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Tax Bites

Sanjib Saha, 1:30 am ET

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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Tooney
Tooney
13 days ago

Thanks for the article.

I don’t own any ETFs, but had read that they are more tax efficient and did not realize they may distribute large cap gains.

After unexpected cap gains distributions in December started making big changes in my tax bill, I switched to having those distributions paid out in cash, rather than reinvesting them. I wanted the cash available to pay the tax liability.

I, too, prefer to avoid tax underpayment penalties. But, as a retail tax preparer for many years, I learned that the penalty for underpayment is relatively low, particularly if the reason for the underpayment is because of cap gain distributions that come late in the tax year. Filing IRS Form 2210 and annualizing income will often wipe out these penalties. If the underpayment penalty amount is worth the trouble of filing Form 2210 and annualizing, that is always an option.

If Form 2210 with annualizing income does not eliminate the penalty, you can always make an estimated tax payment by January 15 to reduce it. Form 2210 is required for a single estimated tax payment.

Sanjib Saha
Sanjib Saha
12 days ago
Reply to  Tooney

Thanks for the suggestions, Tooney.

I’ve owned passive ETFs for quite a while and the gain distribution, if any, is generally small as long as the Index composition doesn’t change much. When a stock gets out of an Index, it will be sold by the ETFs that are tracking the Index and hence there will be a tax incidence. In the case of VIGI, I think the fund changed its Index last year and the new Index composition is quite different than the old one. As a result, there were quite a bit of selling, and hence gains distribution.

Physician on FIRE
Physician on FIRE
13 days ago

I would enourage you to do your rebalancing in tax advantaged accounts (IRA, Roth IRA, 401(k), etc.) and leave your taxable account alone.

Treat your collections of accounts as one portfolio and stop unnecessarily increasing your tax burden.

Your taxable account should be a source of tax savings (tax loss harvesting) and during your accumulation years, the only taxes you should have to pay are on unavoidable dividends.

Best,
-Physician on FIRE

Sanjib Saha
Sanjib Saha
13 days ago

Thanks for your note, Physician on FIRE. I have a smaller tax-advantaged account (I started contributing late) and as a result, large rebalancing bleed into the taxable accounts, like it did in 2020.

William Perry
William Perry
14 days ago

One exception to the underpayment penalty tax is based on your prior year tax, prior year adjusted gross income(AGI) and your filing status. For a married filing jointly status if your prior year AGI exceeded $150K, having 110% of the prior year tax paid in timely in the current year protects you from federal underpayment penalty. For this purpose withheld income taxes are treated as if they were equally withheld throughout the year so having additional withholding late in the year may let you eliminate or minimize any underpayment penalty. A late in the year estimated tax payment can stop further accrual of underpayment penalty, but additional withholding can eliminate the penalty due to the deemed equal withholding treatment. The IRS instructions for form 2210 has all of the exceptions to the penalty listed.

Sanjib Saha
Sanjib Saha
13 days ago
Reply to  William Perry

Thanks, William. Yes I took advantage of the safe harbor rule and had more than 110% of 2020-tax as withholding. So I didn’t owe penalties – otherwise it’d have been insult to injury :).

Scrooge_McDuck88
Scrooge_McDuck88
14 days ago

Like the old saying goes….”Can’t cry about making money”.

Sanjib Saha
Sanjib Saha
13 days ago

Thanks, Scrooge_McDuck88. Very true for the most part (e.g. earned income), except that fund distributions (whether for inflation compensation or to pass on gains) are not really “making money”, but “realizing tax on part of your NAV”.

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