The annual cost of saving money in a taxable brokerage account is higher than most people think. The dividends, interest, and realized capital gains which make up the normal growth of taxable account assets are often taxed at both the state and federal levels.
You can compute the annual drag on your account with the following formula:
Annual Drag = Annual Total Return * Marginal Tax Rate
Assume that your portfolio has a 7% annual total return. Your total return could be any combination of interest, dividends, and capital gains. Interest and ordinary dividends are normally taxed at income rates, but we will assume that everything is taxed at the lower capital gains rate. While in practice we would recommend that you try to avoid capital gains or use math to decide when and what to realize, for the sake of simplicity we will assume that you realize your capital gains each year.
In 2021, if you live in Virginia and earn between $40,526 and $445,850 ($80,801 and $501,600 married filing jointly), you are subject to a marginal federal capital gains tax rate of 15% and a marginal state tax rate of 5.75%.
In this case, the formula for the annual drag of taxes on your account is:
Annual Drag = 7% * (15% + 5.75%) = 1.4525%
In this example, your portfolio might be underperforming by -1.4525% simply because your investments are in a taxable brokerage account. Other account types would not be burdened by this taxation.
Assuming that you have a 1.4525% annual drag on your investments, the 30-year impact of such tax-drag is significant.
If it were invested in a tax-free environment such as a Roth account, $100,000 invested with a 7% annual total return would grow to $761,226 over 30 years. In a taxable account where growth and dividends are subject to the federal and state taxation every year, it would only grow to $505,171.
This $256,055 difference in value represents 33.64% less value in the taxable account than the Roth account ($256,055 / $761,226). In this way, the 30-year effect of a 1.45% drag is 33.64% less.
Said differently, the 30-year effect of a 1.45% drag is that you miss out on 256.05% potential future value.
This 1.45% annual drag may seem like a small amount, but the effect over long periods of time such as 30 years is significant.
Many of our clients are in higher tax brackets. Some pay a 20% federal qualified rate and/or a 3.8% Net Investment Income Tax (NIIT) on top of a state tax rate (5.75% in Virginia). Here is the annual drag for various capital gains tax rates and investment returns.
|Assumed Growth||Annual Drag for
20.75% Tax Rate
(15% + 5.75%)
|Annual Drag for
24.55% Tax Rate
(18.8% + 5.75%)
|Annual Drag for
25.75% Tax Rate
(20% + 5.75%)
|Annual Drag for
29.55% Tax Rate
(23.8% + 5.75%)
If you have any taxable account investments, we recommend maximizing your contributions to every tax-advantaged account you can up to the annual contribution limit.
We recommend funding your Roth IRA even when you can’t afford it to lower the taxable account balance and thus the annual drag on your assets. Favorable Roth IRA distribution rules mean that you can access those funds if you need them later.
You may also benefit from regular Roth conversions. In a Roth conversion, you take a traditional IRA and you convert it to Roth. Then, you pay the tax from your taxable account. By paying the tax from your taxable account you reduce the amount which is subject to dividends, interest, and capital gains being taxed each year. Paying the tax now to shelter more in a Roth reduces your taxable account and lowers the future drag your taxable assets face.
Another way to increase your after-tax assets is to fund your HSA for the maximum. A health savings account (HSA) is even better than a Roth IRA for qualified medical expenses and functions like a traditional IRA for other expenses. For this reason, it is better than saving in a taxable brokerage account. At its best, it can provide both a tax deduction and still be used for qualified medical expenses tax-free.
If you have any taxable investments but are not investing the maximum you can in qualified retirement accounts, you are not yet optimizing your after-tax return. If you want help taking advantage of the tax-advantaged accounts available to you, consider getting started as a client.
Photo by Eastman Childs on Unsplash