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Know How Not To Give It All Away In Taxes – Part I

**This is the first of a two-part excerpt from Chapter 6 of THE RELAXING RETIREMENT FORMULA on What You Own, Where You Own, and Where You Withdraw From

I believe Rose and Bill are right. I think you have every right to legally reduce the amount of income tax you pay all the way down to zero if you can. And Rose is also right about the relationship between investments and taxes on the other side of The Employment Dependency Threshold. It is both highly complex and critically important. There are tax efficiencies you must take advantage of if you’re going to make your money last.

People who make decisions about investments separately from the decisions they make about taxes pay a heavy price for doing so. I’ve separated the previous chapter on investing from this one on taxes for the sake of clarity, but I was only able to do so by tabling certain topics then and promising to come back to them later. The first of those, which we’ll return to now, is the tax benefits of the low-cost index and asset class funds I recommended previously.

What You Own

In the previous chapter, I recommended index and asset class funds as a more disciplined and cost-effective way to own a globally diversified portfolio. They’re also highly tax-efficient. If you’ve ever owned an actively managed mutual fund outside an IRA, you’ve probably already experienced having to pay taxes on capital gain distributions at the end of the year even if you haven’t sold any shares. The value of the holdings could even have gone down, and you might still have owed taxes.

This frustrating lack of control over when you pay taxes is a function of the frequency with which managers of such funds trade. They buy and sell based on strategy, timing, shareholder redemption requests, managerial changes, and the phases of the moon for all we know. Index and asset class funds, by contrast, buy and hold a pre-set mix, and trade only when the fund’s mix no longer matches the asset class. This means that it’s predominantly you, and not the fund’s manager, who decides when you buy or sell, and thus, when you pay taxes.

COACH’S CORNER: Low-cost index and asset class funds give you more control over when you pay taxes.

Where You Own

Having discussed what to own, we now need to talk about where to hold what you own. In the same way it was helpful to imagine two different futures for Bob and Linda, it’s useful to think about two different worlds, the IRA and the non-IRA world, in which Bill and Rose can hold what they own. Both fixed income funds (CDs, bonds, and money markets) and equity funds (stocks), can be held in either world. Where you position your savings within this complex geometry makes an enormous difference in how much you’ll pay in taxes and thus how long your money lasts.

We recommend that you navigate based on what kind of income tax is assessed where. Because federal capital gains tax rates currently top out at 20 percent while ordinary income tax rates climb as high as 37 percent, it can be worth tens of thousands of dollars to position as much of your money as possible in the territory where capital gains rates rather than ordinary income rates apply.

The easiest way to see this in action is to look at several different kinds of investments, and see how the earnings from each would be taxed in each world, and how that should influence your asset location strategy.

Ordinary Income Tax Rates

  • You pay ordinary income tax rates (maximum 37%) on interest you earn on bank CDs and money markets, and on the interest and dividends you earn from bonds and bond funds held outside of an IRA or 401(k).
  • All interest and dividends earned inside an IRA or 401(k) are sheltered from taxes. However, you pay ordinary income tax rates on the full amount you withdraw from an IRA, and any gains you withdraw from an annuity.

Strategy: If you don’t need to withdraw the interest from CDs or bonds, it’s best to hold them inside of your IRA as long as possible. You pay no taxes now, and keep accruing compound interest.

Capital Gains Tax Rates

  • You pay capital gains tax rates (maximum 20%) on the realized profit from the sale of stocks, stock mutual funds, and real estate held outside of an IRA or 401(k) for more than one year. You also pay them on year-end capital gain distributions on mutual funds held outside of an IRA, even if you don’t sell the fund.
  • Capital gains on the sale of stock funds held inside an IRA or 401(k) are not subject to taxes after the sale. However, all funds later withdrawn from this world are subject to ordinary income tax rates (maximum 37%).

Strategy: Holding stocks and stock funds outside of an IRA allows you to benefit from the lower capital gains tax rate.

Selling A Stock Fund Purchased For $100,000 At $150,000

  • If held outside of the IRA world– you pay capital gains tax rates (maximum 20 percent) on the $50,000 profit.
  • If held inside of an IRA—you pay no taxes when you sell, but when you withdraw you pay ordinary income tax rates (maximum 37 percent) on the same $50,000 profit.

Strategy: Holding equity investments outside an IRA allows you to benefit from the lower capital gains tax rate.

Selling A Stock Fund Purchased For $100,000 At $80,000

  • If held outside of the IRA world– you can use your $20,000 loss to offset the same amount in other capital gains you’ve realized, reducing the taxes you’d be paying. If you earned no capital gains, you can offset $3,000 in ordinary income, and carry the remaining $17,000 loss forward to cancel out future capital gains.
  • Within an IRA—you derive no tax harvesting benefits from your realized $20,000 loss.

Strategy: Holding stock-related investments outside an IRA or an annuity allows you to potentially benefit even from a loss.

COACH’S CORNER: Whenever possible, position funds strategically to pay lower capital gains tax rates rather than higher ordinary income tax rates.