Many people are familiar with the concept of owning a diversified investment portfolio, however, I believe tax diversification across your investment accounts is equally as important. An effective tax strategy focuses on helping you pay the least amount of tax over the course of your lifetime.
It’s uncertain what tax rates and policy will be in the future, so one method to mitigate the risks of paying higher taxes in the future is to own assets in a variety of account types. From a tax perspective, there are three main types of accounts that I’ve outlined below. Creating a thoughtful savings plan to build up each of these account types over your lifetime can provide additional financial flexibility as your life circumstances change or new tax legislation is passed.
When building a financial plan, I focus on a three-bucket approach for my client’s annual savings & investment strategy. These “buckets” consist of the following account types:
- Tax-Deferred
- Tax-Free
- Taxable
To better understand what types of accounts are included within each bucket, when it would be beneficial to consider funding this type of account, and how one should invest money within each type of account, I’ve put together an outline below.
Tax-Deferred Account Types: Traditional IRA, Traditional 401k, Traditional 403b
What is it: A tax-deferred account is an account that allows you to defer income from being taxed in the current year. This is attractive for individuals who are currently in a high tax bracket and likely will continue to be going forward. This account allows you to receive a tax deduction in the year funds are contributed to this account. The money can then be invested and grow inside of this account tax-free. However, when you withdraw the money from these types of accounts, the tax you “deferred” will then be due.
Who benefits from these accounts: Individuals who are currently in a high tax bracket (think 32% or higher) and anticipate they will be in a lower tax bracket when they are no longer working full-time or individuals who live in a high tax state and have plans to relocate to a lower tax state.
How should I invest money within this account: Since the only time you pay tax on any of the money within a tax-deferred account is when you take it out of the account, this makes it attractive to own investments that are not tax efficient. For example, Real Estate Investment Trusts, or REITs, are publicly traded investment funds that primarily own commercial real estate. REITs can provide diversification benefits to stocks and bonds, however, the rents collected from the real estate properties are passed through the REIT to investors. While this makes for a nice passive income stream, this income is considered “non-qualified” in the eyes of the IRS, which means it is taxable at the same rate as your salary. In contrast, “qualified” dividends are taxed at a lower, long-term capital gains rate.
Tax-Free Account Types: Roth IRA, Roth 401k, Roth 403b
What is it: You pay taxes upfront, before the money is deposited into your Roth account. Once the money is in the account, you can invest these funds and benefit from tax-free growth. When it’s time to withdraw money from this account, you don’t pay any tax on the distributions.
Who benefits from these accounts: Individuals who are early in their career or are in a lower tax bracket (think 24% or below) will find Roth accounts most attractive. The younger you are, the more time you will have to benefit from your account growing tax-free. Additionally, as you advance in your career, it’s likely that your income will also increase, which leads to higher taxes. As your income & tax bracket increases, then you could look to switch your contributions from Roth to Traditional (Pre-Tax) accounts.
How should I invest money within this account: Since the money is growing tax-free, typically you will want your Roth accounts to be invested for the highest growth potential. Stocks are the growth engine in your investment strategy, while the primary purpose of owning bonds is to provide stability for your investments when stocks decline in value. The combination of tax-free growth and a multiple decade time horizon for this designated retirement account, lead to a diversified portfolio of stock ETFs or mutual funds as the primary investment strategy for Roth accounts. One final tidbit about Roth IRAs – unlike Traditional IRAs that are subject to Required Minimum Distributions upon turning age 73, Roth IRAs do not have mandatory distributions. So if you don’t need additional cash in a given year, you can continue letting your investments grow tax-free within your Roth IRA.
Taxable Account Types: Brokerage Account, Savings Account, Certificates of Deposit (CDs)
What is it: These accounts are funded with income that has already had taxes withheld or cash from your checking account. With these after-tax dollars, you can choose if you want to invest some of your excess cash or keep this money accessible for upcoming expenses. A brokerage account can be established at a financial custodian (Vanguard, Fidelity, Charles Schwab, etc.) and can be held in your individual name or jointly with your spouse. These accounts can be invested in publicly-traded securities (stocks, bonds, ETFs, money market funds) based on your time horizon for needing these funds and your comfort with taking investment risks. Savings Accounts and CDs are held at banks and can provide interest income for any cash you anticipate needing over the next 1-2 years and want to keep safe.
Who benefits from these accounts: I believe all individuals could benefit from building up a taxable investment account. These benefits include: flexibility, tax diversification, no contribution limits, and no early withdrawal penalties. Anyone can establish a brokerage account and begin funding it with as much or as little as they choose. I believe setting up automatic deposits on a monthly basis can be a great habit to start building up a non-retirement account. If you need to access these funds for buying a new car, putting a down-payment on a house, or paying the kid’s tuition, you can sell your investments and redeem cash within a few days to cover these expenses. Unlike a retirement account that imposes a 10% penalty if you withdraw money before age 59.5, there are no early-withdrawal penalties for these accounts. Lastly, when you invest money in a brokerage account, you only pay tax on the growth of your investments. The growth above your initial investment is treated as a “capital gain” and for investments held over one year, they are subject to a lower tax rate than what you pay taxes on your earned income.
How should I invest money within this account: Tax efficiency is one of the most important aspects of crafting your investment strategy for a taxable brokerage account. As I mentioned above, you want to locate investments that are not tax efficient (real estate, bond funds, & mutual funds) inside of your retirement accounts since these accounts are not subject to taxes on an annual basis. Within a brokerage account, you want to prioritize investments that are targeting to return money to investors through capital appreciation vs. capital distribution. Owning individual stocks or stock-based exchange traded funds (ETFs) are often tax-efficient investments to own within a brokerage account since most produce no or very little investment income. However, not all stocks and ETFs are created equal. Stocks that pay dividends, high-turnover ETFs, or funds that produce large amounts of capital gains distributions are not ideal investments to own within a brokerage account because you are subject to taxes on this investment income every year. Depending on your risk capacity and time horizon for needing to access money, bond ETFs can still have their place in your brokerage account. For individuals in a high tax bracket, tax-exempt bonds can be a good solution to balance both stability and tax efficiency within your portfolio.
As you can see, each of these account types have their role within your overall financial plan. Your stage of life, current tax bracket, and timeline for needing access to these funds, influence which account types make the most sense for you to prioritize in a given year. As these factors change year-to-year, we adapt your annual savings plan to prioritize which accounts suit your current situation. By having investments spread across all three of these account types, you create additional flexibility for your financial situation going forward. Financial flexibility is what I aim to maximize for the individuals and families I serve.