Practicing tax optimization can make a real difference in return over your lifetime. Much of the advice I read about investing in IRA/401(k) accounts makes sure that the average investor doesn't 'blow themselves up' by losing too much of their money. Such advice is often confined to "invest for the long term and keep the portfolio broadly diversified and relatively conservative."
Such advice is prudent, but is it enough for truly investing in a tax-optimized fashion? And when you retire, from which accounts should you begin to withdraw your money first?
Of course, everyone's investment and tax situation is quite different. However, there are at least a few general guidelines for investors to take into consideration, especially when they are in the highest tax brackets:
1. Separate the asset allocation decision from how you divide investments across accounts.
The most important principal in safe investing is to have broad diversification across the major asset classes. Although cost is always a factor, it is even preferable to mix up investment styles. Refrain from making any big bets and make sure to keep asset allocation changes to a minimum if you want to keep your risks low. Time diversification is also a powerful tool to utilize. It is best to put a little money into your investment portfolios each year. Then, after you retire, don't make any drastic adjustments and only take out each year what you need for living expenses. In this way, you can reduce dramatically your risk over time. Only after you along with your advisors have made your asset allocation plan, can you now look at how to apportion those assets across tax deferred and taxable accounts.
2. Allocate those investments that kick off the most short-term taxable income first to the tax-deferred accounts.
Logically, since the tax-deferred accounts don't have to pay taxes until much later when your money is withdrawn, you would want to shelter all the current income you can from being taxed each year. Because you are limited in how much the government allows you to put into such accounts, you would look to defer as much of your investment's tax gains as possible. In particular, products anticipating a lot of ordinary and short-term gains are the highest taxed and should be included here. Examples of the types of investments that are often preferred in tax-deferred accounts include:
- Dividend stocks and dividend oriented funds
- Taxable bond funds along with corporate and government taxed bonds and CDs
- Active stock and options portfolios
3. Allocate the balance of investments that kick off either little or no current taxable income to the taxable accounts.
In this way, you are paying fewer taxes in your accumulation years as these categories of investments can either be appreciating in a non-current taxable manner or simply earning little current income. Examples of the types of investments that are then apportioned to taxable accounts include:
- Bank accounts, money market funds
- Municipal bond funds and bonds
- Stocks and stock funds focusing on appreciation over the long term
4. When you retire or you need your money sooner, if possible, draw first from the taxable accounts
Throughout your life, as much as you can, you should make sure to keep the tax-deferred accounts fully funded as they are one of the few 'gifts' you will ever get from the government. However, it is important to always consider your liquidity situation. Since there are penalties for early withdrawal from tax advantaged accounts, you would first want to build up your savings accounts to use in the case of emergency or for short to medium-term needs, like saving to buy a house.
Later, when you retire and begin to draw on your long-term investments, logically, you should first withdraw from your taxable accounts. Within these taxable accounts, the sequence should be to first sell any long-term capital gain assets as you will pay at a lower tax rate on this portion. It is best to defer withdrawing money out of your tax-deferred accounts as long as possible, as each year, your money is growing without having to pay current taxes on any gains. In effect, you are able to continue to make money on the money owed to the IRS as you are delaying the tax payment until you are older and likely even in a lower tax bracket.
Also important is to make sure to factor in estate taxes and inheritance planning when designing your withdrawal plan. Taxable savings enjoy what is known as a "step up in basis" when they are passed to a beneficiary. Essentially, your beneficiary can potentially sell an inherited asset and owe no income tax. It is well worth first reviewing your withdrawal plan with your estate attorney.
Before closing, let me reiterate that each person's requirements can be quite different and it is difficult in such a short article to cover all personal scenarios. There are often other more critical factors than taxes to consider, such as the liquidity you need to keep in your overall portfolio as well as the appropriate risk level assessment. Indeed, I have seen more money lost over the years by people focusing too exclusively on the tax impact and overlooking investment considerations. My objective in this article is to at least give you a general set of guidelines on how to approach the challenge of where to allocate what assets. Of course, it is important to also review your decisions with your financial advisor and tax accountant before executing your plan.