Trust account, brokerage account, IRA, 401(k), 403(b), tax-deferred, Roth IRA – what do all these account titles mean and why does it matter to you? Taxes. Taxes are one of the major headwinds faced by investors.
To improve one’s after-tax return, investors need to determine the optimal types of accounts to hold particular securities (also known as asset location).
At Dowling & Yahnke, our goal is to use the tax attributes of each account type to place each investment in the most tax-efficient bucket. We tend to place securities which have low amounts of ordinary income (e.g., municipal bonds, broad index funds, tax-managed funds, and individual stocks) in taxable accounts. Conversely, securities which generate higher levels of income (e.g., Real Estate Investment Trusts) would be held in tax-deferred or tax-free accounts.
There are generally three broad categories (“buckets”) of investment accounts:
Examples of a “taxable account” include brokerage account or a living trust account. The investments within these types of accounts are often taxed differently than assets in your retirement accounts (e.g., 401(k) or rollover IRA). Investment assets in a taxable account can produce income that is taxed as ordinary income or more preferentially as capital gains (or even tax-free). The taxation on these accounts is driven by two factors: the type of investments and how long the investments are held.
Asset selection: Within a taxable account, we prefer to invest in securities that are taxed preferentially, such as municipal bonds or low yielding assets. For example., California municipal bonds are double-tax free for California residents.
Investment Holding Period: If you hold a security for more than one year, the gain recognized on that sale would receive capital gain treatment (which is substantially lower than marginal ordinary income tax rates). Should the security be sold before the one-year anniversary, any gain would be treated as ordinary income.
Unique Opportunities in Taxable Accounts: There are special occasions to further enhance the tax efficiency of taxable account. From time to time, securities in a taxable account may be valued below the price at which they were purchased – this is called an unrealized loss. Tax Loss Harvesting is the disciplined approach to realize such losses and replace the sold position with a similar security (e.g., replace Coke with Pepsi). Such realized capital losses can be used to offset capital gains or used to partially offset ordinary income.
Tax-deferred accounts are funded with contributions that have not been subject to income tax (therefore, they are tax-deferred). They are commonly pre-tax contributions from earnings and come in the form of a 401(k), 403(b), and individual retirement accounts (IRAs). Contributions to these accounts may receive an income tax deduction and will grow overtime without being taxed. However, every dollar that is distributed later will be taxed as ordinary income. Also, you must typically begin taking Required Minimum Distributions (RMDs) from tax-deferred accounts at age 72, which could lead to “forced” withdrawals and a corresponding tax burden.
Qualified Charitable Distribution: A tax-advantaged way for IRA owners older than 70-½ to support their favorite charities is to make Qualified Charitable Distributions (QCDs). By making direct gifts to qualified charities from an IRA, the taxpayer benefits because the donation is excluded when determining Adjusted Gross Income (AGI). AGI is an important metric used in various tax calculations. Reducing AGI by making IRA QCDs can produce tax saving opportunities.
Roth IRAs are the most popular income-tax free assets whereby you make contributions with after-tax dollars. Unlike a taxable account, every dollar taken out of a tax-free account is typically tax free. These are one of the most powerful wealth accumulation accounts you can have since the earnings and growth held within Roth accounts will never be subject to income tax. RMDs are not typically required, allowing wealth to compound for future beneficiaries (who will then be subject to withdrawal rules).
Roth Conversions. You may be able to do a “Roth conversion” whereby you pay tax on a withdrawal from a tax-deferred account (traditional IRA) in a low tax year and “convert” the funds into an after-tax Roth IRA. This is a powerful strategy that takes advantage of compounding tax-free growth over future years.
As you can see, an asset location strategy across “tax buckets” is integral to long-term portfolio performance and tax efficiency. Dowling & Yahnke places an emphasis on tax efficiency with each investment choice and its placement in the respective tax bucket. Just as the positive effect of compound returns on wealth is true, so is the negative effect of not tax planning your investment strategy.
D&Y Is Here to Help
As an independent, fee-only wealth advisory firm, we provide time-tested, objective investment management and financial planning while adhering to the fiduciary standard. Founded in 1991, we’re a San Diego-based firm that currently manages over $4 billion for more than 1,200 clients, primarily individuals, families, and nonprofit organizations. Contact us if you’d like to speak with an advisor about your portfolio.