Taxable account,
Is any of it tax free?
Yes, that’s your basis

A few years ago, I started listening to the hunting podcast Meat Eater and watching the show of the same name. I have never been hunting, but I found the stories of bear encounters, adventures in the wilds of Alaska, Bolivia, and other far-off places immensely fun.

Steve Rinella, the host of Meat Eater, has a master’s degree in journalism. He has written several books and his use of language is beautiful. The breadth of vocabulary he can draw on to describe a landscape is one of the first things I noticed when I heard him speak.

It seems from listening to his show that every feature of an animal or a place has a name. A tree bent a certain way over water has a specific name. Water flowing over a downed tree has a term to describe it. Animals of a certain size or disposition all have words to describe them succinctly.

These words matter. They make communication easier between partners. They make it easier to tell stories that convey an experience.

The same is true with finance. Not every term is essential (prior to getting my Series 7 license, I had no need or desire to know what a Bear Put Spread was. No, it has nothing to do with bears or marmalade. Sorry, Paddington).

But there are some basic financial terms that will make your life a lot easier if you understand them.

For example, I have heard people throw around the word “interest” willy nilly. “I can invest in an index fund and generate interest.” To quote Inigo Montoya, “you keep using that word… I do not think it means what you think it means.”

Investing in an index fund generates capital appreciation. Capital appreciation is treated differently than interest on a tax level and is created by different means than interest. Your tax return knows the difference between interest (Schedule 1) and capital gains (Schedule D), so you should too.

While we’re here, a pension is not a 401(k), which is not an IRA, which is not a brokerage account. Words matter.

There will be other FiKus for these someday.

A very helpful word and concept to understand in your financial life is “Basis.”

The first thing to know about basis is that it is, 100% of the time, tax-free. This is because it is money that has already been taxed.

But just because money has already been taxed does not make it basis.

Post-tax money becomes basis when it is invested in an appreciating asset. Houses, businesses, stocks, ETFs, and mutual funds all qualify. Bank accounts and CDs do not count. These are interest-producing instruments and are taxed annually. Every time you pay the tax on that .05% of interest your savings account is earning, or the annual tax on the interest you will eventually have earned in your CD, paying the tax is resetting your basis. With a savings account or CD the basis is always the account value, meaning there’s no use for the term in those accounts.

Nor is there a use for Basis in a deductible IRA or 401k. These accounts are opened with pre-tax dollars. The basis in these accounts is always zero. This means that 100% of every withdrawal is taxable to the account owner.

However, basis matters a lot in many other types of assets and accounts. Some examples:

Roth IRA: Your basis is always eligible for withdrawal at any age without penalty. If someone contributed $50,000 to a Roth IRA worth $75,000, their basis is $50,000. That $50,000 is available to be withdrawn, tax and penalty free, at any age.

Taxable Investment Account (aka Non-Qualified Account): Your basis in the investments within the account will tell you if a given holding (stock or fund) has capital gains or losses. This is critical knowledge for tax harvesting. It will also be the starting point for determining the performance over time of all of the holdings in the account.

Real Estate: The amount paid for a house – such as the principal payments on a mortgage, or amounts spent on capital improvements like a new roof – are Basis. When the house is sold, these funds return to the seller tax-free. The difference between the sale price and the basis is capital gain, and Internal Revenue Code §121 will tell you how much of that realized gain you owe tax on.

Income From a Non-Qualified Annuity: A non-qualified annuity is purchased with after-tax dollars. If it is converted into an income stream, a portion of each income payment will represent the original investment – your basis – and will be tax free.

Unfortunately, the world of finance doesn’t have the beautiful lexicon Steve Rinella uses to describe the Brooks Range in Alaska. But the clunky words like “Basis” matter a great deal and can describe your financial landscape in a way that helps communicate where you are and what you need.

If there is any financial lingo you want to see in another FiKu, please let us know!