Understanding the strategies can be very beneficial in a rising tax rate environment.
After-tax savings include bank and non IRA brokerage accounts and investment real estate as examples. Basically, anything that’s not a tax- deferred retirement account or a Roth IRA would be considered after-tax. After-tax savings strategies have become more prevalent in the face of the growing concern that tax rates may be rising, making tax-deferral a poor choice.As a result, financial planners have had to retool in order to devise innovative new strategies that can keep the IRS from taxing more of your retirement. On an after-tax basis, turnover can really damage your return in typical mutual funds. That’s why I use funds with low turnover for my client’s taxable account. This technique minimizes annual capital gain distributions allowing the position to grow untaxed. If you do this, your money will grow at a faster rate. Remember, it’s not how much you earn, it’s how much you keep!
I want to tell you a story about a retiree, Shirley Bachman to help illustrate the importance of including after-tax strategies in your retirement plan.
Case Study: Shirley Bachman, retiree
Shirley Bachman was a widow who had accumulated what she thought would be a comfortable savings for retirement. Her financial assets totaled $1 million and it was split nearly equally between an IRA and a taxable account. She counted on the income from her investment accounts, Social Security, and a small pension to make ends meet.
When Shirley turned 70½, she had to begin to take her required minimum distribution (RMD) from her IRA. This additional taxable income was making 85% of her Social Security taxable. She found making the higher quarterly estimated tax payments was straining her budget. What she needed was a more tax-efficient way to generate income.
Shirley still lived in the single family home she’d raised her children in and didn’t really want to move. However, she was considering the option of selling her home and moving into a smaller condominium that would hopefully be less costly to maintain.
When Shirley came to me for financial advice, I found she considered herself to be a moderate investor. She knew growth would be needed to help keep pace with inflation. Her accounts were invested equally in stocks and bonds. Like most Americans, she had invested both her taxable account and her IRA the same way. Could there have been a better way to allocate the investments from a tax-efficient standpoint and still maintain the moderate risk allocation?
The answer was yes—an answer supported by a study from Robert Dammon and Chester Spatt, finance professors at Carnegie Mellon. Dammon and Spatt published a study in the Journal of Finance1 that showed some simple rules of thumb. Their first assertion was investors should put their taxable fixed income investments (government bonds, corporate bonds, and certificates of deposit or CDs) along with real estate investment trusts (which are mostly taxed at ordinary income tax rates) into tax-deferred accounts. Ordinary income tax rates can be as high as 35%, but long-term capital gains and qualified dividends are taxed at a maximum rate of 15%, so the stock assets should be placed in taxable accounts. The study found this allocation was beneficial even for those who trade stocks frequently.
Thus, putting the most highly taxed assets into tax-deferred accounts like an IRA or 401(k), and holding those assets with tax preferred treatment like stocks and stock mutual funds, which generate long-term capital gains and qualified dividends, in taxable accounts can easily add 20% in portfolio value over time. This is especially true for middle-aged investors who have a longer period to compound. (Note: calculating taxes can get complicated, since it depends on how long you hold the security and whether the accounts will be subject to state income tax.)
Some investors would argue it doesn’t matter if you hold bonds in a taxable account, because they’d only invest in tax-free municipal bonds. Dammon and Spatt’s study concluded municipal bonds should only be used in taxable accounts after the tax-deferred accounts have been filled with taxable bonds. The reason is municipals historically pay a much lower yield than taxable bonds. Earning the higher returns on the taxable bonds in a tax- deferred account more than offsets the tax paid when you have to start drawing from those accounts and paying tax on the distributions.
The disadvantage is compounded if you end up holding stocks in the tax- deferred account, because you’re holding municipal bonds in the taxable account. You lose the 15% tax treatment on your capital gains and dividends, because all withdrawals from tax-deferred accounts are taxed as ordinary income. The investor could end up paying as high as 35% on the capital gains earned from his or her stock holdings in an IRA.
Paying the lower tax rates on stocks is just one advantage of holding them in a taxable account. The other comes from the reality that not every stock investment is going to work out favorably. Every portfolio is going to have some losers from time to time. Taking a loss in a taxable account allows you to write off that loss against other income. Capital losses will offset capital gains 1 to 1. In the event you have a net loss, you can write it off against other income up to $3,000 in one tax year. Losses over $3,000 can be carried forward to future tax years until they can be used. Losses in a tax- deferred account can’t be used on your tax return.
The argument we frequently hear against this strategy surrounds the need for a lump sum withdrawal when the stock market is down. What if you need to take out $50,000 in the middle of a stock market correction? Wouldn’t you be putting yourself in a situation where you bought high and are now selling low? Shouldn’t you keep some money in bonds in the taxable account for this situation? Not at all. The objective in this situation isn’t to reduce your stock holdings in a down market.
To accomplish this, we’d sell $50,000 of the stock security in the taxable account and simultaneously sell $50,000 of a bond in the tax-deferred account. With the proceeds from the bond sale, we’d buy $50,000 of the same security. You’ve effectively taken your withdrawal from the bond side of your portfolio. (Of course, be careful if you’re selling a security in your taxable account at a loss. If you would buy the exact same security in your IRA, a wash sale would be triggered, and the loss won’t be allowed. In this situation, you want to buy another stock or stock fund but not the exact one you just sold at a loss.)
In Shirley’s case, we were able to move all of her bonds to her IRA account and replace the bonds with stock mutual funds in her taxable account. Using the asset allocation strategy advocated in the next section, we selected diversified stock mutual funds that complemented her other stock holdings. We also replaced the stock fund holdings she had that were underperforming or not already tax-efficient. By holding a small cash position and periodically selling portions of her stock funds to replenish it, she was able to take monthly distributions that equaled the income she’d been receiving.
Finally, we arranged to have her tax liability withheld from her RMD at the end of each year. This eliminated the need to make quarterly estimates. Paying her tax liability at the end of the year was also beneficial in that it allowed her to retain earnings on the tax payment longer than if she had sent in the money quarterly. Her cash flow improved significantly, and her total tax bill was reduced by nearly 15%.
1 Rober M. Dammon, Chester S. Spatt, and Harold H. Zhang, “Optimal Asset
Location and Allocation with Taxable and Tax-Deferred Investing,” The
Journal of Finance, Vol. LIX, No. 3 (June 2004): pp. 999-1038
- Decide on your allocation between stocks and bonds and then allocate
all of your bonds to your tax-deferred accounts first.
- Only use municipal bonds in your taxable account after you’ve filled
your tax deferred accounts with taxable bonds.