Savvy investors often spread their risks by investing in a variety of asset classes such as stocks, bonds, commodities, and real estate. But with a changing tax landscape, investors might consider three more classes: taxable, tax-deferred, and tax-free.
In days gone by, taxpayers often worked under the assumption that their tax bracket would be lower after they retire. Therefore, a common strategy was to defer as much taxable income as possible to the golden years. Now, however, with the possibility of higher tax rates in the future, it could be more efficient to pay those taxes today while rates remain lower. Since no one knows for sure what Washington will do, it might be time to hedge your tax risk and allocate your portfolio between accounts with differing tax consequences.
Diversifying your investments
- Taxable accounts, such as savings or brokerage accounts, result in current taxation on earnings, but they do provide maximum flexibility. You can withdraw as much as you wish whenever you wish, with no IRS penalties or taxes. Keeping some of your nest egg in this type of account will provide immediate funds for major purchases or debt reduction.
- Tax-deferred accounts, such as IRAs or 401(k)s, only postpone the payment of taxes; eventually you will have to pay Uncle Sam when you withdraw the funds. But in the meantime, you generally receive a current-year tax deduction when you contribute, and the account can grow tax-free until you take it out at retirement.
- Tax-free accounts, such as Roth IRAs, are funded with after-tax dollars. What you put in, including any investment earnings, can be later withdrawn tax-free. The downside? You generally must wait until after age 59½ (and the account has to be open for five years) to make a tax-free withdrawal.
Diversifying your portfolio is only the first step. The next (and trickiest) step is properly investing in each type. For instance, your goal for a taxable account might be to generate growth while keeping taxable earnings to a minimum. This could be done by investing in tax-exempt municipal bonds or low-dividend yielding growth stocks.
In a tax-deferred account, investment income is not taxed until withdrawn, so earnings can come from any source without immediate tax implications. However, since you must start withdrawing funds from an IRA or 401(k) at age 70 ½, you might want to stay away from highly volatile investments as you approach that age. Your account will have less time to rebound from a down market.
Tax-free Roth IRAs offer the longest time horizon for investing since you are not required to make a withdrawal at any age. So investments with higher risks or lower liquidity might fit best here.
In an era of high uncertainty and low expectations, tax-efficient investing has never been more important. To review the tax implications of your investments, give our office a call today.