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Tax Bites

Sanjib Saha

MY TAXES ROSE 50% in 2021. I’ve never paid so much before, not even during my peak earning years. I’m not upset about having to pay my fair share, but the extent of the increase puzzled me. After examining my tax return, I came away with a handful of insights.

To be sure, I wasn’t expecting a large refund. The reason: I suspected that a onetime employment windfall would cause me to owe money, so I withheld more taxes during the year. I wanted to avoid an underpayment penalty at all costs.

While the workplace windfall and some employer stock vesting contributed to higher taxes, I made moves in my taxable brokerage account that increased the pain. I had rebalanced my portfolio in early 2020 to take advantage of the stock market swoon. The market recovered and soon my stock allocation exceeded my target portfolio percentage. I trimmed my stock holdings in 2021 to get them back to an acceptable size.

Many of the stocks I sold last year had risen in value, so rebalancing increased my capital gains for the year. I’m not much bothered by that. Regular rebalancing is part of my investment process, and this was the expected result.

Here’s where the unexpected happened: I invested the rebalancing proceeds in a short-term inflation-indexed Treasury ETF. I wasn’t planning on much income from this investment, thanks to the chronically low interest rate. But soaring inflation changed the dynamic, boosting the value of inflation-indexed Treasurys—and leading the fund to distribute a large sum that was taxed at the ordinary income rate.

The most unexpected surprise came from capital gains distributions in my ETF portfolio. Vanguard International Dividend Appreciation ETF (symbol: VIGI), for example, distributed more than 6% of its net asset value in capital gains. Half of those gains were short term, so they were taxed at the ordinary income rate. It was an unfriendly reminder that the vaunted tax-efficiency of ETFs isn’t guaranteed.

To prepare for the taxes we might face, we can keep a close eye on our portfolio. Our brokerage statements will list the dividends and interest we receive. Fund company websites will tell us what size distributions to expect. Sound like too much work? Alternatively, you might keep a little extra cash on hand—just in case you owe money when you file.

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