Beware the Tax Man
Your investments are taxed in two ways: profits are taxed at capital gains rates and most dividends and interest are taxed at income tax rates. Tax rates can change almost yearly based on new or sunsetting tax laws, but for your planning purposes it's okay to assume that capital gains rates are lower than income tax rates. Any money you pay toward taxes on your investments counts against your overall returns. By thinking ahead about which investments to hold in tax-sheltered retirement accounts and which to hold in regular taxable accounts, you can help your portfolio be more successful.
Strategies for Taxable Accounts
Your taxable accounts are accounts whose funds are available to withdraw at any time. There are no tax restrictions like the ones on retirement accounts that limit the amount you deposit or restrict when you can withdraw money. Interest, dividends, and capital gains from investment sales from taxable accounts are taxable in the year they are realized. Your bank accounts, money market accounts, and individual or joint investment account are all examples of taxable accounts.
Use your taxable accounts to hold liquid money for emergencies or for upcoming expenses. Try to concentrate your stock investments in your taxable accounts to take advantage of profits being taxed at the lower capital gains tax rate. Stocks are more volatile than bonds, and if you have losses in your taxable account, you'll be able to count those against your capital gains to save tax.
Pooled investments such as mutual funds and exchange-traded funds don't pay their own taxes. When they have a taxable transaction such as interest earnings or capital gains, they pass it through to their individual shareholders. In your taxable account, this income is taxable to you on your next tax return.
Strategies for Retirement Plans
Retirement accounts — for example, your IRAs and employer retirement accounts — are called tax-deferred accounts. This means that you don't pay any tax on the activity in them until you withdraw money. Retirement plan withdrawals are taxed as income, meaning you can't take advantage of lower capital gains rates for stock investments in these accounts.
Remember, your asset allocation is the mix of investment classes over your entire portfolio — not just in one account. With that in mind, put more of your bond allocation into your retirement accounts to shelter the current income they are creating. Hold more of your bond mutual funds, CDs, and individual bonds themselves in your retirement accounts than you do in your taxable accounts.
Think of it this way: If you're in your 40s or 50s, you probably have about 30 percent or so of your asset allocation targeted to fixed income. By putting as much of that fixed income as you can in your retirement accounts, and then holding the remaining 70 percent of your portfolio in your taxable accounts, you will save tax money.
Contribute to a Roth IRA in the years you're eligible; they are a great tax planning tool. Withdrawals are tax free and can be delayed past age 70½. You don't get to deduct your deposit on your tax return, but the tax free withdrawals in retirement can be a great source of liquidity.
Planning for Withdrawals
Avoid limiting your tax planning flexibility in retirement by overfunding your retirement accounts. This doesn't mean you shouldn't save for retirement! Just think carefully about which accounts to invest your retirement savings into. Remember, money withdrawn from accounts such as IRAs and 401(k)s or other employer accounts is taxed as current earned income. Granted, contributions to retirement accounts will often get you a tax deduction at the time you make the investment, but imagine being retired with your only source of cash being an account that carries a tax on withdrawals. What would you do if you needed to buy a car after you're retired? With only retirement accounts to draw from, you would either incur the interest costs for a car loan or pay income taxes on the money that you withdraw from your IRA to buy the car. Be sure your retirement savings is going into retirement accounts and taxable accounts that bring tax-planning flexibility in the future.
Some risks you can see — such as the stock market going down — but others sneak up on you — such as inflation over a long retirement. Taking enough market risk by including stocks in your portfolio is an important way to reduce inflation risk — the chance that your nest egg won't keep up with the cost of living.