15% vs. 35%

You’ve taken the steps you need to take.

You’ve determined the amount of income you’re going to need to withdraw from your Retirement Bucket™ (accumulated investments) each year to supplement your social security and pension income.

You’ve calculated the investment rate of return you now ‘must’ earn to produce that supplemental income each year and still keep pace with inflation.

You’ve even carefully crafted your investment allocation to give yourself the best shot at producing that rate of return you need to earn among fixed income and equity investments.

Now the question is: if half of your money is in tax deferred retirement accounts (like IRAs, 401(k), 403(b), etc.), and half of it is not, and you’re going to invest in equity funds (stocks) and fixed income funds (bonds and money market funds), does it matter where you hold each of these “types” of investments?

The resounding answer is “YES, it makes a huge difference!”

The difference lies in the way you’ll be taxed.

Which Tax Would You Rather Pay?

Since it is election season, the debate continues about what tax rates should be, and for whom!

However, at the end of the day, there will still be two different types of income taxes.

And, the rates you pay are drastically different.

As it stands right now in 2012, ordinary income tax rates run as high as 35%.

Capital gains tax rates, however, max out at only 15%.

Given this severe disparity, your goal should be to pay capital gains rates whenever possible.

So, when do you pay ordinary income tax rates and when do you pay capital gains tax rates?

When it comes to your investments, you pay ordinary income tax rates on:

  • Interest you earn at the bank (CD, money market, etc.)
  • Interest or dividends you earn on a bond or a bond mutual fund
  • Taxable withdrawals from an IRA or annuity

You pay capital gains tax rates on:

  • Profit from the sale of stocks, stock mutual funds, and real estate
  • Internal capital gain distributions from stock mutual funds (even if you don’t sell the fund)

Examples in Practice

Fixed Income Investment:

  • If you earn interest on a CD that you hold outside of an IRA, you pay ordinary income tax rates on that interest.
  • If you earn interest on a CD that you hold inside of an IRA, the tax on that interest is deferred as long as it is in your IRA. However, when you withdraw money from your IRA, you then pay ordinary income tax rates on the entire amount of your withdrawal.
  • If you’re not withdrawing this interest or dividend income, you’re better off deferring the tax on it inside of your IRA. When you withdraw it, you’re still going to pay ordinary income tax rates just as you would have if you held it outside your IRA. But, you’ve benefited from tax deferred compound interest along the way.

Equity Investment:

  • If you buy a stock for $50,000 outside of your IRA, and later sell it for $70,000, you pay capital gains tax rates on that $20,000 gain (maximum 15%).
  • If you bought that same stock inside of your IRA for $50,000 and later sold it for $70,000, there would be no tax on the sale as long as the proceeds remain inside your IRA. However, when you then withdraw that money from your IRA, you pay ordinary income tax rates (as high as 35%) on 100% of your withdrawal, no matter where the money came from.
  • If you hold your equity investments inside of your IRA, you forgo the opportunity to pay the lower capital gains tax rates.

Two Big Mistakes

There are 2 big mistakes I see too many retirees make:

  1. Because they were conditioned to hold their highest appreciating assets in their IRA and 401(k) during their careers, they continue to hold their stock or stock mutual fund investments inside of their IRAs after they retire.

By doing this, it insures that they will never be able to qualify for lower capital gains tax rates on their earnings. Instead, they pay the drastically higher ordinary income tax rates when they withdraw those gains from their IRA.

Think about it. On the same $100,000 gain, you could pay $15,000 (15% capital gains tax rates), or as high as $35,000 (35% ordinary income tax rates). That’s a difference of $20,000 more in taxes on the same $100,000 gain! Which would you rather pay?

  1. The second mistake is they are not able to deduct their capital losses. This was especially critical in 2008 and 2009 when stock prices plummeted substantially.

Let’s say that you bought a stock for $50,000 and later sold it for $30,000, thus taking a $20,000 loss. If you purchased that stock outside of your IRA, you would be able to deduct $20,000 against any capital gains you incurred this year. If you don’t have $20,000 worth of gains, you can apply a $3,000 loss toward any ordinary income earned that year, and carry the remaining $17,000 realized loss to use in future years.

If you took the same loss on a stock that you bought inside your IRA, you are not able to deduct that $20,000 loss because it was incurred inside of your IRA.

That $20,000 capital loss could be worth as much as $7,000 in tax relief to you! However, if you incurred the loss inside of your IRA, you are not able to deduct it. Pretty substantial, wouldn’t you say?

We have Relaxing Retirement Members who I met back in 2003 after the dot com crash. Prior to working with them, they suffered losses in excess of $300,000 inside their IRAs!

They were not very happy to learn that they couldn’t deduct ANY of those losses.

Inside or Outside of your IRA?

Given this, and your available options, you’re much better off holding your equity investments outside of your tax deferred retirement accounts (IRAs) and your fixed income investments (bonds and money markets) inside your IRA.

To put this in larger perspective, the moral of this Retirement Coach Strategy of the Week is that your investment decisions can’t be made in a vacuum, especially during your retirement phase of life.

Most people make decisions concerning their investments separately from their decisions concerning their taxes.

In contrast, your investment planning decisions have to be made simultaneously with your tax planning decisions. Otherwise, it’s highly likely that you’re going to pay a lot more money in taxes over the course of your lifetime than you are legally required to.

This is money that could have gone to more vacations for you, or presents for your grandchildren.

Where would you rather see it go?

Take the time plan it out ahead of time.

In a future blog post, we’re going to continue this discussion and reveal another strategy to potentially reduce your taxable required minimum distributions from your IRA when you turn 70 ½.