No one wants to pay the IRS any more taxes than necessary and most prefer to put the deed off as long as possible. That’s why investors and taxpayers use tax-deferred accounts as the favored approach to tuck away their retirement savings.
Tax-deferred instruments such as IRAs and 401(k)s do help millions plan a successful retirement, but taking another step can be beneficial and complementary. One needs to look at taxable savings accounts to add another dimension to the portfolio in terms of flexibility and efficiency.
Flexibility
It pays to evaluate the structure of a portfolio. Not only do investor’s want to get the greatest return with the least amount of taxes paid, they also want to have some flexibility. Investors in the 40-to-50 age group typically have most of their assets in 401(k) plans because it is the tax system that we live in. If investors neglect to save into an after-tax account, the flexibility they have before age 59 1/2 is limited. That’s also true during retirement when money is required from the portfolio assets.
What if cash is needed for a new car, a new roof or some other emergency? If the money is taken from tax-deferred accounts, before 59 1/2, taxes have to be paid on the amount taken out — as well as a 10% early withdrawal penalty. If the withdrawal is after age 59 ½, ordinary income tax will still be owed but no withdrawal penalty.
For example, if an investor is over age 59 ½ and needs $30,000 for a new roof, he/she will need to withdraw approximately $40,000 from the tax-deferred account to net enough for the $30,000 new roof (assuming a 25% tax bracket). If the person is under age 59 ½, the gross amount needed is now a little over $46,000. Not very fun and not very flexible!
If the investor has a taxable account, however, there is no age 59 ½ early withdrawal restriction. The taxes on the withdrawal will depend on realized capital gains or loss on the investments sold from portfolio assets. If it is a long-term realized gain, the taxes will be calculated at the capital gains rate (currently 15%) versus one’s ordinary income tax rate, if sold from tax-deferred assets. This is one good reason why it is beneficial for investors accumulating wealth to save into both tax-deferred and taxable accounts.
That’s where after-tax saving comes in handy. One can take money from a savings account or other taxable instrument and cover the emergency without having to pay a penalty as with a tax-deferred account. If managed properly, the taxes can be minimized.
Tax-Efficiency
What makes a taxable account, “taxable”? Taxable means taxes must be paid in the same year or period in which the income is earned. Taxes are paid on income such as interest, dividends, capital gains distributions, and realized capital gains.
Tax-deferred accounts, however, shelter investments from taxes as long as they remain in the account. Traditional IRAs and 401(k)s are examples of tax-deferred accounts.
Another key advantage to a taxable account is the ability to create a tax-efficient portfolio, which can possibly minimize capital gains taxes. Investors should realize that some investments are more tax-efficient than others. It’s better to put the more tax-efficient investments in the taxable accounts. Consider broad-range index exchange-traded funds or index mutual funds especially for equity sectors. Look for investments with low turnover, which limit capital gains distributions. Structure less-efficient investments such as taxable bonds and high-dividend equities in the non-taxable area.
A well-conceived investment plan should include taxable and tax-deferred savings as important components of a strong financial foundation. Understanding these concepts will result in better decisions now and in the future.
