As an investor, it’s easy to blow it. You could sell too early, buy too late. Bet on a loser or pass over a winner. But often the most damaging mistake has nothing to do with the selection or timing of investments—it is carelessness when it comes to managing a portfolio for taxes. This is particularly important when you’re planning how you’ll take withdrawals for retirement income.
Save more for retirement
Where you hold different kinds of investments—whether in a taxable, tax-deferred, or tax-free account—and which assets you tap first for retirement income are significant factors that can impact after-tax returns over the long term.
Understand why it matters where you keep your money
“You can achieve a higher rate of return and make your wealth last longer if you pay attention to the differing tax attributes to different investments and accounts,” says David Blanchett, director of retirement planning at Morningstar.
Consider a $1 million portfolio split evenly between a taxable account and a tax-deferred IRA, and assume a couple filing jointly has a 35% income tax rate and is subject to the 15% capital gains tax rate.
If the couple held stock index funds in taxable accounts and taxable bond funds in tax-deferred accounts, after 10 years they would have $1,694,671 after taxes, according to an analysis by The Vanguard Group. If the investors’ reversed the location of the two asset classes—putting the stock fund in the IRA and the bonds in the taxable account—they would have $1,531,413 after taxes, almost 10% less.
Know which assets to put in tax-deferred accounts
For the best after-tax returns, investments with the biggest tax consequences should be sheltered in tax-deferred accounts such as a 401(k) or IRA. Among these are corporate bonds, bond mutual funds, and REITs, whose income is subject to income tax rates of up to 37%. Other good candidates for tax-deferred accounts are investments that generate short-term capital gains, such as actively traded stocks or mutual funds with high turnover. Gains are considered short term if the securities are sold less than 12 months after being purchased, and are taxed at your income tax rate, which can be as high as 37%.
Taxable accounts should hold the most tax-efficient investments, such as tax-exempt municipal bonds and separately managed investment accounts in which a manager actively harvests losses to offset gains and minimize taxes. Other investments in this camp include stocks held for the long term and mutual funds with low turnover rates, such as stock index funds.
Palmer Garson, managing director at Silvercrest Asset Management, says her clients’ fixed income allocations are split between taxable and tax-sheltered accounts. “The vast preponderance of fixed income exposure is in municipal bonds, and that’s held in taxable accounts,” she says. “We like to put private investments with an income orientation in our tax-deferred accounts.”
For example, some of Palmer’s clients have venture debt investments in their portfolios kicking off 18% or more in annual income, she says, adding that these are prime candidates for a tax-deferred account.
“I really can’t stress enough how important asset location is,” Palmer says. “It has compounding effects over the long term.”
Tap your Roth IRA last
Just as it matters what type of account is holding your investments, the order you tap into different accounts also has tax implications.
If you have a Roth IRA, its tax-free status puts it in a separate league from your other accounts. Roth IRAs are funded with after-tax dollars, but assets can be taken out tax free, even by heirs.
To take full advantage of the tax-free status, place high growth investments in a Roth and consider it the last place to tap for retirement income, says Stephen Curley, chief investment officer at WaterOak Advisors in Winter Park, Fla. “If you plan on leaving an inheritance, a Roth is the most valuable asset you can give your kids,” he says.
Tap taxable accounts first
So if you should tap a Roth IRA last, which accounts should you tap first for income? Conventional wisdom holds that investors should draw from taxable accounts first.
Municipal bond income is usually the top priority—it’s tax free. Next best are stock dividends, which are taxed at capital gains rates of up to 20%.
Avoid selling stocks that are performing well unless you can harvest losses to offset realized gains, Garson says.
Money taken from a regular (non-Roth) IRA will be subject to income taxes, and minimum distributions are required when investors turn 70 ½. (There are no distribution requirements from a Roth.)
Although you generally want to allow IRA assets to compound tax deferred as long as possible, if your IRA is large enough, minimum distributions could push you into a higher tax bracket.
“To avoid this, and if you’re in a lower tax bracket in your 60s, you might want to take some money from your IRA,” Curley says.
Another move to lower future IRA distributions: Convert small portions of your IRA to a Roth IRA every year, suggests Ken Stern, a managing director at Lido Advisors in Los Angeles. Income taxes are owed on converted assets, but aim to keep conversions small, so they don’t push you into the next bracket, to manage the up-front tax hit, he says.
Also consider the benefit of diverting up to $100,000 of required IRA distributions directly to charity, Curley says. You won’t get a charitable deduction, but you avoid having to count the distributions as taxable income. That’s a trade-off may taxpayers will be able to live with.
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