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When it comes to your finances, paying a big bill at tax time doesn’t feel great. Worse yet, if that bill comes as a surprise you and your tax/financial professional(s) were not on the same page, ugh!.
In this episode, Tyler Emrick, CFA®, CFP®, sheds light on traditional culprits that cause nasty surprises at tax time. Whether capital gain distributions, under-withholding on your income, or lack of knowledge/coordination between you and your professional team, we cover it all on today’s episode of Retire Smarter.
Here’s some of what we discuss in this episode:
- Interest rates have increased ordinary income and what most Americans are used to being taxed on.
- Investment considerations to factor in that will impact taxes.
- Stats on capital gain distributions and better investment options for tax purposes.
- Sometimes you are under-withholding taxes on your income, so what should you change?
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The Hosts:
Kevin Kroskey, CFP®, MBA – About – Contact
Tyler Emrick, CFA®, CFP® – About – Contact
Episode Transcript:
Tyler Emrick:
When it comes to finances and taxes, having a big bill at tax time is the worst. Worst yet is if that bill comes as a surprise to you because your CPA, investment professional, or financial planner were not on the same page. Today, we shed light on the biggest culprits causing nasty surprises at tax time, whether it’s capital gains distributions, high interest rates, or underwithholding on your income, we cover it all, coming up today on Retire Smarter.
Walter Storholt:
It’s another edition of Retire Smarter. I’m Walter Storholt here, alongside Tyler Emrick, wealth advisor, CERTIFIED FINANCIAL PLANNER at True Wealth Design. Tyler is also a Chartered Financial Analyst and the resource that we turn to, each and every episode, for guidance and advice through this financial landscape.
I am quite interested in today’s episode, Tyler, because I have been in this category where I’ve received a nice big surprise tax bill. I used to do a lot of 1099 work back in the day.
Tyler Emrick:
I see.
Walter Storholt:
Yeah, it was tough to manage as a young gun, working a lot of 1099 jobs and trying to navigate these waters. This rings true to me this week.
Tyler Emrick:
Fair enough. Did you head into April going, “Uh-oh, uh-oh, I wonder how big it’s going to be this time?”
Walter Storholt:
Oh, yes. Yes, very much so, my friend. I’m sure people have had much more than I have, but we have had a five-digit bill pop up before in April.
Tyler Emrick:
Yes. That’s not insignificant.
Walter Storholt:
That’s not a fun surprise.
Tyler Emrick:
No, not at all. Being a 1099, you’re all on your own there, for sure. You’d be surprised, sometimes W2 employees, it comes around, and for whatever reason the withholding is messed up, or maybe you get some portfolio income, or whatever the case may be. Boom, before you know, you get that surprise come tax time which is never fun.
As I think about today, the podcast, and what we’re going to be covering, I’d figured it would be a good time to dive into some of those major culprits that are behind some of those surprises, so that way we can come into tax time being a little bit prepared. We’re in mid-March here, so our small business owners, a lot of them are either on extension or have the business returns. Then we’re vast approaching that April 15th deadline, so it’ll be here before you know it. As you’re getting those returns, or as listeners are getting their returns complete if you find yourself in that camp, you got a little bit of a bill, well hey, maybe today on the podcast, we’ll dive into something that affected you and how you might be able to prepare for it for the upcoming year.
Walter Storholt:
I kid you not, I’m looking at my calendar today. Later today, there’s a big entry with about four hours blocked off, and in all caps it says, “Do taxes,” with several exclamation points after it.
Tyler Emrick:
Yes.
Walter Storholt:
The time is upon us, absolutely.
Tyler Emrick:
It is, it’s here. Of course, as you think about what affects that return, whether your withholding or your tax bill is impacted, a lot of times it does come from your actual underlying investments and your portfolio.
As I think about those first things to touch on here today, the first thing that comes into mind has everything to do with your portfolio. It’s really a byproduct of the higher interest rate environment that we’re in. Over 2023, and really maybe reaching back in 2022, it was a big deal for a lot of families to reevaluate their banking relationship, reevaluate where they were holding their cash because well, we’ve seen a spike in interest rates. I think the average interest rate on a high-yield savings account now is approaching 5%.
Walt, it was .22% back in May 2009 and literally was depressed for almost a decade. A little different, to say the least.
Walter Storholt:
Yeah, that has definitely changed over the last decade plus.
Tyler Emrick:
It has. You back into the math a little bit on that. If you had $100,000 sitting in a high-yield savings account earning around 5%, that’s $5000 of interest that is going to flow through and come down on the good old tax return, and be taxable to you. Someone just in a marginal tax rate at 24%, that increases their tax bill over 1000 bucks from a Federal standpoint.
Walter Storholt:
That’s pretty…
Tyler Emrick:
It can add up.
Walter Storholt:
A lot of people aren’t going to be keeping that in mind, I wouldn’t think.
Tyler Emrick:
It is, especially considering earlier on and for over a decade, really we weren’t seeing a whole lot of that interest because it was so low so we weren’t seeing a lot of it flow through on the returns. 2022, it picked up a little bit and certainly, here in 2023, I’m sure there’s going to be more than a handful of conversations about, “Well hey, I didn’t think this interest was taxable, or I didn’t know how it was actually going to flow through on the return.”
I was sitting with a family literally just a week ago, and they were very happy because they got their return done so they were ahead of the game, Walt. Theirs were finished up and they said, “Hey, our taxes, we ended up owing around 6000 bucks.” We dove into the return a little bit, and these higher interest rates were really the culprit. They ended up having quite a bit of interest, they used a number of CDs, and they were individuals who really just keep a lot in cash. A lot of times, this is a personal preference and something that we want to monitor. This was one of my first conversations with them, diving into how much they normally kept in cash. From their standpoint, they’re going and saying, “Hey, we’re getting a decent interest rate on this right now,” but after we consider the amount of taxes that we had to pay on that interest, those four and five percent interest rates look closer to 3%, or maybe even a little lower after you account for that tax bill that you got to pay on them.
Walter Storholt:
It’s interesting when you look at all the different ways that these little tax hits can come at you. A lot of different angles and ones that you didn’t necessarily think about.
You mentioned the one about the interest rate increase, I graduated in ’09 from college, so I was conditioned all those early working years to not be thinking about the interest that’s being created in savings accounts and those kinds of things. That was a nothing burger, not a concern. Now all of a sudden, that’s kind of something to keep in the back of your mind.
Tyler Emrick:
Absolutely. Well, you think about it just from an overall portfolio construction standpoint. That couple that I was meeting with, and when we got down to it, it really is driving their decision on what is the right size and the right amount to maintain in their cash positions, and really approaching it from a tax lens and not just an investment lens.
Diving down into these higher interest rates a little bit too, the Fed comes out this week and I think they’re going to give a little more guidance on what they’re expecting interest rates to do for the remainder of 2024. It seems like we’re expecting rates to maintain the level that they’re at, and maybe start to decrease towards the end of the year here. If that does come to fruition, and the government and the Fed is right, you’re going to start to see the interest rate on those savings accounts and those money market accounts start to decline over the latter half of 2024, as interest rates go down.
We look at our job as financial advisors, all the time we’re meeting with investment companies and trying to get a lay of the land. I think one of the most common slides on those slide decks when we’re getting those presentations are around where interest rates are right now, where they might be heading, and should families be maintaining the amount in cash in their savings accounts and money market accounts that they do right now.
One of the best charts that I had seen was taking a look back over the last 30 years or so, and taking an inventory of when did rates peak. If you look at that, there was a handful of times where interest rates had peaked. Really, we’ve got to go back to, I’d say about the mid-2000s, to find a time where interest rates were about at the same level as where they are now. Before that, we’d really have to go back into the late and mid-’90s. Really, there hasn’t been, at least in more recent history here, a time period where interest rates have been that high.
What this slide did is it takes an inventory and says, “Okay, well how good of an investment was a CED? Let’s compare it to some other alternatives,” whether it be treasuries or a couple different bond indexes. And say, “All right, if you would have invested in a one-year CD at the peak of where interest rates were and then you look at your two-year return, how does the CD stack up compared to some of these other alternatives?” Really, there was only one time period over the handful that they had analyzed going back to the mid-’80s, where that one-year CD rate actually provided more wealth and came out ahead of the other three options. Again, those other three options being treasuries, and Bloomberg bond indexes, which are the US Aggregate Bond Index and the Corporate Bond Index. Just one time in a handful, going back to the mid-’80s where CDs proved to be better performers over that time period.
Which, if you peel back the onion on that a little bit, it sort of makes sense. You look at CDs, the only thing that you’re getting there is the interest rate. When you look at a treasury or a bond investment, you’re getting two types of return. You’re getting interest, but then you’re also getting the price appreciation from those bond investments as well. A fancy term for that is maybe adding what we call duration risk or credit exposure, to increase your returns a little bit.
We don’t want to forget about those CDs and how much we’re keeping in cash. I don’t want to say we want to be fooled, but we want to keep that perspective in line when we got to the bank and they’re like, “Hey, we got this one-year CD, it’s paying 5%. What do you think?” We don’t want to lose sight of the other investment options that we have available to us and we certainly don’t want to lose sight of the tax impact that that interest is going to flow through on the return.
I go back to that family that I met with within the last week and they had that big tax bill. They’re looking to retire. If they maintain the large cash position that they have and getting the interest rates that they are, they’re looking at getting maybe 15 to $20,000 of interest on their return each year. Well when they turn the corner and retire, we were looking through and exploring some healthcare options for them, and those healthcare options, especially the individual healthcare plans on the ACA, which Walt, I know we’ve talked about a multitude of times on the podcast here, what you pay for those plans is directly tied to the amount of income that hits on your tax return. Having these CDs kicking off that 15 to $20,000 of interest on an annual basis and that being taxable, that would directly impact and probably increase … For their case, it increased their healthcare premiums that we were estimating by a couple thousand dollars more per year, too.
There could be other, I don’t want to call it, in their case, a double whammy on the interest that they’re getting, but there’s the tax consideration. But also, there is the healthcare consideration for their situation, once they do retire and go on an individual healthcare plan.
Walter Storholt:
As you lean into all of this, Tyler, I’m reminded of a struggle I had in the early days as well, was trying to figure out that difference between how perhaps regular income and then capital gains were handled. Especially when you then considered short-term and long-term, and that’s where it starts to get complex for a lot of people. Or again, where it just becomes hard to calculate just how much you should be withholding, which I would imagine is part of the problem that leads to these surprises that people get.
Tyler Emrick:
Oh, absolutely. You look at a money market position that’s paying you interest on a monthly basis, that’s ordinary income. You didn’t hold that investment for over a year and that’s taxed at your ordinary income rates. What that means is is the more income that you have, whether it be by working, or pulling money out of your retirement accounts, or whatever the case may be, that means that you could be paying more and more in taxes.
In the scenario that we ran through here, I just assumed it was a marginal rate of 24%. But in the case of the family that I had met with before, they were going to be paying almost 32% on those interest payments because their ordinary income is quite high and they’re in those higher tax brackets. For those high-income earners, you start looking at that cash management and the interest hit, it’s ordinary income. Versus hey, you have an investment, an ETF, or a stock, or whatever the case may be, you hold those investments for over a year and then you sell them, those are considered capital gains and they’re taxed at, traditional would be a more favorable rate. Sometimes, they’re not taxed at all. That timing and the way that you receive the income or distributions matters quite a bit.
Which leads me to the second, I guess culprit that I want to bring up. We talked about higher interest and those interest payments on the savings accounts and money market accounts. When you look at your other investments, such as mutual funds, there are these things called capital gains distributions. You ran into those ones yet, Walt?
Walter Storholt:
Yeah, yeah. Those aren’t any fun, right?
Tyler Emrick:
No, not at all. For any listeners that have investments that are outside of your retirement account, so outside of Roth accounts, outside of IRA accounts, and they’re just in what’s called a taxable brokerage account, this allows you to actually pick and choose different investments. Sometimes those investments can be a CD, those investments can be a stock, they can be mutual funds. There’s a whole host of things that you can invest in in these taxable brokerage accounts.
For a number of years, one of the popular things that were held were mutual funds. Simply put, a mutual fund is just a place where you hand a company your money, and then they go and invest it for you. There are thousands of these mutual funds out there that have different objectives, and goals, and so on and so forth. I bet a lot of listeners run into mutual funds mostly through their retirement plans that they have through work because mutual funds are the biggest investment option that are available inside of those.
But these mutual funds, when they’re held outside of a retirement account, there can be a little bit of issues. One of the issues that comes into play in the situation that we’re talking about here today is these capital gains distributions. There are laws in place to where mutual funds have to distribute a certain percentage of gains each year inside of their account. If that mutual fund let’s say invests in stocks, and the stocks are being traded throughout the year, there might be a build-up of gains inside of that mutual fund and those have to be paid out.
In a typical year, Morningstar, they do a lot of research and analysis on this, but a typical year, they estimate that between five and 10 percent of a mutual fund historically, or at least on average, gets paid out. But in some cases, they can be much, much higher. You do a quick Google search on capital gains distributions and there’s this doghouse list that comes up frequently in those searches. Basically, it’s a list of mutual funds for the prior year that had higher than 20, sometimes up to over 30% of their fund’s value distributed in the form of these capital gains distributions.
The reason why that can be a problem is that, from your standpoint or an investor’s standpoint, you can’t stop that distribution, Walt, so it’s coming to you no matter what. That distribution is going to be taxable to you in the year that it happens. Individuals and families can get this big surprise from the mutual funds that they hold because they get these big capital gains distributions that are then taxed to them, and then they’ve got to handle that when it comes time to file the taxes.
Walter Storholt:
Just hits you from all angles, doesn’t it?
Tyler Emrick:
It does. The good news is there are better options out there, and there are things to consider when you are building and constructing your portfolio. One of the easiest things to do as you look at your taxable brokerage accounts is to use investment vehicles that limit or try to minimize those capital gains distributions.
Now there are some mutual funds out there that do a good job at this, but normally a better wrapper is holding instead of the mutual fund, is to hold it as an ETF, or in exchange traded funds. These are taxed a little bit differently, they have a little bit different rules that they have to follow. One of the big ones, in the case of an ETF, is that those capital gains distributions are not written in stone and they don’t have to come to you like they do in the form of a mutual fund. Just simply changing that wrapper or the vehicle that you use in those accounts, and using ETFs versus mutual funds can be a nice easy way to help limit those capital gains distributions, thus limit some of those surprise tax bills when it comes time to file your return.
Now of course, there are some horror stories here. I think back to just in 2022, I was meeting with a family last year. I typically ask for prior year tax returns when I’m going through a family situation. This case was no different. I was sitting down with them and I was talking them through their 2022 tax return. To paint the picture here a little bit, Walt, 2022 was not the best year from a performance standpoint. I was very happy to put it in the rearview mirror. The S&P 500 was down over 20%, the bond market had a historically bad year. I think the ag bond index was down somewhere around 15%. Really, there was no place to hide in 2022 and investors seen their accounts, a lot of times whether you were an aggressive investor or a conservator investor, saw some pretty historic hits at the end of the year when they were looking at their account balances.
This family was no different. But when I looked at their return, they had almost 25, $30,000 of actual gains that hit their tax return that they had to pay taxes on from those investments that were down. One of the reasons for that is they were getting capital gains distributions from some of their investments. What happened, in their situation, is hey, they went through 2022, their accounts were all down because of the poor performance from the stock and bond standpoint, but yet, then they had this double whammy when it came time for taxes because then, those investments actually kicked off some gains that they had to pay taxes on. It increased their tax bill almost four grand that year. Walt, they were in a situation where they lost money, but yet they still had to pay taxes on those investments returns.
Walter Storholt:
Oh, that’s definitely not a fun surprise to happen.
Tyler Emrick:
No, not at all. Mutual funds wasn’t the only thing in their portfolio that was doing this. They actually had an all-stock strategy that they were managing. The advisor that they were using was buying and selling a lot of stocks to maintain the allocations that they thought were appropriate. Well, a lot of times, with those strategies, and all those different stock sells and buys, that can add up over time and create gains that flow through on the returns.
You just need to be mindful of these things, as we’re building and thinking through the portfolio. We talked about how interest can impact it, capital gains distributions, and portfolio income in general can impact it as well. We want to be mindful of both, especially when we’re looking at and trying to construct that portfolio outside of our retirement accounts, when those taxes become very substantial and significant. And sometimes, give us those big surprises when we go to file.
Now that’s it from a portfolio construction standpoint. But sometimes, Walt, we’re just flat out under-withheld. I think back on those 1099 years that you had mentioned. A lot of the families that I work with that are on 1099, when we first started working with them, they find themselves in a very similar situation. Frankly, it’s just that they’re not withholding enough on the income that they earned.
Walter Storholt:
I think that’s where a lot of this just comes down to, is trying to predict and do that math ahead of time, just the basics of getting that as close to zero as you can when you’re doing all these calculations.
Tyler Emrick:
Yeah, absolutely. Well, and two, you got to think about it, you’re running a business, you’re being a consultant, there are a lot of things that are on your plate. A lot of times, like what we mentioned on the intro, sometimes your CPA, your investment advisor, your financial professional, all these professionals that you have in your life, they’re not really communicating as effectively as they should. There’s so much value in having a cohesive unit that are helping you make decisions in your best interest. I see it so much, especially when it comes down to taxes, and those withholdings, and getting some of that stuff right.
Even if you’re working and you’re not a small business owner or not on a 1099, sometimes you’re just under-withheld because maybe a lot of your income comes in the form of bonuses, or whatever the case may be. The fix can be simple. A lot of times, we’re filling out new what they call W4V forms that you can turn into your employer, that adjusts your tax withholding, or allows you to add additional withholding out of each paycheck. We’re looking at that for clients, every single year, and trying to manage what that tax withholding looks like so we don’t get in a situation where there is a pretty substantial bill when it comes to tax times.
We also see it for individuals when they have a major life event or a change. A lot of the families that we work with come to us when they get serious about retirement, so we work with a lot of retirees. When you think about that as a life transition, well hey, a lot of times your income’s going away. Sometimes you’re starting social security, sometimes you’re starting distributions from retirement accounts. All these things trickle down and have a tax impact, and understanding how that withholding is going to happen, and where it’s going to come from is extremely important.
I think about social security, for example. We help a lot of individuals apply for social security. What always surprised me, when I was doing all those, is there is no place when you apply for social security to say you want a certain amount withheld for taxes. It just boggles my mind, Walt. You actually have to go to their website, print off a form, and either fax it, mail it in, or drop it off to the office. They don’t make it intuitive to think that, “Hey, this social security potentially could be taxable to me, I might want to do some withholding.” It’s not part of their process and something that you need to do separately outside of the normal application, which always rubbed me the wrong way.
Walter Storholt:
Yeah. Yeah, we want to try … The goal for you is to make life a little easier. That’s not always the goal of other entities, right?
Tyler Emrick:
Sure. No, absolutely. There is a multitude of ways that you can get those tax payments down. In the case of social security, they have what’s called a W4V form that you can fill out and have some Federal tax withholding done. Certainly, you can withhold it on retirement plan distributions. Some family we work with are living off of a monthly distribution from their retirement accounts. Then just like while you were working, when you were making a paycheck, and you were withholding off the top and sending some to the IRS. Same case applies here when you start pulling money out of your retirement accounts, you can withhold taxes off the top, and go ahead and send it to Federal and state governments to make sure that that tax bill gets paid. Then when it comes time to file your taxes, and you get what’s called a 1099, then that document will say, “Hey, you withdrew this much but you went ahead and pulled and paid this much in taxes for Federal and state,” just like you do on a traditional W2.
Of course, we have some individuals that are making estimated tax payments as well. These are estimated quarterly tax payments where you can just go on the IRS’ website or your state’s website and complete those payments online, or actually mail in a check every quarter.
There are more than a handful of ways for you to get the appropriate tax withholding, but I think the biggest thing to remember is did you have a life event, did you have an income change or something substantial that would trickle down to your taxes, and do you need to rethink and adjust some of that withholding that you’re doing. Now a lot of times, it’s not just the pain of having that tax bill, but sometimes the good old IRS will hit you with penalties too, if you don’t withhold enough throughout the year. At the end of the day, we don’t want to be paying anything in penalties.
There are some Safe Harbor rules that are in place, Walt, to make it a little bit easier, that they use to test to determine if you have a penalty or not, for under withholding. A lot of times, if you file your tax return and it shows less than $1000, then you’re not going to get penalized on that. Or if you paid in at least 90% of the taxes shown on your return for the taxable year, or 100% of the taxes shown on the return for the prior year, whichever amount is less. Those are a couple rules that you can use to say, “Hey, did I withhold enough and do I might have a penalty coming up?” Of course, they like to make things as complicated as possible, so there is a slightly altered rule for high-income earners. If your adjusted gross income is above 150, 150,000, if you file separately, if your income is above 75,000, then you actually got to pay the lower of 90% of the taxes shown on your current year return or 110% of the taxes shown on the previous year.
There are a few other special rules that come into play, but those are a baseline that you can use to judge and say, “Hey, we want to avoid those penalties, let’s keep ourselves out of that and make sure that we’re paying enough throughout the year.”
Walter Storholt:
That’s great. Great points all across the board there, Tyler. Good advice overall here. Is there a neat way we can wrap a bow around this conversation, for those who are maybe still trying to get their taxes done for this year, things to be thinking about? Or is this really a let’s start thinking about 2024 taxes, for next year, and making sure that we’re paying enough each quarter? And is this something that you guys help clients determine and figure out, this whole tax piece?
Tyler Emrick:
Sure. I think it’s absolutely something that’s probably a 2024 endeavor and preparing for the upcoming year. As in everything that we do and on every podcast, I feel like I say the same things, but having some type of plan in place and having a strategy when you head into the upcoming year, that’s extremely important and that’s how you alleviate some of these surprises when they come up. If you don’t have somebody looking at this for you, or your investment professional and your CPA is not communicating in regards to this portfolio income that’s hitting, you’re really missing out.
I think, as with anything, taking a more holistic approach, integrating your investment and income strategies together to provide better outcomes at tax time is really the approach to take. Of course, that’s the approach that we take here at True Wealth Design, and we feel like that’s the route to go. If you don’t have somebody looking at it for you, or if you don’t feel like there’s adequate communication between the professionals that you’re working with, we’d be happy to have a conversation and talk to you a little bit about how we do it here at True Wealth Design, and how we can set you up for 2024 taxes.
Walter Storholt:
Very good. Well, here’s how you have that conversation with Tyler and the great team at True Wealth Design. Just give them a call at 855-TWD-PLAN. 855-TWD-PLAN. Or you can go to truewealthdesign.com, which we have linked in the show description today. You can click on the Are We Right for You button and schedule a 15-minute call with an experienced advisor on the team. Again, just go to truewealthdesign.com, and click the Are We Right for You button. You can make sure you get these taxes all straightened out and ready for next year, go ahead and start thinking in advance. While you’re at it, not only thinking about the tax piece of this conversation but all the other elements of financial and retirement planning. Tyler and the team are going to help you make sure that you’re well set up there as well. All you have to do is go to truewealthdesign.com and book your 15-minute call today to get started.
Tyler, thanks for all the great guidance and advice on the show today, enjoyed it. I won’t say it was a fun trip down memory lane, back to those days when I used to get those bigger bills.
Tyler Emrick:
Yeah, fair enough.
Walter Storholt:
It at least reminds me of why I got on track, right?
Tyler Emrick:
I was going to say it just reminds you of being on track on how helpful it is.
Walter Storholt:
That’s right.
Tyler Emrick:
Happy to be here, had a lot of fun, and I’ll see you on the next one.
Walter Storholt:
Yeah. When you see the threat of that penalty coming up, you get straight real fast. It definitely helps keep you in line.
Well, for Tyler, I’m Walter, thanks for joining us. We will talk to you next time on Retire Smarter.
Speaker 4:
Information provided is for informational purposes only and does not constitute investment, tax, or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.
