The Grocery Store Experience
My family loves shopping at Trader Joe’s. They do a great job of creating a fun atmosphere. They have mini-shopping carts and stickers for my kids, and the best part – is they have samples!
As my wife and I walk through the store, we gather every item we need, place it in our cart, and go on our way. My children? They grab anything and everything that looks tasty, place it in the cart and assume Mom or Dad will pay for it.
By the time we get to the check-out counter, we have three carts: mine, my 4-year-old’s, and my 3-year-old’s. We inevitably take some of the cookies, candy, and snacks that my children have grabbed and place them back on the shelf. Of course, I make sure to ask for extra stickers to compensate for being Mr. Scrooge 😊
At the end of our shopping experience, we pay full price for some items, receive a discount on others, and some we put back on the shelf to avoid paying altogether.
The 1099 Experience
This time of year, investors who hold a taxable investment account (registered as a Trust, Joint, or Individual) are receiving their Consolidated Form 1099s from their financial institutions. For most non-financial advisors, I would guess that a Consolidated Form 1099 looks much like a physician’s findings on an X-Ray report look to me… a ton of jargon, some numbers that don’t make sense, and more confusion than clarity.
There generally are four sections on these 1099s: Form 1099-DIV, Form 1099-INT, Form 1099-MISC, and Form 1099-B. Each of these sections has a handful of line items, all of which have varying impacts on our tax situation.
A full description of the Consolidated Form 1099 is not the scope of this article (I wouldn’t want to bore you), but let’s dive into a hypothetical Joint investment account.
- It might hold dividend-producing stocks. These dividends are taxable, although hopefully, most of these dividends will be “Qualified,” which means they are taxed at preferential rates (either 0%, 15%, or 20%). Dividends deemed “non-qualified” are taxed at your Marginal Tax Rate (the tax rate you pay for your next dollar of wages, which can be as high as 37% plus state tax rates).
- It might hold cash or fixed-income investments, which pay interest. This is taxable at your Marginal Rate.
- This account may hold Municipal Bonds, which pay federally tax-free interest (and potentially state tax-free interest). Note: even if it is tax-free, this interest will still be reported on your Form 1099 and can affect other calculations (like your Medicare or marketplace health insurance premium)!
- If trades were made in your account, you will have capital gains or losses shown on your 1099-B. Short-term gains (for positions held 365 days or less) are taxed at your Marginal Rate, and long-term gains (for positions held greater than 365 days) are taxed at preferential rates (like qualified dividends).
The bottom line: An investor should expect to pay taxes on a taxable investment portfolio and should plan accordingly.
However, there are a few things an investor may look at strategically (all situation-dependent):
- Depending on the tax bracket, consider municipal bonds that pay interest tax-free.
- Depending on risk tolerance and time horizon, consider equities (stocks) as they are generally more tax-efficient than fixed income.
- Depending on liquidity needs, many private Real Estate Investment Trusts (REITs) pay an income that is mostly tax-deferred (due to the depreciable nature of real estate).
- If your portfolio includes high-income instruments (like BDCs or high-yield bonds), consider “shielding” these strategies within a retirement account before implementing them in a taxable account. We call this asset location.
- As for trading, avoid short-term gains if possible. You may also have positions in a loss – these positions can be sold if you’d like to offset the impact of other gains, a strategy called tax loss harvesting.
It’s important to NOT let the tax tail wag the investment dog, but we encourage you to speak with a professional to ensure your taxable account is not being hindered by unnecessary taxation.
Q2: Should I only withdraw dividends and interest and avoid touching my principal?
Imagine you have a beautiful apple tree in your backyard. This tree produces a steady supply of apples each year, which you can pick and enjoy. The apples represent the dividends and interest from your investments, while the tree represents your principal. As long as you only pick the apples, the tree remains healthy and continues to produce more fruit year after year.
This is the conservative approach as you live off the natural yield of the tree without harming its ability to produce in the future. But is it also okay to trim some of the tree branches, or is that a big “no-no”?
The answer, of course, comes down to “how much?” and “how often?”
Structuring a portfolio to simply take the fruit of the tree (i.e., dividends and interest) provides tremendous confidence in retirement, as it allows one to know that the tree itself (i.e., the principal) remains intact (even though that principal value may fluctuate, sometimes significantly). However, we run into many client scenarios where we not only give permission but we encourage trimming the tree and taking withdrawals of the principal value.
Johnny Appleseed
Let’s walk through the story of two wonderful clients, Johnny Appleseed. Johnny and his wife, Daisy, worked incredibly hard throughout their careers. They managed to consistently save 15% of their income, even when the kids were young and their wages were modest. Due to the compound effect of their investments, they have now accumulated a $5 million portfolio, which produces $225,000 of annual interest and dividends.
The $225,000 covers all their lifestyle needs, including taxes. The Appleseeds, now in their 70s, realize that their days of extensive travel are numbered. They’ve always wanted to take their children and grandchildren on a special trip but could never justify this expense because it meant dipping into their principal (aka selling investments), something they were always taught is a grave sin.
But the Appleseeds have always relied on professional advice, and this time was no different. They approached their Advisor and asked if it would be possible to take this $100,000 extra withdrawal.
The answer came back a resounding “Yes! I’ve been waiting for this day!”
The Advisor knew that the Appleseeds are conservative by nature and not prone to overspending. Most of all, this allowed the Appleseeds to experience a dream come true, something they never thought possible.
Of course, constantly trimming the tree will lead to less and less fruit over time, so balance is necessary. However, the money you have accumulated is a resource, and we encourage the disciplined, prudent use of this resource toward your unique life goals and aspirations.
We hope you continue to enjoy this Q&A format. Please send your questions and comments our way – we love to hear from you!
