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“Tax drag” can hold your money back from reaching its fullest potential—what is it, how does it work, and what do the outcomes look like? Plus, we share a wild money story involving $90,000 of debt. Have a money story of your own? Email us at moneywithkatie@morningbrew.com, and we’ll anonymously share it.

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Our show is a production of Morning Brew and is produced by Henah Velez and Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our Chief Content Officer and additional fact checking comes from Kate Brandt.

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Katie:

Welcome back, Rich Girls and Boys to Rich Girl Roundup, the weekly casual convo of The Money with Katie Show. I'm your host, Katie Gatti Tassin. And here is a quick message from our sponsors.

Okay. Onto the roundup; Henah, how are we doing today?

Henah:

I'm good. This week's question came from Ian B., which simply said, “tax drag” and my thought immediately went to RuPaul's Drag Race. But I also think that when you and I first talked about tax drag, I remember having this aha moment, and so I thought it'd be really valuable to cover with the audience.

Katie:

Okay, amazing. Well, tax drag is kind of a fun topic. I mean, I think the phrase itself…is it? I think it is. So it's meant to connote, think “drag” on something that's going very fast. So like planes and cars, things that are supposed to be aerodynamic, but then—

Henah:

Michael Phelps.

Katie:

Sure.

Henah:

They like—don't swimmers shave their legs so that they can be more aerodynamic?

Katie:

Yeah, okay. Amazing point. So little non-aerodynamic design components like body hair cause the machine or Michael Phelps's body to have to exert more energy to go faster. They slow you down. Clearly, I don't have an engineering background, but bear with me.

So that's kind of why they call it “tax drag” because it's a little at the margins, but it does compound over time. So I think about this as the way that we talk about exponential compounding of your investments. It's that your money is going out and it's making money, and then that money is making money and then that money's making money, so on and so forth. This is reverse compounding.

Henah:

It reminds me of when you use the example that investing in a traditional 401(k), like giving yourself a raise in that—you're basically saving the taxes, which prevents tax drag, which is kind of where my brain clicked in place, but is that right?

Katie:

Yes. Usually when we talk about tax drag, we're talking about the growth inside of those tax-sheltered accounts as opposed to just the initial deferral because yes, we are giving ourselves a raise by using that account. We're saving money on our taxes that we can go save elsewhere or invest elsewhere. But once the is invested, even it is sheltered from taxation for decades. The difference between growth in a tax-sheltered account that is not having any taxes taken out of it every year, the way that dividends and yield get taxed annually in things like taxable brokerage accounts or even high-yield savings accounts, you're going to pay taxes on the yield in a high-yield savings account. That's not just free money that they let you keep. So it's that there's a sort of umbrella over the rainstorm of the IRS and that money then stays in the account to continue compounding versus being taxed on.

Now, realistically, you're probably not actually withdrawing money from a taxable account to pay the taxes. Maybe you are with the high-yield savings account. I could see that one working a little different because a little more liquid than having to sell securities. But theoretically that other income that you're using to pay a dividend tax bill is money that could have been saved or invested instead. So it's looking at the overall effects of tax on growth and the way that those effects compound over time, because over time, if you're skimming a little bit off the top, but that little bit is now no longer compounding, it has magnified effects later in the future.

Henah:

It also reminds me of the paying a CFP 1% of your assets every year for that compounds to take money away from you.

Katie:

Yes.

Henah:

Okay. Can we run through maybe an example with numbers to put some finer points on this?

Katie:

Sure. Okay. Let's pull up an example. So I'm going to plug in a $100 monthly contribution just for simplicity's sake, and we'll say that we're making this a hundred dollars contribution for 40 years, and one of us is doing it in a taxable account and the other is doing it in a tax-deferred account like a 401(k).

And let's pretend that we are both investing that $100 a month in the exact same asset, so we're contributing the same amount of money and buying the exact same thing, but that one of us is doing it in a taxable account and the other is doing it in a tax-deferred account for 40 years. So this is especially dramatic if I turn on this feature that will basically say, pretend I'm also increase my contributions by the tax deferral. If I get an upfront tax deduction, increase the contribution by that amount. So 40 years from now, the taxable account has $168,000 in it, which is great. The tax-deferred account has $302,000 in it. So we're talking the same contribution for the same amount of time with the same rate of return, and it's almost twice as much money.

Henah:

$140,000 difference. So essentially what happened over those 40 years is that that $140,000 was chipped away year over year from the taxes, and then that was not used to compound and create more growth.

Katie:

Yeah. We have some bigger taxable accounts just because the tax-advantaged accounts have annual contribution limits on them. So we have put money in taxable accounts, put a lot of money in taxable accounts for that reason, and every year we get our 1099-DIV form that says, okay, you had this much in dividends, you owe hundreds or thousands of dollars in taxes on those dividends. Now, granted that didn't start out that way, but once it gets to a certain point, it's like, okay, now we're seeing some meaningful, we're chipping it away at this in a meaningful way. And I think that that is exacerbated over time as the account gets bigger. And so in the beginning, you're not going to notice really a difference, I don't think. But over time, as the compounding happens, it becomes more and more obvious.

Henah:

Well, I think the thing too that people often are asking is, taxable brokerage accounts are liquid. They're available all the time, but there's also the limit on the tax-deferred accounts, but you can't touch it or there's a penalty. So I guess the last piece I would just tell is working with a CPA or CFP to determine how you might need to shift things to make this more favorable to you, depending on your life goals or the capital gains you're going to be on the hook for outside of regular income taxes. Is there anything you want to add there?

Katie:

The only thing that comes to mind is the fact that the capital gains tax rates are so favorable that it would be interesting. I think in that example, $168k versus $302k is quite dramatic, but if we're talking about a drawdown wherein maybe the 401(k) plan has high fees and that you've got a different type of drag, you've got fee drag now on that account. Now, I don't know, maybe over time it's starting to look a little bit more comparable. And if I can take out, if I'm a married couple will say, if I can take out $90k to $100k a year and pay no capital gains taxes, I have a 0% tax withdrawal from that account compared to paying taxes on the tax deferral later where I can get my standard deduction for free. But then any amount above this year, it's around $27k for a married couple or $29k something in that range… Yeah, if I can get the first $29k, but then any amount above that I'm paying as if it's earned income, it would be interesting, I think, to flush it out to an end-of-life scenario. And you're just showing the drawdown too and going at the end, is it still is your lifetime tax bill lower? That would be an interesting analysis to run. But I think upfront it does make a lot of sense because of that initial huge tax deferral that you get and that you can invest that too.

Henah:

So what I'm hearing is we're going to bring back Eric Jones on the show, and y'all are going to debate this.

Katie:

Someone who likes doing math more than me, actually, I could probably model this out. I bet I could do this relatively easily. It would just be, or—

Henah:

Maybe you can ask chat GPT to do it.

Katie:

Oh, good thinking; Deep Fake Katie. I love it.

Henah:

So we have a wild money story. You said you wanted more nuance, you wanted more details, you wanted fewer soundbites. So I brought one.

Katie:

I want to be swept up. I want to be emotionally invested.

Henah:

Okay, I think I can do this. You ready?

Katie:

Clears throat.

Henah:

This is from someone I personally know. So I asked on my Instagram, what is a good net worth in your opinion if you're around 30 years old? And I really just asked this because I was curious what people were going to say, and the answers were fairly wide ranging. Anyway, someone said anything positive at this point, because I had to dig myself out of $90,000 of debt.

Katie:

Oh my gosh.

Henah:

And I was like, what? I'm so sorry, but also can you share more?

Katie:

Ha! You go, listen, this would make an amazing podcast episode.

Henah:

I did in fact say that. And I said, are you comfortable with me sharing this? And they said Yes.

 So to give you some context, this person…we’ll call them Jill. Jill's other parent died when they were a child. And so their friends and family created an account for tuition for Jill's siblings and Jill to use. So when they talked to their living parent about going to college, the plan was that Jill's parents were going to use the funds for that first year of school. So the next two years of college, Jill got financial aid. So all they had to do was pay for the housing. And so they took out loans for just those two years. So maybe like $10,000 or something like that per year. And then the final year, Jill's living parent was on their third marriage, and they supposedly wanted to pay for their tuition and housing as a graduation gift. Okay, you following me so far?

Katie:

Well, no, because I thought that they got a fund to pay for all of this. Why is this not being used?

Henah:

For the first year.

Katie:

Oh, the fund was just intended for one year of school?

Henah:

Because there are multiple siblings. So they spread it out and they said everybody can get one year.

Katie:

Oh, okay. Following tracking.

Henah:

Following. So a few weeks before finals, Jill gets a notice that they haven't paid tuition at all, which is interesting. That was also how the other story—

Katie:

I was just going to say, is this the $8 million tax fraud guy? Do we have an overlap?

Henah:

It's not. But apparently a lot of people find out things are going wrong from their tuition not being paid.

And so they can't take their finals, they're not going to get their diploma. So Jill calls their living parent to say, what's going on? And Jill's parent says, oh, I swear I paid. So Jill says, okay, can I have proof so I can go take my finals? But then their parent says they can't find it and stops answering their calls.

So at this point, Jill's in a panic. So Jill calls her older sibling who's been a parent figure to them, and their sibling says, let's just get you a loan and we'll figure it out later because this money is supposed to be there. This was going to be a gift that's coming in, whatever.

Katie:

Oh, no.

Henah:

But then.

Katie:

Oh no.

Henah:

Jill’s loan application is denied.

Katie:

Oh No.

Henah:

And that didn't make any sense to them. So they run the credit like, why would this be denied? And the credit is awful, horrible. So at this point, Jill's sibling is now mad at her thinking that she's the reason that her own credit is bad.

Katie:

No, Jill's sibling. No.

Henah:

When another family member jumps in and says, okay, I think I realize what's going on here. So what they found out is that, are you swept in? Is this doing justice this week?

So eventually what they find out is that Jill's parent was taking out loans for all of Jill's years of school and not using any of them for education and doing it under Jill's name. And after some additional digging, they found out that the funds that they were going to have for that first year of school for Jill, those were also missing because they took the money out before they even started college. So a grandparent steps in helps pay the tuition so they could finish a semester.

And I said, oh my gosh, okay, I'm so sorry that this happened to you. What were they spending that kind of money on? Because this is $90,000 at this point. And they said, “My parents spent it on an addition to part of their home expensive vacations in their second and third marriage, a business. They ran into the ground by not showing up for work, drugs, the whole gambit.”

So basically, ever since this person, Jill has been working, they've had to save every last penny to use towards those debts. And I said, do you have a relationship with this parent anymore? And they said, no, we've had no contact for five years. And I don't blame them at all because what a traumatizing and scarring experience to go through when you should be starting your life with a clean slate. So isn't that wild?

Katie:

Is there no recourse? I guess she could press charges, but she probably doesn't want to.

Henah:

Yeah, I think that's where they left it off. And there have been no repercussions for what they have gone through from this besides now losing contact with their child.

Katie:

Oh my gosh, what a horrible, that's terrible. It also just goes to show that you have no idea how people ended up in the situations that they're in, or this is why you cannot moralize something like debt. Imagine being Jill getting berated by a personal finance person saying, you don't deserve to be inside a restaurant. You don't deserve to live a life because you have debt. It's like, it's not even my fault. I had nothing to do with it, but it's now my responsibility to get out of it.

Henah:

I've known this person for 15 years. So it's crazy too, because you really don't know what goes on behind closed doors. You really have no idea what people are dealing with and how other people's bad money decisions have affected them.

Katie:

Are their parents bad money decisions…

Henah:

Other people's bad money decisions. So my heart goes out to them, but it is something I think telling how many stories have come up where they found out bad money, things were happening from their parents because of something that they were dealing with regarding their education.

Katie:

Yeah. I have to say, even when I first started doing this five years ago, I remember I had been told this by multiple people that this happened to them. So unfortunately, I think this is more common than we might like to think. This is not the first time that I've heard this.

Henah:

Their parents were using their social security number and stuff?

Katie:

Yeah, and taking out school loans and spending them and not telling them, and then it's in their names, so they have no recourse. And it's like, well, do I press charges against my own parents? I mean, it's a horrible situation.

Henah:

Yeah. There's just so much emotionally involved in it. It's not even an identity theft ring. What happened to you, Katie? I mean, obviously that was terrible too, but it feels like so much more personal and hard and challenging to navigate when it's your own parent.

Katie:

Oh my gosh. Yeah. Just the layers of betrayal.

Henah:

Yeah, the dynamics that have to change emotionally. But I also was like, so you've paid off $90,000 in debt at this point that's not even yours. And so you're behind the eight ball kind of for the rest of your life. If you're going to talk about compounding and snowball effects because of something your parent did.

Katie:

Oh my gosh. Well, we're ending on a bright note as always. The Money with Katie Show known for its unceasing optimism.

Henah:

Stop it.

Katie:

Well, if you've got a wild money story that you want us to tell on air, email us at moneywithkatie@morningbrew.com and we will gladly tell it. And that is all for this week's Rich Girl Roundup.