Location, location, location. It matters when it comes to real estate. It also matters when it comes to the way you hold and invest your retirement savings.
You cannot control what happens with the tax code, but you can control how your investments are held. As various types of investments are taxed at varying rates, some investments are better held in taxable accounts and others in tax-deferred accounts. The objective is to maximize after-tax wealth. This is generally accomplished by locating tax-inefficient assets in retirement accounts and more tax-efficient assets in non-retirement or taxable accounts.
What kinds of investments are usually better off in taxable accounts? Think equities in the form of index funds, growth funds, and tax-managed funds or ETFs. These investments generate more of their total return from appreciation and capital gains. In light of favorable long-term capital gains rates and because you can control when to realize gains for income tax purposes, keeping these types of investments in taxable accounts makes sense.
Investments that are better off in tax-deferred accounts generate more of their total return through income rather than appreciation. These include taxable bonds, real estate investment trusts, and funds trade frequently and realize short-term capital gains. Commodity investments would also be included in the tax-inefficient category.
Roth IRAs should hold the highest expected return asset in order to maximize tax-free growth over time.
Timing Withdrawals. You do not want to outlive your money and minimizing income taxes will help. To that end, you want to time withdrawals from your retirement accounts in a tax-efficient way.
This type of work is highly customizable for each individual and often varies yearly. Yet we can observe some general rules of thumb. By drawing down taxable accounts first, you will face the capital gains tax rate instead of the ordinary income tax rate, which is generally lower for most retirees. In taking money out of the taxable accounts to start, you are not only giving yourself a de facto tax break but also giving the retirement funds in the tax-advantaged accounts more time to grow and compound. Withdrawals from tax-deferred accounts – such as traditional IRAs and 401(k)s and 403(b)s – can follow, and then lastly withdrawals from Roth accounts. This tends to be the order of withdrawals assumed in most financial planning software programs.
Tax loss harvesting can also help. Selling investments that decreased in value will give you capital losses. These can directly lower your taxable income. As much as $3,000 of capital losses in excess of capital gains can be deducted from taxable income, and any remaining capital losses above that can be carried forward. Additionally, whenever you sell stocks or funds with capital gains, strive to sell shares or units having the highest basis to reduce the gain.
Consider special distributions for company stock. If you own company stock in your 401k, and it has appreciated significantly over time, it is often more advantageous to take an in-kind distribution—the payout is in securities, not cash– of company stock rather than rolling shares over to an IRA. This technique is called Net Unrealized Appreciation or NUA. The question is whether you want to pay ordinary income tax or capital gains tax. If the distribution is in-kind, ordinary income is paid on the share’s cost basis only. The net unrealized appreciation remains tax-deferred until the shares are sold and at their sale is taxed as a long-term capital gain.
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent, local wealth management firm and resides with his family in Bath Township.