it gets even a little bit more complicated when it comes to your house. Because a lot of times if you’ve been in your house for 10, 15, 20 years, those records are somewhat lost to the dustbin of history. And certainly, changes to cost basis or add-ons the cost basis like we were talking about earlier: remodeling, enhancements to the property. Those, if you don’t keep those documents, those receipts, you technically aren’t supposed to claim them, you would have to defend that if you got a letter from the IRS. So capturing or recording cost basis is extremely important to the proper paying of the ultimate capital gains tax, but most people don’t do that. They don’t appreciate that. And going back to newer investors today who are trading a lot more frequently, they have no clue what I’m talking about right now.
Allison Dubreuil, Wealthway Financial: Well, to sum it up, because I did want to talk about what you need to keep and what you don’t need to keep. So for any investment that was purchased in 2011 or later you should be covered. You’re required to track this for you, the custodian
Kevin Zywna, Wealthway Financial: And even if you don’t physically have it, it’s probably on your custodian’s website, right. You could typically go back five or 10 years. You can get it from the custodian.
Allison Dubreuil, Wealthway Financial: So from 2011 forward, you should be good with it. investments. So that’s stocks, bonds, mutual funds. With a house, though, I mean, you should really keep records of everything for the entire duration that you’ve owned that home and then probably for a few years after the sale, so the look back period for the IRS to audit you is typically three years with some exceptions. So it’s a good idea to keep all of the records regarding your home regarding capital improvements for the entire time you own the home plus another three or four years after you sell it, just to be sure you don’t have to go through an audit and prove your work.
Kevin Zywna, Wealthway Financial: We get this question a lot from our clients, how long should I hold my old tax returns and documents? Three years is the normal amount of time. There are some minor exceptions to that. So to be safe for five years, but beyond five, typically, if you haven’t received a letter from the IRS or phone call – they won’t call you. It’d be a letter.
Kevin Zywna, Wealthway Financial: If you haven’t got that letter in five years, you’re probably safe. And you don’t need to keep your documents past that point.
Allison Dubreuil, Wealthway Financial: Do you know what percent of taxpayers get audited? It’s
Kevin Zywna, Wealthway Financial: It’s about 1-2%.
Allison Dubreuil, Wealthway Financial: It’s rare
Kevin Zywna, Wealthway Financial: Chances are low. However, there’s a lot what we do see that this doesn’t qualify as an audit. But it’s not uncommon to get a letter from the IRS that says, hey, something doesn’t match up here. You’ve reported X on your tax return. Yet we’ve got a statement from your bank or your brokerage company or your employer that says you actually made Y. Something doesn’t add up here. We need clarification. So that is not uncommon. That’s where having those records for at least three years closer to five will help you rectify those circumstances and situations.
Allison Dubreuil, Wealthway Financial: Right. Well let me tell you the IRS is not quick on their feet. They are probably just now getting around to it. We have clients who are now just seeing letters from 2018 filings so know that it will take a while if it pops up.
Kevin Zywna, Wealthway Financial: They are notoriously slow. They’re understaffed like a lot of employers right now. There’s a little bit of background on how long to keep your tax returns.
Kevin Zywna, Wealthway Financial: Right now we’re going to go up to Carrollton and speak with John. Good evening, John. You’re on Dollars & Common Sense.
Caller: My sister has helped me out a lot over the years. And so I have given her $50,000. I had the bank send it to her. She deposited it into her account. Now, that’s not considered income, and she won’t have to pay taxes on that, right?.
Kevin Zywna, Wealthway Financial: John, did you give it to her as a gift? Or did you give it to her as a loan?
Caller: I don’t know.
Kevin Zywna, Wealthway Financial: Right, then that is not income to your sister, that is a gift.
Caller: Declare on taxes?
Kevin Zywna, Wealthway Financial: Well, she would not have to claim it as income, that that was a gift for you. So if she’s not going to claim it as income, it will not show up on the tax return, and she will not have to pay tax on it.
Caller: Thank you so very much.
Kevin Zywna, Wealthway Financial: Okay, John, you got it. Thanks for the call.
Allison Dubreuil, Wealthway Financial: Thank you. So yes, it’s a common question. Many people are concerned if I give a gift, what are the tax consequences? Is it taxable to the recipient? Is it taxable to me? Well, in almost any case, with gifting, it’s not a taxable event. Now, it just might be reportable, depending on the amount that you’re gifting in a year, but not taxable.
Kevin Zywna, Wealthway Financial: Not really want to get into all the estate tax planning complexities around gifting. But just know that anyone can give any other person up to now and 2020 to $16,000 per year without any tax implications on either side of the equation. So the giver does not have to report it. And the receiver does not have to report it.
Allison Dubreuil, Wealthway Financial: Since John gifted more than $16,000, technically, he should be telling his tax advisor about that, not because it would cause any tax implications. But just because that does need to be tracked over the years when you give more than $16,000 to someone in a year.
Kevin Zywna, Wealthway Financial: Right. So just know that right now, the magic number is $16,000 per year, per any person.
Allison Dubreuil, Wealthway Financial: And back to our topic on capital gains – capital gains tax cost basis. Before we wrap up, I just wanted to make sure that we touched on one other piece about what you need to keep and what you don’t need to keep. Because we said keep cost basis records keep all of your home your real estate records. So do you need to keep every monthly brokerage statement or 401K, IRA statement, bank statement, or credit card bill?
Kevin Zywna, Wealthway Financial: No, the answer is no. You don’t have to keep them physically anyway. You do not have to receive them in the mail and put them in a file and save them for a decade.
Allison Dubreuil, Wealthway Financial: Right? I mean, we hear of people that have piles and piles of paper. Just keep the most recent statement so that there’s record that there is an account and where it is and where someone would go and an emergency. But you don’t need to keep every statement because your custodian has records of those and can typically regenerate them for you by request.
Kevin Zywna, Wealthway Financial: We’re big fans of keeping your financial life as reasonably simple as you can. So let your brokerage firm, your 401K company, your bank, be the library that keeps all that documentation. Receive it in a notification and electronic form if you ever want to go look at it. Nowadays, I would hope most everybody is accustomed to having log-ins and passwords to get this. You know, it’s essentially at your electronic fingertips whenever you need it. So you don’t need to keep binders full of paper statements anymore.
Allison Dubreuil, Wealthway Financial: I sometimes hear people with concerns about signing up for electronic statements. They think that’s a security risk. Well, your information is being held electronically whether you sign up for electronic delivery or not. Electronic delivery doesn’t mean it’s being emailed to you in an unsecure fashion. It’s most often just a notification that you can log on to your account securely where there’s all sorts of security features – and access your statement yourself. So no more significant risk to do digital, it’s worth the simplification.
Kevin Zywna, Wealthway Financial: I would argue that in some cases, it’s more secure. Because, you know, you leave it around your house, maybe you have a cleaning person come in, maybe you have your neighbor over? Well, brother, who who’s snooping around your desk paperwork? And, you know, that you have that stuff laying around. It’s liable to get out or get in somebody’s hands or have somebody else’s eyeballs on it. Whereas when it’s locked behind the digital wall of your bank account, only you with the login and password can see that information. So there are security benefits to actually keeping it in electronic form.
Allison Dubreuil, Wealthway Financial: I would just say don’t be afraid of electronic record keeping in this day and age. So keep the most recent statement for all of your accounts, shred the rest, or just sign up for electronic delivery and save the trees. See we’re doing our part.
Kevin Zywna, Wealthway Financial: Save the trees, lower your taxes, make sure you capture your cost basis, the date and amount of purchases to your investments. That way when you actually do sell them, it will make tax preparation that much more easy and accurate.