Common Investor Mistake No. 2: Bad Tax Split With Your IRAs

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Huw Aaron

Huw Aaron

 

Investors can’t control the returns on their investments or know how profitable they’ll be. But they can know the fees and taxes they’ll pay and cut those to a minimum. Most people think of investing as posting gains, but much of it is about cutting predictable costs. Tax efficiency helps determine how much of your gains actually end up in your pocket.

Investing and taxes can be complicated, and a lot of people throw up their hands and walk away — but keep reading. If you minimize taxes now, you can have a more comfortable retirement. If you kick this can down the road, you’re handing more money to the IRS than you owe. They’ll appreciate it, but your future self won’t.

One way to minimize taxes is to max out your use of tax-deferred accounts like a 401(k) and an Individual Retirement Account (IRA). Many investors will have assets left over after they reach their limits. If you’re in this situation, it’s important to split assets between tax-deferred and taxable accounts thoughtfully.

A simplistic strategy would be to put stocks in your tax-deferred account and bonds in your taxable account. While that’s a starting point, you can do much better.

The way to start thinking about asset allocation is by asking which assets are likely to be taxed the least. Municipal bonds are exempt from federal and many state taxes, so you don’t want to use up valuable space in tax-advantaged accounts with municipal bonds. Put them in the taxable bucket.

Assets such as highly volatile stocks likely to generate tax losses should be kept in the taxable accounts, because those losses can be harvested (by selling those assets when they’re down and switching into something similar), and use to offset other taxes.

Once you have run down the list of your assets with the least tax exposure, and put them into your taxable accounts, you can turn to your tax-deferred accounts, where space is limited. Investments throwing off lots of cash, like high-dividend stock or high-yield bonds, should probably go in your IRAs, where the income they generate can grow untouched. If you need the income soon, of course, you’ll need to make other decisions.

By deferring taxes on that income until you retire, you’re also betting that you’ll be in a lower tax bracket, which is usually the case when people stop working. But if you’re in the 15 percent income tax bracket or less, tax management is less important, because in most cases you can hold investments for over a year and avoid capital gains.

Another factor to consider is how long you plan to hold onto a given asset, security or fund. Taxable accounts are costlier when you begin to trade and shift your assets, so ideally you would keep your long-term bets there. For funds you’re testing out, are less committed to, or consider risky, your tax-deferred account may be the right home, since you can trade out of them if necessary at a lower cost.

To sum up: Taxable accounts should house your lower-return bonds, municipal bonds and growth stocks that you don’t plan to trade. Tax-deferred accounts are the place to put assets you may trade, as well as securities throwing off income.

This is the second installment of a six-part series. Read Common Investor Mistake No. 1: The Home Bias Trap here.

Simon Moore CFA, MBA, is chief investment officer at the award-winning retirement service FutureAdvisor. FutureAdvisor provides an online service to analyse and improve upon your retirement savings choices. It only takes a few minutes. Get your free analysis at www.futureadvisor.com.

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