Think of these opposites: Good/Bad. Rich/Poor. Gain/Loss. Joy/Sadness. Investment Returns/Income Taxes. Yes, Uncle Sam is happy to take all the joy out of your investment returns and tax them. That’s why tax efficient investing is so important.
You have three types of investment accounts: taxable, tax deferred or tax exempt. For taxable accounts, you must pay taxes in the year income is received. Retirement accounts, IRAs and annuities are examples of tax deferred accounts, in which you pay tax on the income when you take it out. Tax-exempt accounts, like Roth IRAs and Roth 401ks, are not taxed even at withdrawal.
Strategy #1: Know Your Bracket. The tax brackets have changed for 2018. The top federal marginal rate of 37% will hit taxpayers of $500,000 and higher for single filers and $600,000 for married couples filing jointly. There can be a huge difference between taxes on current ordinary income and taxes on long-term capital gains. Capital gains are the appreciation on your holdings over time and often represent a very significant portion of your total investment return. Securities held for over a year generally qualify for long-term capital gain taxes, which are taxed at 0% to 20%, with most investors paying 15%. The difference between ordinary and capital gains taxes on your investment income can be substantial.
Strategy #2: Asset Allocation includes Asset “Location.” Tax efficient investments should be in taxable accounts, tax inefficient investments should be in tax deferred or tax-exempt accounts. For example, bonds are tax inefficient. Interest earned on bonds in taxable accounts is income in the year received and is taxed at ordinary income tax rates. However, bond interest earned in a tax deferred account is also taxed as ordinary income, but only at withdrawal, when presumably you might be at lower income and tax levels. Hence, bonds should generally be located in tax deferred accounts, such as IRAs and 401ks.
Stocks are more tax efficient. First, the qualified dividends received on stocks are taxed at the capital gains tax rate, which is likely less than your ordinary income tax rate. And, second, the largest part of your investment return on equities is often your capital gain, which is also generally at 15% tax and is only paid when you sell a security. Hence, stocks and equity funds are tax efficient and generally should be located in taxable accounts. Conversely, holding equities in retirement accounts is not generally a good idea because even though the tax is deferred, the ultimate withdrawals will be taxed at ordinary rates, not capital gains.
Alternative investments, which are designed to be non-correlated with bonds and stocks, may generate more ordinary income than tax-efficient income. Hence, they should generally be located in tax deferred accounts. Tax-exempt accounts, such as Roth accounts, can hold tax efficient and tax inefficient holdings. Hence, tax-exempt accounts are already tax efficient and can hold all three asset classes; equity, fixed income and alternatives, in appropriate asset allocations without any income tax cost.
Strategy #3: Grow your Roth Assets. Because Roth assets are tax-exempt and, therefore, 100% tax efficient, they are the most valuable investment asset you can own; both in your lifetime and your heirs. Roths only have investment returns, no taxes. Furthermore, Roth accounts, unlike traditional IRA accounts, do not require minimum distributions when you and/or your spouse reach 70 ½. Upon your passing, the beneficiaries of your Roth assets can “stretch them” by allowing them to continue to grow them tax-free. However, the heirs will be required to take minimum distributions.
Roths can be funded in a number of ways. If you have earnings, you can make Roth contributions of $5,500 per year ($6,500 if you are 50 or over) if your income is below a certain threshold. In addition, if you are working for a company with a 401k plan, that plan may allow Roth 401k contributions. In this case, there are no earnings limitations and you can contribute $18,500 ($24,500 if you are 50 or over.) You can also convert IRAs to Roths. This is done by paying income tax on the difference between the amount converted and the cost basis of the IRA. There is no limit of the amount you can convert. The concept is “pay tax once, have the Roth grow tax-free forever.” Oftentimes this conversion takes place after retirement but before age 70 ½ and is done in an annual installment amount to keep the tax implications within a given tax bracket. We encourage you and/or your CPA to look at this possibility.
Strategy #4: Do an Income Tax Projection. Tax projections are really important, particularly in 2018, with all the new changes brought on by tax reform. The projection provides information as to your income, deductions, tax bracket, estimated taxes (to minimize surprises and penalties) and, hopefully, also possibilities for tax savings. We prepare “unofficial” tax projections for our clients for these very reasons. Investment management must consider income taxes.
Ultimately, your return on investments is your gross return less the income taxes. Therefore, we encourage you to make your investment portfolio operate as tax efficiently as possible and accentuate the positive; good, rich, gain, joy and investment returns. Rather than the negative; bad, poor, loss, sad and income taxes. You should make yourself happy, not Uncle Sam.