We have been writing a series of articles about retirement. We recently discussed being happy during retirement. Now that we are all in a good mood, let's go the other direction and talk taxes. While rarely a fun topic, it is one that needs to be considered and should be part of your broader retirement plan. Having a good plan in place well in advance will help prevent a lot of stress in the future!
We often speak about diversifying when we are investing. We diversify by sectors, we diversify by company, we diversify by investment type and we routinely encourage our members to have no more than 2-3% in any single investment. Diversifying helps reduce volatility in our investments.
Another important way to diversify is tax diversification. Due to the different ways investment accounts are taxed, and the different rules governing them, each has its benefits and drawbacks. It is often a good idea to have funds spread across accounts of each type.
The risk is that we do not know what tax rates will look like in 5, 10, 20 or 40 years. Ideally, if we knew what our tax situation is now versus what it will be when we withdraw the funds, we could make the best choice. Since it is impossible to perfectly predict the future, we suggest that investors consider diversifying.
There are three main types of investment accounts:
Traditional IRA: Provides a tax deduction the tax year you put money in, reducing your taxes owed and allowing funds in the IRA to compound tax-free. Funds are taxable when they are withdrawn at income tax rates. A traditional IRA is a bet that your tax liability when you retire will be lower than they are for you now.
Roth IRA: Provides no tax deduction up front, but withdrawals are generally tax-free. A Roth IRA is a bet that your tax liability is lower now than it will be when you retire.
Taxable Account: No tax deduction, and gains are taxed at applicable income or capital gains tax rates the year they are realized. While missing out on the tax benefits of IRAs, taxable accounts redeem themselves by being extremely flexible. Investors can control when they realize gains or losses and adapt quickly to changing tax laws, without worrying about penalties or limitations.
Death and Taxes
Nothing is certain about life except death and taxes, except that they are equally comfortable topics of discussion. The problem is that we rarely have an idea of when or how we will die and we have little idea of what tax rates will look like in the future.
Looking at a history of effective tax-rates over 100 years, we can see that they have quite a bit of volatility, especially if your income level puts you in the top 1%.
Broadly speaking, taxes have generally trended higher, and when you consider that most retirees will have a lower income than when they worked, they are likely in a lower tax bracket. So even if taxes have increased, being in a lower bracket could result in an individual's tax rate being decreased.
On the surface, that is a pretty strong argument for Traditional IRAs, at least for workers who are in their prime and are earning what is likely to be the highest incomes of their career. Additionally, since a Traditional IRA lowers your taxes for the immediate year, that allows for investing a larger amount up front and in some cases, it might put you in a lower tax bracket or reduce your taxable income enough to qualify for other benefits.
It is always worthwhile to run a little "what-if" scenario past your tax preparer or test through TurboTax just to see what impact putting funds in a Traditional IRA will have on your taxes. Sometimes, putting a little extra into a Traditional IRA can reduce your taxable income enough to qualify for other tax benefits. It doesn't hurt to check!
Why The Roth?
The Roth IRA is going to be most efficient if your tax rate is lower today than it will be when you retire. That makes it best for years where your taxable income is already relatively low and for younger workers who are in lower tax brackets or might have other deductions that substantially reduce their effective tax rates. If you are already in the 0% or 12% tax bracket, the Roth is clearly the way to go.
There are some features that might make Roth's tempting even if you believe your tax rate will be lower when you retire.
First, IRAs have a 10% "early withdrawal" penalty for withdrawing before age 59.5 with a few exceptions. For Traditional IRAs that penalty applies to all funds. For Roths, the penalty does not apply to the original principal. Roths allow you to withdraw your initial contribution anytime, tax and penalty-free after the account is 5-years old.
Second, Traditional IRAs have "required minimum distributions" or RMDs that start when you turn 70.5 years old. Since we focus on high current income at HDO, your portfolio might be producing enough dividends to fulfill the RMD requirements. However, if it is not, the RMD rules might require you to liquidate some of your investments at a time when liquidating might not be the best investment decision. Roth IRAs do not have any withdrawal requirements. Investors can leave funds there forever and pass the Roth IRA on to their heirs.
The additional flexibility of being able to access your original contributions without penalty and having the freedom to choose when to withdraw funds, or even not to withdraw them at all, are good reasons to choose a Roth over a Traditional IRA.
Taxable accounts are often overlooked. We believe that they have an important place in an investment plan. The largest benefit of taxable accounts is flexibility.
Investors are capped at how much they can deduct when putting money into a Traditional IRA, and they are limited to how much they can put into a Roth IRA at all. The current limit being $6,000 with an additional $1,000 catch up if you are over 50. Roth IRA limits are also phased out for high-income earners, those who have AGI's over $137,000 individually or $203,000 for couples are ineligible.
You can also withdraw money whenever you want, subject only to anti-money laundering ("AML") holding periods, which is 5 trading days. And there is no RMD requirements. You can put as much or as little money in or pull it out whenever you believe it is best for you, not because of government regulation.
Taxable accounts allow you to take advantage of things like "tax-loss harvesting" which can reduce your taxable income up to $3,000 for a married couple or $1,500 for an individual. When you have a down year or recognize more losses than you recognize gains, that will reduce your taxable income and you can carry forward larger losses into future years. While we never set out to have a loss, it doesn't hurt to make a little lemonade.
For those looking to pass funds along to an heir, when taxable accounts transfer upon your death, the heirs receive a "stepped up" tax basis. So if you have an investment you bought for $10, and it is worth $20 when you die, your heir's basis will be $20. So if they sell at $30, they will pay taxes on a capital gain of $10, instead of $20. For Traditional IRAs, the heir would have to pay income taxes on 100% of the amount withdrawn, but for Roth IRAs they would be able to withdraw tax-free.
K-1s and Tax-Advantaged Investments
At HDO, many of the investment opportunities we find are partnerships that issue K-1 tax forms instead of 1099s. These investments introduce complexity into both Traditional and Roth IRAs.
Unrelated Business Income (UBTI) that can be generated by these partnerships will be reported and an excise tax will be levied if it exceeds $1,000 in an IRA account. The 990-T form that has to be filed is for the account, not on your individual taxes, so it will be filled out by your broker, usually for a fee.
While many partnerships have little or even negative UBTI, it is not always predictable. To avoid this complication, we prefer using taxable accounts for partnerships.
Another type of investment that does better in a taxable account are investments that have tax-advantaged distributions. For example, the best way to take advantage of the tax-free 6.4% distribution from America First Multifamily Investors (ATAX) is to hold it in a taxable account.
Each type of account has its own advantages or disadvantages, and which option will be best will vary from person to person and will even vary over the course of an investor's lifetime.
The key questions to consider are-
- Is your tax rate likely to be higher or lower when you withdraw? If it will be lower, then the Traditional IRA will provide the most savings. If it will be higher, then the Roth will save the most. It is always worthwhile to check to see if a contribution to a Traditional IRA will have a material impact on your immediate taxes.
- Is it possible you will want to access the money early? When it comes to flexibility, taxable accounts reign supreme. Want to pay off your mortgage? Need emergency cash? Want to save money for non-retirement expenses? Taxable accounts let you take out however much you want whenever you want.
- When will you want to take out the money? Traditional IRAs are quite rigid, they are meant to incentivize retirement savings and with no ability to withdraw anything without penalty before 59.5 and mandatory RMD's starting at 70.5, subject to a few exceptions, investors have little flexibility. For accounts that are primarily intended to be passed along to beneficiaries, or to provide a nest-egg in case you achieve centenarian status, the Roth or taxable account is a better choice, allowing you to leave your dividends reinvesting and enjoy the magic of compounding until you need it.
- What investments do you intend on acquiring? For accounts that will invest heavily in partnerships that issue K-1s or investments that are tax-advantaged, a taxable account is going to be best.
We are not tax advisors and we cannot offer individualized tax advice. We encourage members to consult their own tax advisors and make sure they bring up these relevant issues to strike the best balance between managing the burden of taxes while maintaining flexibility to handle the unpredictable.
Author's note: Thanks for reading! If you liked this article, please scroll up and click "Follow" next to my name to receive our future updates.
High Dividend Opportunities, The #1 Service for Income Investors and Retirees
We are the largest community of income investors and retirees with over 3000 members. Our aim is to generate high immediate income. We recently launched our all-Preferred Stock & Bond portfolio for safe high-yields ahead of a weaker economy and market volatility.
Join us today and get instant access to our model portfolio targeting 9-10% yield, our preferred stock portfolio, our bond portfolio, and income tracking tools. You also get access to our report entitled "Our Favorite Picks for 2019"
Disclosure: I am/we are long ATAX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.