Investors leave a lot of nickels and dimes on the table, and over time those pennies can total up to quite a few dollars. One way to avoid those leaks from your nest egg is to optimize the benefits of tax-advantaged accounts. An investor might have taxable accounts, traditional IRAs and retirement accounts (such as 401(k)s), and Roth IRAs. After-tax returns can be increased by holding the right assets in the right accounts.
To boost your wealth, after determining your asset allocation, strive to have the assets owned in the most tax efficient accounts when possible.
Let’s review the key tax features of the different accounts:
? Earnings compound tax-free in IRAs and other qualified retirement accounts. The longer the returns compound in the deferred account, the greater will be the wealth that accumulates and the more it will be worth after taxes.
? When earnings and pre-tax contributions are distributed from a deferred account, they are taxed as ordinary income. It doesn’t matter how the distributions would have been taxed had they not been in the account. The distributions are taxed at the taxpayer’s ordinary tax rate.
? Under current law, long-term capital gains and qualified dividends earned in taxable accounts are taxed at a maximum 15% tax rate. For taxpayers in the lowest tax brackets, lower rates apply. Short-term capital gains (imposed on assets held for one year or less) are taxed as ordinary income. Capital gains are not taxed until the asset is disposed of.
? Investment returns in a Roth IRA compound tax deferred. In addition, qualified distributions from a Roth IRA are tax free.
? Stocks and other investments that tend to generate long-term capital gains have higher long-term returns than do bonds and other investments that primarily generate interest.
? Losses incurred in IRAs and other tax-deferred accounts rarely are deductible. Losses in taxable accounts are deductible dollar for dollar against capital gains, and up to $3,000 of excess losses each year can be deducted against other types of income. Additional excess capital losses are carried forward to future years and used in the same way.
You can see there are significant differences in the taxes imposed on the accounts, both annually and in total over the life of the account. The greater the gap between your ordinary income tax rate and the long-term capital gains rate, the greater the reward you’ll receive from matching the right asset to the right account.
The conventional advice is to own stocks, real estate, and other capital gains property in taxable accounts. Investments that generate primarily interest income should be held in tax-deferred and tax-free accounts.
This advice works well for the classic investor whose stocks and equity mutual funds are held for the long term. As long as the mutual funds minimize annual distributions subject to taxes, most of the investment returns will be taxed at the maximum 15% rate. Any losses in the taxable account will offset the gains and possibly other income.
Putting these tax-advantaged investments in a tax-deferred account would convert tax-advantaged capital gains income into ordinary income because distributions from an IRA are taxed as ordinary income.
Yet, the conventional advice does not work for every investor. Investors who should consider other strategies include those who own stocks and mutual funds but rarely hold them for more than one year and those whose equity mutual funds do a lot of trading and distribute a lot of taxable gains each year. The gains earned by this type of investor would be taxed as ordinary income. The investor could be better off holding those investments in tax-deferred accounts.
For investors who don’t follow the textbooks, the optimum advice is different from the classic advice. I suggest these guidelines be used to allocate assets between different types of accounts.
? Stocks and equity mutual funds should be held in a taxable account unless at least 25% of the annual return from them is taxed at ordinary income tax rates.
? Bonds and other investments that generate ordinary income should be held in tax-deferred vehicles when possible. These investments include high-yield bonds, preferred stock, and most real estate investment trusts.
? It is best to own the highest-returning investments in tax-free accounts such as Roth IRAs.
? The greater the tax rate difference between your accounts, the more important it is to get the allocation between the accounts correct.
? A corollary to that guideline is the lower the pre-tax difference in the rates of return between the different investments, the more important it is to get the allocation correct. When stock returns were greatly exceeding those of bonds in the bull market, the excess returns could make up for getting the account allocation wrong. If stocks earn only a few percentage points annually more than bonds, as they have for the last decade and could continue to for another decade, it is more important to get the tax allocation correct so after-tax returns from the stocks are maximized.
Estate Planning is an alternative consideration in your asset placement. Assets that primarily are for an inheritance or for emergencies should be held either in a taxable account or a Roth IRA. Traditional IRAs and other tax-deferred accounts are the least tax-efficient assets to inherit. Heirs often receive a relatively small portion of these accounts after taxes. An IRA is included in the estate and potentially subject to estate taxes. In addition, heirs must include IRA distributions in ordinary income. With an inherited taxable account, on the other hand, heirs can increase the tax basis of the assets to current fair market value. The assets then can be sold immediately for no taxable gain.
These guidelines might have to be adjusted if tax rates change. Current tax rates are locked in until at least the end of 2012, and you should use them to inform your decisions until any changes are made.
Of course, taxes are a secondary consideration. First determine the appropriate asset allocation for you. Then, match the assets to the most tax-efficient accounts as best you can. Don’t implement the wrong asset allocation for you or turn down investment opportunities because you can’t achieve the optimal allocation between accounts. But you’ll increase lifetime after-tax wealth to the extent you can optimize the tax allocation.
RW May 2011.
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