The Affordable Home You Overlooked and the Investment Tax Trap You Need to Prepare For

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19:38Elizabeth Ayoola:If your investments are making you money, you could end up owing the IRS a penalty on top of your tax bill, just for not paying enough during the year. This week's money question comes from Colleen, who's trying to get ahead of it. Here's her question. Bear with me, people. It's a long one. Hi, y 'all. My husband and I both have investments that luckily have been making money the last few years, which is great. What's not so fun is not getting any tax refunds anymore and instead owing money when it comes to tax season as nothing is withheld from these accounts while they make money throughout the year.

20:11Elizabeth Ayoola:We are considering how to better prepare for next year's taxes and wondered y 'all's thoughts on two strategies. Number one, we have the option to select additional withholding of whatever amount we want with the companies we work at. The benefit of this would be a little less in each paycheck, but we don't feel it so strongly all at once by owing the government on one day. And it's spread out throughout the year instead.

20:36Sean Pyles:Option two, we can instead open a high-eld savings account and put the money we aren't withholding into it throughout the year so that it grows even a little and we pay our taxes from this bucket. This would mean we still owe taxes from our investments when filing, but at least some of it could come out of interest we've made throughout the year. But then we would owe money on this earned interest too. So then is it worth it?

20:58Elizabeth Ayoola:Similar potential future third option. If we have the money to dump in all at once instead of deposits throughout the year, we choose a CD that matures before taxes are due and deposit that chunk into there to grow. And again, have some of that interest cover some of what we will owe. But same question about paying on the earned interest here too. Would love your thoughts. Colleen. All right.

21:21Sean Pyles:Well, shout out, Colleen. You really did your research with all of these strategies, so kudos to you. You're way ahead of the game here. To help us answer Colleen's question on this episode of Smart Money, we're joined by our tax and investing pro, Bella Avila. Bella, welcome back to Smart Money. Hi, guys. Thanks for having me back. So it sounds like Colleen's in a kind of good spot. Her investments are making money, which is what most people want their investments to do. But of course, investments in taxable accounts can trigger a tax bill, and this is in contrast to a non-taxable account. Think like like your 401k, basically.

21:53Sean Pyles:And so getting a tax bill from your taxable investments can happen in a few different ways. Can you lay those out for us? Yeah. So you're right. When you sell an investment for a profit, you'll owe taxes on your earnings. But like you mentioned, that isn't the only scenario in which someone might owe taxes on their investments. A few other common reasons are if you had interest or dividend income. And even if your dividends were reinvested, that's true. And then if you're invested in a mutual fund, you may also owe capital gains tax even if you don't sell anything. And that's because if the mutual fund manager sells securities in the fund, your share of that profit is technically considered a capital gain.

22:29Sean Pyles:And for some people, they may not find that they owe taxes until they get a form from their brokerage account or whoever they're working with come January or so at the beginning of the year. They may not even know that they might owe taxes on dividends that are reinvested. And that can be an unfortunate surprise.

22:46Elizabeth Ayoola:Yeah. Very unfortunate. All right. Let's talk through each strategy Colleen mentioned, and we're going to start first with withholding extra from their paychecks. Now, this is something I personally do to cover my business taxes every year. Bella, explain how this works. So if you find that your full tax liability isn't covered by what your employer takes out of your paycheck, and in plain English, that just means you owe more taxes than you're paying throughout the year, you can tell them to withhold more tax on future paychecks by submitting a new W-4 form. And if you don't want to go the W-4 route, you can also send estimated tax payments to the IRS yourself.

23:24Elizabeth Ayoola:For the record, you can pay estimated taxes a couple of ways. One is you can use direct pay, and that entails going through the IRS website and paying with your bank account. Pretty straightforward. Or if you like going to the post office, you can mail a check with a payment voucher using Form 1040ES. All right. So, Bella, how can Colleen and her husband calculate the right amount to withhold. I personally found this a little tricky. It may be hard because they can't predict investment performance or growth. If we could have it our way, the market would just keep going up. But they can look at whether their investments are composed of long-term versus short-term capital gains, right?

24:02Yeah, like you said, this is where it gets pretty tricky since not all investment income is taxed the same. I think I could spend this entire segment talking about the nuances of interest and capital gains and dividends and how they're all taxed, but I won't put you all through that. I will say that I think it makes the most sense to withhold extra on your W-4 if you have pretty stable investment income. And in that case, I would lean on prior year 1099s and last year's tax return to see how much tax I owed on my investments and get a rough idea of how much extra to withhold. But just keep in mind that if you continue to put money in these investments throughout the year, your investment income could increase, and then it might make sense to withhold a little bit extra than you think you need to.

24:44Sean Pyles:At the same time, there's always going to be a little bit of guesswork involved because, as you mentioned, a mutual fund manager might sell some stocks in the portfolio, and then you would be liable for some potential taxes from that. So do your best based on the information that you have in the past, like Bella mentioned, using maybe a prior year's return, but just know that it's probably not going to be perfect. So, Bella, can you tell us more about adjusting your W-4 to withhold taxes. There are two ways to do this. You can input the amount into the other income section of your W-4 or the extra withholding section, right?

25:16Yeah, let's break those differences down. As an example, let's just say I made$5 ,000 from my investments last year and expect to net about the same this year. I could put$5 ,000 on step 4A, other income, and my employer would withhold my highest ordinary tax rate on that income. Okay.

25:33Sean Pyles:And so with this method, you don't really have to worry about calculating the actual taxes you might owe, right? Yeah, that's right. Your employer kind of does all the work for you. They'll do the math and withhold everything. But the key thing here is that not all investment income is taxed the same as your ordinary income, which is what your employer will withhold. So let's talk about that second option you mentioned, step 4C, extra withholding. This section lets you put the exact amount of tax you want withheld each pay period. It does require some math on your part, but it might give you a higher shot at accuracy.

26:03And then I do want to plug the IRS's withholding estimator here, which can help you with your calculations. It has fields for you to enter your interest income, dividend income, short-term and long-term capital gains. And at the end, it even spits out a mostly pre-filled W-4 for you, which I think is pretty handy. But just keep in mind that you might want to revisit it throughout the year to avoid over or under withholding your taxes.

26:25Elizabeth Ayoola:Bella, to me, it sounds like this extra withholding option is kind of like the W-4 version of estimated payments then. Yeah, you can totally think of it that way. I would just say that estimated tax payments give you a little bit more flexibility. You can change the amount and cadence on your terms, whereas you'd have to submit a new W-4 to your employer each time you want to make a change to your withholding. Yeah, what I'm hearing here is it sounds like it could be easy to miss the mark with all of this guesswork sometimes. I remember that I attempted to use the IRS calculator and as soon as I opened it, I closed it and messaged my tax person.

26:59Elizabeth Ayoola:There were too many boxes and numbers for me.

27:02Sean Pyles:I was going to say, if you don't feel like doing all this, you might want to hire a CPA or some other kind of tax professional because this is a lot of heavy lifting and numbers to crunch on your own and you don't want to do it wrong.

27:12Elizabeth Ayoola:Yes, totally. It can get complicated quickly. Yeah, don't want no smoke with the IRS. Well, my tax expert personally told me to withhold, I don't know, an extra maybe$500. And I haven't underpaid since. Works for me.

27:23Sean Pyles:We actually got a massive refund this year. So maybe you're over withholding, Elizabeth.

27:28Elizabeth Ayoola:I may be, but I haven't got hit with an overpayment penalty. So I don't know. Where are we?

27:33Sean Pyles:There you go. I guess. Yeah, that's the question is, would you rather overpay now and get a good refund or avoid that penalty?

27:41Elizabeth Ayoola:It's always interesting. And we're not going to go down that rabbit hole right now with this argument that, you know, if you overpay, then you're giving the IRS a free loan. That is true. But I also like a bulk cash. OK, I love that. So, you know, I'm in the same boat. I'm right there with you.

27:57Sean Pyles:I get it. As someone who owes almost every single year, I actually upped my withholding this past year because I'm hoping to kind of mitigate some of what I will end up owing maybe this coming year. And I would just really like a refund because it feels nice to get a windfall, even if it's just a few hundred bucks. Amazing. So Bella, getting back to the topic at hand, instead of having to constantly adjust a W-4, do you think estimated taxes might actually be the easier route? I think it's definitely something to look into instead of tweaking your W-4 specifically for one-off situations. For example, if I sold some stock for a profit and owed capital gains tax on my earnings, I'd probably just estimate the tax I owe using a capital gains tax calculator and then send it as an estimated tax payment to the IRS since that's not really recurring income that I'd want my employer to withhold taxes on.

28:45Sean Pyles:Okay, moving on to Colleen's second strategy, let's talk about saving money for taxes in a high yield savings account to earn some interest before giving that money over to the IRS. And I really like this strategy because that way you have a little more control over the money that you're keeping in your accounts. But like Colleen said, they might actually end up owing taxes on the interest they're earning in this account. So then they would have potentially a larger tax bill. Yeah. So unfortunately, I do have to poke some holes in this idea. If the plan is to calculate how much extra tax you owe during the year that's not being withheld and then divide that up into monthly contributions to a high-yield savings account, it's honestly not my favorite strategy.

29:20Colleen asks if the interest is taxable, and it is, but that's not really a deterrent in my opinion. The main thing I would be concerned about is the IRS's underpayment penalty. When you file your taxes, if you owe more than$1 ,000 and you're withholding from your job or estimated tax payments throughout the year didn't cover at least 90 % of the tax you owed for the year or 100 % of the tax you owed for the previous year, you'll get hit with a penalty, which right now is 6%. And for high earners, the rules can be even stricter. So let's just say you ended up with a$3 ,000 tax bill last year, but you decided to keep your withholding the same this year and not make estimated tax payments.

29:57If you stash$250 a month in a high yield savings account earning 3 % to 4%, you could still face that 6 % penalty for underpaying your taxes, which kind of cancels out any interest you would earn. In my opinion, this seems like more of a headache than it's worth. And if you've already done the math on how much extra you need to withhold for the year, you'd probably be better off just tweaking your W-4 and not having to stress about it.

30:19Sean Pyles:Yeah. The IRS wants their money like today. So do not underpay that.

30:23Elizabeth Ayoola:Yesterday, if they could have it yesterday. Have either of you ever been hit with an underpayment penalty?

30:29Sean Pyles:I have not. Although the amount that I owed this past tax season made me up my withholding because I was a little concerned that this coming year's tax season, I actually would maybe have an underpayment penalty. And this is because my tax situation changed a lot over the past year. I got married. I'm renting out a house now. I have some investment income and I just didn't want to take the risk. So I upped my withholding again, so I can hopefully maybe one, cover my tax bill and two, possibly get a refund. I would just like to have a refund for once. I'm the same where I haven't been hit with it before, but I think it definitely takes some effort on my part to make sure I'm on track to owe as close to zero as I can at tax time.

31:07For example, I'm pretty picky when it comes to what I invest in to make sure whatever I choose doesn't lead to a surprise tax bill.

31:14Elizabeth Ayoola:Thank you guys for sharing your business.

31:15Sean Pyles:Time for you to share yours, Elizabeth.

31:17Elizabeth Ayoola:I was not hit with an underpayment penalty because luckily my withholding was enough, but I have shared, I believe on the podcast before that my first year in business, I was not paying quarterly estimated taxes, but luckily I wasn't earning a lot of money that year. So I didn't get hit with the underpayment penalty, but almost. Yeah, it's hard Trying to figure all this stuff out. Right? All right. Back to the high-yield savings account option. It sounds like even if Colleen stashed away money in that high-yield savings account and made those estimated tax payments, she could avoid the underpayment penalty.

31:47Elizabeth Ayoola:But it just doesn't sound like she would make that much in interest quarterly anyway. But Colleen, it's up to you to decide whether it's worth the stress.

31:55Sean Pyles:Quick aside, my cat just bit me while we were recording. So I'm sure. You were very calm. Well, I did flinch, but hopefully it's not too obvious. Yeah, he wants to be on my lap because it's cool and rainy today.

32:08Elizabeth Ayoola:Well, maybe our listeners and viewers need to know that too. Yeah.

32:12Sean Pyles:Okay. For people who are only listening, head to YouTube or Spotify and watch my cat bite me in this episode.

32:18Elizabeth Ayoola:It's a cute cat, even though it bites.

32:20Sean Pyles:He's very cute, but sometimes a jerk. Anyway, let's move on to the final option here, which is using a CD, a certificate of deposit, to stock away money until tax time. And this sounds like a slightly maybe more rigid version of the high yield savings account strategy because you wouldn't be able to access that money until the CD term is up without potentially losing your interest. And maybe a fee would be thrown in there, too. So, Bella, what are your thoughts on this? Kind of same thing as the high yield savings account. I'd be concerned about the underpayment penalty again. And then kind of like you were saying, a CD feels even riskier than a high yield savings account to me since you lose that withdrawal flexibility.

32:57If your money is locked up in a CDN till maybe March of next year, but you realize you need to make estimated tax payments throughout the year to avoid the underpayment penalty, you might be in kind of a tough spot.

33:08Elizabeth Ayoola:Yeah, that would be a tough spot to be in. Colleen, what are you going to do? Please tell us. Write us if you're listening, please. But before then, are there some hybrid options that Colleen can try? Anything that we haven't covered, Bella? Yeah, I think a hybrid approach like tweaking your W-4 and sending in estimated tax payments could make sense if you're dealing with different kinds of investment income like steady monthly dividends and then the occasional big capital gain. But at the end of the day, like you guys were mentioning, working with a tax pro if you can to figure out the right approach could definitely make sense because this stuff can get complicated.

33:39Sean Pyles:Yeah. And again, you do not want to be on the wrong side of the IRS and end up owing them money because they can get expensive and just give you a whole other headache you don't want to deal with. Yeah. So let's actually talk about lowering your investment tax bill. What options might Colleen have here? There are a few things that come to mind for me. The first thing being try to hold on to your investments for over a year if you can. This could bring you down to the long-term capital gains tax rate, which is more favorable. Yeah, that's a good thing to mention. And one thing I want to clarify, too, is we've been talking about capital gains taxes, and there's short-term and long-term capital gains.

34:12Sean Pyles:And I think people don't understand that short-term capital gains tax is just your ordinary income tax rate. And the long-term tax rate is going to most likely be much lower than what you'd pay on your ordinary income. Yeah, that's right. And then moving on to the second thing I wanted to mention, I'd also encourage people to look into investments with more favorable tax treatments like ETFs if taxes on mutual funds feel like a burden. Or maybe see if keeping your investments in a tax-advantaged retirement account could make sense for you. Oh, quick clarifying question. Can you talk about why ETFs would actually be preferable to mutual funds tax-wise here?

34:46So with an ETF, you won't actually pay capital gains tax until you sell your shares. whereas like I mentioned with a mutual fund, the manager can sell shares and you might not know until tax time.

34:57Sean Pyles:Got it, okay, thank you. And then the last thing I kind of want to talk about is you might want to look into tax loss harvesting which is a strategy where you sell certain assets at a loss to offset your gains. A lot of robo-advisors actually offer this service and for free sometimes.

35:11Elizabeth Ayoola:Man, every year I say, I'm going to look into my tax loss harvesting and save money on my taxes. Do you guys think I've done it yet?

35:17Sean Pyles:I'm going to guess no because you said this, But hey, you can carry your losses forward. So you might not have wasted those losses yet.

35:25Elizabeth Ayoola:That's the part I like, you know, just saving. That's all this is. All right. It feels like ultimately Colleen and her husband hate the idea of giving their cash straight to the IRS. And they want to try to make some interest on their money first. I feel you, Colleen. I too hate giving chunks to the IRS. I too hate it. Yeah, I totally get why people feel that way. But in the U.S., taxes are pay as you go. So you have to pay them while you earn the money or like we talked about, you might get penalized. So I think implementing tax saving strategies where you can is the safest move. And then if you have extra income left over once you've covered all your bases each month, that's what I would recommend using to help you build wealth and interest bearing accounts.

36:05Elizabeth Ayoola:Well, Bella, thank you for coming on and educating us on taxes. And we hope Colleen has gotten her question answered. Yeah. Thank you guys for having me. I hope it was helpful.

36:15Sean Pyles:It's also a good reminder that it's never too late or honestly, even too early to start strategizing for the next tax season. Yes. Okay. Well, that's all we've got for this episode. Remember that we're here to answer your money questions, so send them our way. You can hit us up on the Nerd Hotline, text us, or leave a voicemail at 901-730-6373. That's 901-730-NERD. You can also email us at podcast at nerdwallet.com or drop us a comment on Spotify or YouTube. Yeah.

36:42Elizabeth Ayoola:And if you have some strategies that you've been using during tax season that you want to share, you can send us an email or leave a comment, as Sean said. All right. Join us next time to hear about how to set up a sinking fund because we are getting organized this year. Follow Smart Money on your favorite podcast app that includes Spotify, Apple Podcasts, and iHeartRadio to automatically download new episodes.

37:02Sean Pyles:Here's our brief disclaimer. We are not your tax, financial, or investment advisors. This nerdy info is provided for general educational and entertainment purposes and may not apply to your specific circumstances.

37:13Elizabeth Ayoola:This episode was produced by Tess Vigland. Hilary Georgie helped with editing. Eve Krogman edits our audio and our video. And a big thank you to NerdWallet's editors for their help.

37:22Sean Pyles:And with that said, until next time, turn to the nerds.

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