Part II: Why Placement Matters
Recently, we talked about how important it is to make your investment planning decisions simultaneously with your tax planning decisions during this critical phase in your life.
Otherwise, it’s highly likely that you’re going to part ways with a lot more of your hard earned money in taxes over the course of your lifetime than you are legally required to pay.
In blog entry, let’s talk about another very important reason why you want to give careful thought as to “where” you’re going to hold your different styles of investments in your retirement years.
As a brief warning, I will admit that this gets a little technical, but I think it’s worth knowing if you want to reduce your tax burden and keep more of what you’ve worked so hard to save.
Required Minimum Distribution
In order to illustrate this, let’s briefly discuss the IRS Required Minimum Distribution (RMD) rules on your IRA.
Within guidelines, you can deposit money to your IRA (or company sponsored 401(k), 403(b), or 457-MA Deferred Compensation Plan) and defer all income taxes on the growth of that money until you make a withdrawal.
However, there are additional rules governing withdrawals from your IRA. First, if you withdraw money from your IRA prior to age 59 ½, in addition to paying income taxes on the amount you withdraw, you will also pay a 10% excise penalty tax in most cases. (There are a few exceptions as we outlined in a recent post)
The second rule that you must follow is that beginning in the year that you turn 70 ½, the IRS requires you to withdraw a certain amount from your IRA (Required Minimum Distribution) and pay income taxes. The amount you must withdraw is based on the value of your IRA and your life expectancy.
For obvious reasons, this rule is in place is to make sure the federal government gets their tax money back!
Here’s the key point: whether you “need” the money to spend or not, they force you to withdraw and start paying taxes on the money you’ve saved.
This is where the problem comes in. What if they require you to withdraw $80,000 from your IRA this year, but you only want to withdraw $40,000 for your supplemental income needs?
You probably already know the answer: you have to withdraw and pay taxes on all $80,000!
Knowing this, if you’ve done your planning correctly, and you know that you’re not going to “need” to withdraw as much from your IRA at age 70 ½ as the IRS is going to “require” you to withdraw, what can you do about it?
“Where” You Hold Different Styles of Investments
Well, this loops back to our recent article and why it’s so important to simultaneously understand the tax implications when you make investment decisions, i.e. “where” you’re going to place different styles of investments.
As we did in that article, let’s make the assumption that you know the investment rate of return that you must earn (huge point), and that you’ve crafted your investment allocation to produce that return you need to earn among stocks, bonds, money markets, etc.
Assuming that half your money is in tax deferred accounts (IRA, 401(k), 403(b), etc.), and the other half of your money is not, “where” should you hold each style of investment (i.e. stock funds, bond funds, etc.)?
Given historical ‘long term’ results, equities (stocks) have typically outperformed fixed income investments (bonds and money markets) by a long shot. (While this is certainly not a lock in the short term, it certainly has been over the long term)
If we make the assumption that your stock funds will grow much faster over the long run than your fixed income funds, is it better to hold your stock funds inside or outside of your IRA?
The answer is outside your IRA! But, as opposed to the reasons outlined in our recent article, this time, it’s for a potentially different reason.
The Bigger the Balance, the More You Must Withdraw
Think about the Required Minimum Distribution that you must take from your IRA each year beginning at age 70 ½. The amount you must withdraw is based on:
- the amount of money in your IRA (the bigger the balance, the more you have to withdraw), and
- your age (life expectancy)
If you position the stock portion of your investments inside your IRA, and long term historical results continue, your IRA may be a lot bigger at age 70 ½ and beyond than if you had allocated your fixed income investments inside your IRA instead.
If the balance of your IRA is bigger, you may be required to withdraw more and more each year.
And, the more you have to withdraw, the bigger your tax bill will be!
Now, you may be asking, “are you saying that I shouldn’t want my investments to grow?”
No. What I’m saying is that if you’re going to hold some of your money in stock investments, and some of your money in fixed income investments, given the choice, holding your stock investments outside your IRA may lead you to pay significantly less in taxes.
As I stated at the beginning, this is a little technical, but if you follow the logic, it could mean big tax savings for you over the rest of your life.
This is just another example of how critical it is to never make investment decisions in a vacuum at this stage in your life. You must be simultaneously thinking, “what vehicle should I invest in, and where should I position this investment in order to pay the least amount of taxes now and in the future?”