The tax impact on investment income can be mitigated through the transfer of assets into retirement accounts. Not all accounts and investments are taxed equally, however, and the most efficient strategy is not always immediately apparent. The author compares the three broad types of retirement accounts—pre-tax, after-tax, and taxable—and explains which assets are best placed in which type of account, and when.
Investment results blend two broad categories: the known and the unknown. The unknown is the performance of selected assets: How much money will be gained or lost from a particular stock, bond, fund, or investment property? The known, to a much greater extent, is the tax treatment of certain investments. This article demonstrates how, by taking advantage of reliable tax benefits, investors can significantly increase their chances of positive after-tax outcomes in both the short and long term.
Thinking about Tomorrow
The most familiar path to investment tax benefits is the use of retirement accounts. Those accounts fall into two main categories: pre-tax and after-tax. The former provide tax deferral, while the latter offer the possibility of tax-free investment gains. One strategy, then, is to put as much money as possible into tax-favored retirement accounts—pre- and after-tax—and use regular (i.e., taxable) accounts for other desired investments.
Among retirement accounts, it may be desirable to put some money into pre-tax accounts such as traditional IRAs, if contributions can be deducted, and after-tax accounts, such as Roth IRAs or Roth 401(k)s. The pretax accounts provide upfront tax savings, reducing the investor’s current tax burden, while the after-tax accounts offer the flexibility to eventually take tax-free distributions if needed.
The higher the investor’s current tax bracket, the more it makes sense to tilt toward pre-tax retirement accounts. The reverse is also true. For example, consider that Alice is just starting her career, with a modest salary that places her in the 12% federal income tax bracket today. Alice would get little benefit from deferring income tax at 12 cents on the dollar, especially as she might be in a higher bracket when she takes distributions from a pre-tax plan. Thus, Alice might decide to pay tax on her income in her current low bracket and use a Roth IRA as her primary investment vehicle. In addition, if Alice’s employer offers a Roth version of its retirement plan, she could do her investing there. Once Alice has passed the five-year and age-59½ tests, all distributions from her Roth accounts will be untaxed, no matter how much income she reports or how high tax rates are at that time.
As individuals progress through their careers and, hopefully, enter higher tax brackets, pre-tax plans become more desirable. Suppose Alice’s father Charles is an executive currently in the top (i.e., 37%) tax bracket. Charles expects to retire in a few years, at which point his income will drop, along with his tax bracket. In this scenario, Charles might choose to contribute as much as possible to his employer’s traditional 401(k), deferring federal income tax at 37%. State and possibly local income tax can also be deferred. Once he is retired, drawing down his investment accounts, Charles might owe only 35% or 30% or less on these withdrawals, depending on future tax rates and his annual income. This type of “tax alpha” will bolster the returns from his investments.
Once investors have fully used available retirement accounts, other savings dollars can go into taxable accounts, where other tax planning opportunities exist. Gains might be taken long-term in order to take advantage of favorable tax rates; losses might be taken in order to offset the tax on current or future gains. Taxable accounts could hold qualified dividends and tax-exempt bonds, minimizing taxable investment income.
With all three types of accounts (pretax, after-tax, taxable), investors can choose where to place various types of assets and which accounts to tap for cash flow. The historical three-legged stool—investments, pensions, and Social Security—has become a rickety base for retirement security given the decline of private pensions and political questions about Social Security’s future. Today’s three-legged stool—regular, Roth, and tax-deferred accounts—can serve as a replacement, providing tax-favored returns today and tomorrow.
Tips for Taxable Accounts
Once investors have this new three-legged stool in place, they need to decide which assets go into which type of account. They might, for example, start by deciding what should go into a taxable account, rather than into a tax-advantaged retirement account. Money that will be needed soon probably belongs in a taxable account. If an investor expects to hire a contractor for a major home improvement this year, for instance, or take the entire family on a cruise to celebrate an anniversary, the cost could be steep. If the money is in a taxable account, it probably can be accessed with little or no tax cost and no early withdrawal penalty.
Similarly, money that might be needed should also be in a taxable account. Many financial advisors urge clients to have a reserve fund of several months’ expenses in case of emergencies. If possible, that money should not be in a retirement account, where withdrawals will be taxed.
Money in these “will” and “might” categories generally should be placed in relatively stable, low-volatility assets. Not only will this reduce the risk of loss, it will reduce the chance of a tax bill if and when these dollars are withdrawn for spending purposes.
Beyond planned expenditures and emergency funds, the decision on placing assets within a taxable account depends on expected return and tax efficiency. In terms of expected returns, holdings with low potential might be held in taxable accounts. With fewer expected gains, the reason for deferring gains in a tax-favored account may be scant.
For example, consider that Dana intends to invest $10,000 in a bond fund that holds investment grade corporate bonds, yielding 2.2%. This fund has not distributed capital gains to investors, so Dana expects taxable income around $220 (2.2%) per year from this fund. She is in the 24% tax bracket, so this investment would generate $52.80 a year in tax (24% of $220) for Dana. For that much tax deferral, Dana might not find it worthwhile to take up space in her tax-advantaged retirement account.
Note that the answer might be different if Dana were investing $25,000 in a fund holding low-rated bonds, with a current yield of 6%. If Dana were in a 35% tax bracket, the amount of the annual tax on this fund’s payout might be great enough to warrant holding within Dana’s IRA or her retirement plan at work.
Taxable accounts may also make good holding places for investments that are inherently tax efficient, without the need for the tax benefits of a retirement account. As mentioned above, tax-exempt municipal bonds generally pay out interest that is untaxed, so they usually belong on the taxable side; the same is true for funds holding tax-exempt bonds.
Many exchange-traded funds (ETF) are tax efficient, especially if they track a market index, do little trading, and seldom pay out capital gains to shareholders. Indexed mutual funds often offer similar tax efficiency. These funds may be held in a taxable account if investors also have tax-inefficient assets to hold inside their retirement plans.
Tips for Tax-Favored Accounts
Investments that are tax-inefficient should be held in a retirement account if possible. Investors who trade stocks frequently and generate short-term capital gains might want to do so in a retirement account; the same is true for mutual funds that regularly pay out sizable capital gains distributions. If high-yield bonds or high-yield funds are part of the investor’s asset allocation, they could also be a good choice for a retirement account. Real estate investment trust (REIT) funds may also be tax inefficient, with relatively high dividends that might be fully taxable as ordinary income.
A further decision to be made regards which type of retirement account should hold which type of asset. Some advisors prefer to use Roth accounts for long-term holdings because of the five-year and age-59½ tests for untaxed distributions. The longer assets sit in Roth accounts, the greater the opportunity for tax-free accumulation.
A long-term emphasis might mean that Roth accounts would load up on stocks, especially on market subsets such as small cap stocks that historically have posted superior returns. Equities can be volatile, but they also have rewarded patient investors. If history repeats, investors might reap excellent tax-free returns by holding stocks in their Roth accounts.
There is also a case for holding some stable assets (i.e., nonequities) in Roth accounts. The tax code has many quirks, including “cliffs” that generate surprisingly steep tax bills after a modest increase in taxable income. The “tax torpedo,” a term that describes a situation in which an increase in ordinary income results in higher tax on Social Security benefits and a regular tax increase, is one of many possible examples. Investors who face such a dilemma may be able to avoid this situation by tapping their Roth account instead. Therefore, holding some stable assets in Roth accounts for untaxed distributions when needed may help investors avoid this negative outcome.
Checklist for Tax-Efficient Investing
[ ] Retirement plans continue to be the preferred vehicles for tax-advantaged investing.
[ ] Holding pre-tax and after-tax retirement plans, along with regular taxable accounts, can provide flexibility to aid in tax-efficient portfolio rebalancing and distributions.
[ ] Investors in the top brackets may be better served by choosing pre-tax plans, which offer tax deferral, but investors in lower brackets can use after-tax Roth accounts for future untaxed cash flow.
[ ] Emergency funds and money needed soon for substantial outlays should be held in a regular taxable account, where withdrawals may not trigger tax consequences.
[ ] In addition, tax-efficient assets, such as municipal bonds and mutual funds that seldom distribute capital gains, can be held in a taxable account without generating steep tax bills.
[ ] Conversely, tax-inefficient assets, such as high-yield bonds and real estate investment trusts (REIT), can go into retirement plans, where current payouts can compound without a tax haircut every year.
[ ] If portfolio rebalancing requires selling appreciated securities, the trades may be done within a retirement plan so the realized gains will not be taxed immediately.
[ ] Harvesting capital losses within a taxable account can offset current taxable gains as well as potential capital gains to be realized in the future.
Once assets go into the various accounts (taxable, tax-deferred, Roth), they do not necessarily remain fixed year after year. Sales and replacement occur for various reasons. Some investors prefer to establish a target allocation among multiple asset classes and rebalance when the allocation moves away from the predetermined goal.
Rebalancing is, however, tax-inefficient. For example, consider that Fred prefers a 60/40 (stocks/bonds) target allocation, but strength in stocks has driven that allocation to 70/30. Fred would have to sell some stocks to get back to his 60/40 baseline, but selling stocks after a run-up would probably trigger capital gains. How can portfolios be rebalanced with tax efficiency?
One tactic is to take gains within retirement accounts. Fred could sell stocks held in his 401(k) or Roth IRA and use the sales proceeds to buy bonds within those accounts. As long as Fred does not take money from the retirement accounts, no tax will be owed. If stocks falter and the equities in Fred’s overall portfolio fall significantly below the desired 60%, he could sell bonds and buy stocks in his retirement accounts, again without tax consequences. Indeed, this rebalancing flexibility is one powerful reason for holding a mix of asset classes within taxable accounts and within retirement accounts.
Another approach is to rebalance without selling anything, thus avoiding any taxable gains. Instead, new money could go into below-allocation assets until balance is restored. If Fred has been allocating his 401(k) contributions 60/40, stocks to bonds, he could switch to putting 100% of his new contributions into bonds until his overall allocation returns to his desired 60/40 split. At that point, Fred could restore his 401(k) contributions to the normal 60/40 target level.
Retirees who no longer are putting new money into their portfolios could take the opposite approach. When they need to tap their investments for living expenses or required minimum distributions (RMD), they can take money from the asset class that has grown, eventually aligning the remaining holdings in this asset class with the target allocation. RMDs cannot be avoided, so they will be taxed in any event, but investors can use these RMDs to help bring their asset allocation back towards the target.
New Investment Opportunity Offers Triple Tax Breaks
The Tax Cuts and Jobs Act of 2017 (TCJA) has created Opportunity Zones. Investments in these areas offer multiple tax benefits.
With Opportunity Zone ventures, investors can defer paying income tax on capital gains they have taken from profitable sales of securities, real estate, family business interests, and other assets. The deferred gains eventually will be subject to tax, but the tax may effectively be reduced. In addition, any gains from qualified investments under this portion of the TCJA can avoid income tax on a sale or exchange after a holding period of at least 10 years.
The U.S. Treasury Department has approved thousands of low-income communities in all 50 states as Opportunity Zones. To qualify for Opportunity Zone tax benefits, investments can be made into local businesses, new real estate development, or improvement of existing investment property within the approved communities.
For example, assume that Ida recently sold investment property, realizing a capital gain of $300,000. Ida invests her $300,000 gain in an LLC that will acquire a property within an Opportunity Zone and make substantial improvements. Ida’s reinvestment takes place within the required 180 days of taking the $300,000 gain.
Her timely reinvestment within an Opportunity Zone allows Ida to avoid paying tax immediately on her $300,000 capital gain. Five years later, in 2024, Ida can step up her basis in the investment sold in 2019 by 10% of the $300,000 gain ($30,000). After two more years, in 2026, Ida can step up her basis in the older investment by another 5% of the gain ($15,000).
At the end of 2026, Ida will be responsible for paying the tax she has deferred from 2019; her basis in that investment will have been increased by a total of $45,000, reducing the tax she will owe. Ida might have an even lower tax bill if her Opportunity Zone investment has lost value by then; on the other hand, Ida’s Opportunity Zone holding may have gained value. On a sale after a holding period of more than 10 years, Ida will owe no income tax on any gain from her Opportunity Zone investment.
For more information about Opportunity Zones, see “How Collectors Can Utilize the Opportunity Zone Program,” by Sidney Kess and Michael Kelley, The CPA Journal, March 2019, p. 64.
Before RMDs take effect at age 70½, retirees might want to draw down taxable accounts to meet income needs. If Helen, age 66, is overallocated to stocks, she can look for stocks or funds trading at a loss in her taxable account; selling those stocks can help restore her desired asset allocation without generating a tax bill. If Helen needs more money from her portfolio than she can raise by selling losers, she can sell modest winners as well. The capital losses from selling the losers may partially or totally offset the tax bill from selling the winners.
Even if there is no need for more cash, Helen might make it a practice to periodically sell stocks and funds trading at a loss, such as after disappointing results or during a broad market downturn. Net capital losses can be deducted—up to $3,000 per year—and larger losses can be carried over to offset gains taken in future years. This may allow Helen to do some rebalancing in a taxable account, taking gains on winners but avoiding tax on the gains with a bank of losses to serve as an offset.