Friday, October 18, 2019
Keeping Uncle Sam in Mind When Allocating Investments
Anthony C. Kure, CFP®

Anthony C. Kure, CFP®

Managing Director of Northeastern Ohio Market, Principal
Wealth Management, Cleveland - Akron

Keeping Uncle Sam in Mind When Allocating Investments

“Location, location, location” is a well-worn axiom keen-eyed investors employ when evaluating a potential real estate purchase. However, “location” can also be applied when thinking about the types of investment accounts that “house” stocks, bonds, and other investments. Some investors may reduce their tax liability and increase their after-tax returns by wisely allocating investments between taxable and non-taxable (retirement) accounts.

Why? Because the interest, dividends, and capital gains from investments in these accounts matters to Uncle Sam, who we all know is quite interested in collecting taxes on such income where he can.

So what’s the message? In very broad terms, optimizing to some extent may help reduce your tax liability. It may benefit some to keep higher income-generating assets in traditional tax-deferred accounts and lower-income, growth-oriented assets in Roth IRA and/or taxable accounts. This isn’t always applicable and depends on investors’ specific circumstances, particularly stage of life, which is the key determinant of asset allocation. 


Traditional Tax-Deferred Accounts

Let’s start with what often makes sense for traditional tax-deferred accounts. These include traditional 401(k)s, traditional IRAs, and other retirement accounts. Contributions to these accounts are tax-deductible (subject to limitations) and individuals do not pay taxes on dividends, interest, or capital gains. Given the tax-deferred nature of these accounts, investors may opt to hold their high income-earning assets in these accounts so the income paid throughout the year is not taxed. Income taxes are due when distributions are made from the account, often not until the retirement years. Typically, the taxpayer would be in a lower tax bracket at that time compared to the peak wage-earning years. 

Roth IRAs

The next account type to consider comes with many advantages. While contributions to a Roth IRA or Roth 401(k) are not deductible (and subject to eligibility based on income), they are usually best suited to hold higher-growth, higher-volatility assets. Mutual funds that are inefficient for tax purposes are also more appropriate in a Roth account. These funds tend to pay higher levels of capital gains distributions due to more frequent trading during the year, but in a Roth account no taxes are due on such gains. Withdrawals are not taxed either (after age 59 ½) due to the fact “after-tax” money was contributed. In addition, higher-growth, higher-volatility funds are likely to grow substantially over the long term. This does not create a tax issue, as the owner and their future heirs would not pay taxes on the capital gains when investments are sold. Further, there are no required distributions from Roth IRAs during the owner’s life like those required in traditional IRAs.

Taxable Accounts

Finally, we have the standard taxable account which holds “non-retirement” assets. It’s important to keep in mind that, as the name indicates, dividends and interest are taxable each year as income. In addition, capital gains tax is due annually on gains of appreciated assets that were sold. Under current law, the rate on long-term (held more than one year) capital gains is 15% for most taxpayers, which is favorable when compared to ordinary income rates. If held for less than a year, gains on a sale would be reported as a short-term capital gain, which are taxed at the higher ordinary income rates. 

It may be wise to hold any cash reserves in these accounts, which can be accessed tax free for any unexpected expenses. And given today‘s low interest rates, the cash will provide minimal interest income and minimal tax liability as a result. Lower-income, lower-turnover mutual funds may also make sense in taxable accounts. Capital gains taxes can also be reduced by looking for opportunities to offset capital gains with capital losses, a process known as tax-loss harvesting.

The Bottom Line

Taxes are not the most stimulating topic to discuss, but in many cases the tax bill is a families’ largest annual expense. So investors should keep a sharp eye on any means to legally minimize their tax burden. It’s not easy to keep track of all the assets across a multitude of account types, nor is it easy for most people to keep up on changes in tax law. But with a holistic and top-down approach, a smart and tax-efficient allocation may provide some relief, allowing investors to keep more of their wealth in their own hands.

Find more practical advice on a wide variety of wealth management topics by exploring our JIC Blog: Beyond the Numbers library.