Most investors are familiar with the idea of allocating investments across different asset classes to diversify portfolios and manage risk. It’s also important to balance savings across a mix of taxable, tax-deferred and tax-exempt accounts. Why? Simply put, investing for tax efficiency lets you keep more of your money.
The first rule of investing is to choose the right allocation of stocks, bonds, cash and other assets to match your goals, needs, financial situation, appetite for risk and your time horizon. Once you settle on the right mix, asset location becomes key. Strategically placing holdings within a mix of taxable and tax-advantaged accounts can minimize the tax bite out of your returns while you’re actively saving and provide flexibility for managing tax liability down the road.
It’s hard to predict what tax bracket you’ll end up in at retirement and what the tax rates will look like. If all your retirement savings are in a tax-deferred individual retirement account or 401(k) and you’ve saved a lot, your distributions may land you in a high tax bracket. Combined with any other income, IRA distributions can push you above the income level where you start paying taxes on a portion of your Social Security benefits. And if you need to draw extra for that dream vacation or some other unusual expense, that could bump you into a higher tax bracket for that year.
You’re better off with a mix of after-tax, tax-free and taxable investments to save in and draw from. For maximum tax efficiency, consider using the following three kinds of vehicles:
- Taxable accounts include savings and traditional brokerage accounts. You’re taxed annually on the dividends, interest, or capital gains earned on these assets.
Taxable accounts are a good place to keep holdings like exchange-traded funds, individual stocks you’ll hold long-term, tax-managed or passively managed funds. These types of holdings generate capital gains or pay qualified dividends—both of which are taxed at a lower rate than regular income—so you’ll lose less of your return to taxes.
- Tax-deferred accounts include traditional 401(k)s, 403(b)s and individual retirement accounts. These are usually funded with pre-tax dollars and taxed when money is withdrawn.
Assets with high returns that are taxed as ordinary income, such as mutual funds, bond funds and real estate investments, should be kept in these funds to grow tax-free and be taxed when withdrawn in retirement, when income is lower.
- Tax-exempt accounts like Roth IRAs are funded with after-tax dollars, so qualified withdrawals of both principal and earnings are tax-free.
Dividing assets subject to ordinary income tax rates between tax-exempt and tax-deferred accounts helps lower your taxable income in retirement.
Holding a tax-efficient balance of investments means that at retirement, you can pick and plan the mix of withdrawals from accounts in ways that optimize your tax burden. For instance, you could combine draws from low-tax qualified dividends and long-term capital gains with tax-free income from Roth accounts. That helps minimize your draw from tax-deferred accounts until you’re safely in a lower tax bracket.
A mix of taxable and tax-advantaged investments also gives you options for making charitable gifts and bequests through your estate. Taxed investments can be donated to charities for a tax break, for example. Roth IRAs can be left to your heirs who can take distributions tax free.
Consult us to help determine a tax-efficient balance of your investments.
We are Arbor Wealth Management, a Phoenix-based firm that offers comprehensive financial planning services. We’re partners in your financial future. Like a conductor coordinating a beautiful symphony, we’re intimately involved in your financial future. We take the time to know how each instrument in your personal orchestra is performing, keeping all aspects of your plan in tune. We accomplish this by making sure your finances remain pliable, whether you are in an accumulation or distribution stage in life.