Manage Your Investment Holdings - Tax Efficiently

Our retirement savings are generally made up of two types: tax sheltered plans (401k retirement plan, IRAs, etc) and regular investments. Both investment growth within and withdrawal from each type trigger different tax consequences. How can we minimize taxation yet maximize 401k investment returns?

You generated your qualified plan investment accounts through tax-deductible contributions to your 401(k) plan, IRAs, or other similar tax sheltered plans. These grow tax-deferred. But any withdrawal is taxed at ordinary income tax rates - a progressive and high tax rate system. We'll call these 'tax-deferred' accounts.

Regular investments are made up of after tax contributions and have no tax-deferred advantages. If you had stocks, bond, CD, and mutual fund, bank savings - type investments, only the yearly earnings (i.e. dividend or interest) and any increase value of these investments are taxed. We'll call such regular investments 'taxable' accounts.

Yearly earnings of ordinary dividends or interest are taxed at ordinary income tax rates. Typical (designated as qualified) dividends are taxed at long term capital gains rates - which are 15% or untaxed (for 2008-2010) for those taxpayers below the 25% income tax bracket. Any item taxed at long term capital gain rates do not make appropriate 401k investments as they are best held outside of any retirement plan to benefit from the preferential tax rate they already receive.

Increased values of growth investments are taxed when sold at the capital gains tax rates - short term or long term. Short-term (holding for a year or less) are taxed at ordinary income rates. Long-term (holding for more than a year) are taxed low as said above. If you hold long term growth assets, these are not appropriate 401k investments as they do better just being taxed at the preferential 15% rate. If we use the same investment as a 401k investment, we may eventually pay as much as 35% tax when we maker our 401k distribution.

The annual return of any investment is enhanced if it's not taxed yearly. Capital investment, stocks, houses, etc, that give small or little yearly earnings but allowed to grow long term, don't need the benefit of a tax-deferred account. In fact their long term gains are much less taxed in a taxable account.

But those investments (taxable bonds, high stock dividends) that generate a lot of annual earnings grow better through yearly compounding when they're in tax-deferred accounts, such as 401k retirement plans. These earnings would be subject to income tax rates if left in a taxable account. So if we're going to let them grow, we'll keep those in a tax-deferred account. If we withdraw earnings, we lose nothing by keeping them in a tax-deferred account.

Allocating investments among account type

Once you’ve decided on an appropriate allocation between income, equity and cash equivalents for your stage in retirement, you can then allocate each of these among your taxable and tax-deferred accounts (401k retirement plam, IRA, etc) to minimize taxation and maximize growth.

The table presents suggestions about the investment type to allocate in between the two account types. Those assigned to the tax-deferred accounts generally produce a lot more yearly earnings that would otherwise be subject to yearly ordinary income tax rates. Those investments not so subjected are left in the taxable accounts.

But, above all, don’t just be driven by avoiding taxes. Concentrate on first making quality investments that serve your purpose. Give us a call or fill out the card so we can help you find a suitable allocation for your tax saving purposes.

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