No one really looks forward to tax season, do they? Many of us enjoy the end of winter and the beginning of spring, and when you think of it that way it’s pleasant enough. As soon as you call it “tax season”, well, that doesn’t usually evoke the same emotions. Call it spring, and you think of flowers and sunshine; call it “tax season”, and you think of forms, deadlines and checks to write.
With the negative feelings “tax season” evokes, it’s no wonder that along with it comes some frequent misperceptions. For example, how do you feel about paying taxes on investment gains? And, would you rather owe the IRS, or receive money back from the IRS? What if your feelings on these matters, for lack of a better word, were wrong?
Owing Income Tax on Investments
Taxes are due on 401(k)s, IRAs, and other similarly structured and IRS-provisioned investment accounts only when money leaves the accounts, with few exceptions. Interest earned, investment gains, and dividends that occur within the accounts are not taxed as they happen. However, when cash leaves the account, every dollar is considered taxable at current income tax rates.
Non-retirement accounts are the exact opposite of that, tax-wise: no taxes are due when cash leaves the account, however any calendar year that interest or dividends are received, or an investment is sold at a gain or a loss will have an effect on that year’s tax returns. The majority of investors have more in their retirement accounts than in non-retirement accounts, so they are not as used to their investments kicking off taxable gains. It is not uncommon for we advisors to hear our clients note that their non-retirement accounts were negatively affecting their taxes. This leads to the discussion on why it’s better to have to pay taxes on these investments than not to have the investments at all.
Consider a married couple that made $300,000 in 2024. They saved 15% of that, or $45,000, into their workplace retirement accounts and took the standard deduction of $29,200. Without any other additions to their taxable income, they would be solidly in the 32% federal income tax bracket and owe the IRS $40,277 for 2024.
If they had started 2024 with a certain mix of mutual funds and exchange-traded funds, as well as short and medium-term treasuries worth $100,000 in a regular (non-retirement) brokerage account, these investments would have grown by 7.09%. How can I be that precise? I looked at a client account nearly identical to this when creating this example. That investment mix would have generated $545 in taxable interest, $1,754 in taxable dividends, and $5,725 in short-term capital gains. This would increase their federal income taxes due by $2,231, leaving them with a net investment gain after federal income taxes assessed of $4,859.
I agree, paying $2,231 more in federal income taxes is not what anyone prefers to do, however, isn’t it worth it if, overall, you have nearly $5,000 more in your pocket? In simplified terms, paying may be “bad”, but keeping is “better”. I will hand over $2,231 to anyone who will turn around and hand me $7,090 in return. That’s a 4.9% net gain on the initial $100,000 investment, but it’s a 218% gain on the taxes due. When you write that check, know that you’re better off than if you had no reason to write that check. $4,859 better, to be precise.
Owing the IRS versus getting a refund
Isn’t it nice to complete your income taxes and see the federal government owes you money? It’s definitely better than owing the IRS, isn’t it? Well, maybe for one reason I’ll mention later, but mathematically it is better that YOU owe THEM, regardless of how much it hurts to write that check. Let’s look at the math.
Let’s say you’re due $3,000 back from the IRS. That’s not chump change by any stretch. Unfortunately, that is a $3,000 interest free loan that you gave the US government. Helping your country fund its obligations and, increasingly, pay the interest on its debts has a certain nobility, but you can do the same by buying a $3,000 treasury bill, note, or bond and for much of 2024 have earned 5% on it. So, would you rather get a check for $3,000 from the IRS, or have $3,154 already in your account?
Let’s take this further. Let’s say that instead of getting $3,000 back from the IRS, you owed them $1,000. Now it’s the IRS that is giving you the loan. With that loan, just like when they owed you $3,000, you make a little over 5% on it, $51 to be precise. From your $1,051 account, you write the IRS a $1,000 check when the time comes, and you keep the $51. Overall, the financial benefit of owing $1,000 versus receiving $3,000 is over $200, before taxes, of course. At the beginning of 2024, if you’d invested $1,000 in the Schwab government money market fund and liquidated that amount to pay your federal income taxes due of $1,000, you’d be left with $51. Had you over-withheld by $3,000, you never would have earned that $154. That all adds up to $205.
As previously mentioned, there is one instance where it can be argued getting a check from the IRS is better than owing them: were you to have completely wasted that money were it in your possession instead, AND if when you receive it from the IRS you do something productive with it, THEN it’s better to be owed than to owe. Consider that $3,000 to be a form of forced savings. I struggle a bit calling it that because I think many of the people who use their federal income tax refund as a savings mechanism will end up putting that money to non-productive use any way. If you need the forced savings, then how good are you going to be with the money when you do get your hands on it?
If you were to take a vacation every year and pay for it with your IRS refund, I cannot argue that’s not a beneficial thing to do. I know it’s mathematically not the best way to do it; I’d rather you withheld less, accumulate $4,000 over the year, owe the IRS $1,000, pay them, and take your $3,000 vacation. When you get home, you’d still have $205 dollars in that account. If there’s no other way to get that vacation money, and we all need the mental health breaks vacations can provide, then maybe, just maybe, you’re better off getting money back from the IRS to pay for it. You’d have to convince me, though, and I am in the mood to argue this point.
When is a tax loss also an investment gain?
Tax season is also the time of year more clients take a close look at the specific gains and losses of the individual investments inside their accounts. It is a quirk of the Charles Schwab client website that gains and losses reported on the website don’t reflect actual gains and losses.
Mutual funds, and to a lesser extent, exchange traded funds generate taxable interest and dividends, especially bond funds. Every time an account holding an investment receives a dividend or interest payment, the cost basis of that investment gets adjusted to account for the taxability of the transaction, even when no tax has yet been assessed, and even when that investment is inside an IRA and no tax will ever be assessed on that transaction. That’s just how the system reports the cost basis of the individual investments.
In taxable accounts, these taxable transactions get reported on the various 1099’s clients receive early each calendar year, and from those reports the various income items get added to the tax return. As you pay taxes on the investments year after year, the cost bases of the investments increase over time. We have covered the benefit of having investments to pay taxes on in the first place early in this article, but another benefit of paying taxes along the way like this is that it is possible to book a tax loss on an investment that has actually increased in value and paid you interest.
Looking in an actual client account, I see a holding, the BlackRock Strategic Income Opportunities Fund, with a ticker of BASIX. When I log in to the account to see what a client would see, this position is showing a loss of -2.5% since she owned it. However, when I look at the same position in the same account in the system we advisors use to report client returns, that investment is showing a 38% gain. Which one of these is the truth?
Well, they both are. When it comes to the client, she really has made 38% between appreciation of the investment itself, as well as the dividends and interest earned on the investment. As far as the IRS is concerned, on the other hand, there is a -2.5% loss on the investment, as all the taxes paid along the way in relation to the value of the investment today actually results in a current tax loss were the position liquidated. In this way, the client can enjoy both a 38% gain on the investment as well as a -2.5% tax loss she can claim on her income taxes. So, don’t be mislead by what you see in the Schwab system when you log in. A high percentage of the investments that system shows you have lost value in have actually earned you a positive return. If you are in doubt, ask your advisor.
Spring brings out the optimism in many of us. The end of winter is a time to be celebrated as we emerge from our hibernations. Tax season, however, even though it runs simultaneous to spring, is not celebrated in similar fashion. Melting ice and snow, lengthening daylight, and grass turning green are all happening while 1040’s, 1099’s, and W2’s are making their way to us. In this way, tax season actually happens at the perfect time of year. While our tax math is happening, at least we can look out the window to a world getting more green and less gray. Don’t let the idiosyncrasies and oddities of tax math and the Charles Schwab website fool you. A few of the things that appear to be negatives this time of year are, in fact, just the opposite.
Editor’s Note: This article was originally published in the February 2025 edition of our Cadence Clips newsletter.
Important Disclosures
This blog is provided for informational purposes and is not to be considered investment advice or a solicitation to buy or sell securities. Cadence Wealth Management, LLC, a registered investment advisor, may only provide advice after entering into an advisory agreement and obtaining all relevant information from a client. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Past performance is not indicative of future results. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses and is not based on actual advisory client assets. Index performance does include the reinvestment of dividends and other distributions
The views expressed in the referenced materials are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
