When we think about the future of our retirement and financial security, we often do so in terms of how much we should save each month and how much that might add up to in 10, 20, or 30 years. We know we are supposed to invest in IRAs, Roth IRAs and 401(k)s and any number of other confusing acronyms. While this thinking is correct, and the discipline of saving for the future is most important, we need to make sure we take it a step further to make our future nest egg as tax efficient as possible. Because it is not just what you make it’s what you keep.
It can be easiest to understand the concept of tax efficient investing by envisioning three different buckets.
“Non-qualified” - encompasses dollars outside of qualified retirement accounts such as IRAs, Roth IRAs, 401(k)s, etc.
Pre-tax bucket - Traditional IRAs, traditional pre-tax 401(k)s
Roth Bucket – Roth IRAs, Roth 401(k)s.
Keep in mind, these are tax buckets, not investments. You could hypothetically own shares of a company’s stock in each bucket. What we do have to be mindful of is how the underlying investment will be taxed annually and in the future.
Making each tax bucket work for you
The non-qualified bucket is funded with after-tax dollars and could include bank accounts, CDs, money markets, or investments in an individual or joint brokerage account. Typically, you’ll receive a 1099 each year as the assets don’t get any special tax treatment like an IRA or Roth IRA.
However, the 1099 will be dependent on your holdings. If you own mutual funds or ETFs, you may get a 1099 showing capital gains because of the internal trading within the funds. If you own stocks that pay dividends or bonds that pay interest, the 1099 will show that amount.
Here is the kicker: long-term capital gains and qualified dividends are taxed at the capital gains rate. This matters because in most cases, those who are in the 12% regular income tax bracket will have a capital gains rate of 0%. For those in the 22% bracket the capital gains rate is 15%. Taxable interest income from bonds is taxed at the regular income tax rate. More on how we take advantage of this in a moment.
The second bucket, pre-tax, will include assets going into IRAs or 401(k)s that are funded with pre-tax dollars that once inside will grow tax-deferred on all interest, dividends, and gains. These assets become taxable at the time of distribution, usually in retirement and at whatever income tax-bracket you’re in at the time.
The third bucket, Roth, is funded with after-tax assets that once inside will grow tax free on all interest, dividends, and gains. At the time of a qualified distribution, regardless of tax bracket, the assets come out tax free. To take advantage of these tax differences, investments with high growth potential that throw off little in the way of ongoing taxable distributions, such as index funds pegged to the Standard & Poors' 500 or non-dividend growth stocks, often work best in the first bucket, non-qualified accounts. With these, it's possible the only taxes that might apply would be on long-term capital gains.
Conversely, investments that are less tax-efficient are typically best held in traditional IRAs. These might include high-yield bond funds or emerging-market stock funds that do a lot of internal trading (spinning off taxable gains or dividends along the way).
By strategically allocating your assets in the different tax buckets, you can not only align the overall portfolio with the proper risk tolerance but do so in a manner that may allow for more tax efficient growth and distribution.
Strategic withdrawal planning
Now that we understand the different buckets, we can start to see how taxes play a role not only while you’re accumulating your money, but also when you start to withdraw money in retirement. By diversifying your tax buckets, you can meet your retirement income needs and mitigate taxes. Below are a few adoptable strategies depending on your age and income.
What to do at age 72
One strategy relates to age 72 because the second bucket, the pre-tax bucket, was funded with pre-tax money and as a result the IRS requires you to take a required minimum distribution (RMD) annually starting at age 72. If someone has $1 million in IRA money, the minimum distribution will be just below 4% of the account value, which once distributed can be enough of a taxable event to push you into a higher tax-bracket or cause other unintended consequences such as Medicare Income Related Monthly Adjustments (higher Medicare costs).
If you retire prior to age 72, one strategy may include taking money out of the IRA each year to fill up the remainder of your tax bracket, without going over and converting it to the Roth IRA. While this does cause a taxable event in the year that you do it, the idea is that you are doing it in a controlled fashion so that when you get to age 72, the amount of your RMD will be lower and thus less possibility of unintended tax consequences.
Balancing income needs and taxable income
I also recommend working in coordination with your tax preparer and financial advisor to understand the different income thresholds for each tax bracket. This will help you distribute money from all three buckets while ensuring your total income needs are met while mitigating taxable income. An example would be a couple married filing joint whose income is approaching $80,000, which is approximately where the 12% tax bracket goes to 22%. Suppose at the end of the year they need a new roof and request a $15,000 distribution from their IRA. If they did that, most of that distribution will now be taxed at 22% vs 12%, or roughly $1,500 more in taxes. By having diversified tax buckets, they could take that from their Roth IRA, getting the income they need, without pushing themselves into the higher bracket.
Lastly, many individuals have gifting goals both annually and for their legacy. After the 2017 Tax Cut and Jobs Act Legislation, the amount of people who itemized their taxes reduced dramatically. As a result, many people lost the ability to gift to church or charity and get the benefit from the itemized deduction. However, for those who are of RMD age and need to take an IRA distribution; another option exists that does not require an itemized deduction and will still provide tax benefits.
Known as a Qualified Charitable Distribution, an individual can designate a portion or all of their RMD, up to $100,000 annually, to go to the church or charity of their choice. This gift goes toward satisfying their RMD, however keeps it from becoming a taxable event. The custodian of the IRA will take the instructions and distribute the funds directly from your IRA to the receiving church or charity. This allows you to satisfy your giving goals and RMD while minimizing your overall taxable income had you taken the entire RMD and then wrote the checks out yourself.