When you’re saving for retirement, it is obvious that how much you’re saving makes an enormous impact. However, many times people overlook the importance of choosing where you’re saving strategically. In truth, where you’re saving your money is just as important as how much money you’re saving. Keep reading to learn where the most savvy investors save their money to minimize taxes and maximize their wealth in retirement!
Strategically Placing Your Assets
After tax investment portfolio returns are critical in retirement. Despite this, many investors don’t take the proper steps to minimize taxes on portfolio returns, thereby increasing their retirement wealth. Key research centers, such as AQR Research and Morningstar, all show that taxes are one of the key factors in the ultimate value of your portfolio. One of the best ways to avoid excessive taxes on after tax investment portfolio returns is to strategically place your assets in the correct accounts. Choosing your investments correctly and optimizing where you’re holding your investments can have an enormous impact on the final value of your portfolio.
How to Maximize Your Savings by Holding the Right Assets in the Right Places
Most investors have several types of accounts, each with different tax implications. There are taxable accounts, such as regular accounts at brokerages, whose interest or gains are taxed as ordinary income. Then, there are long-term capital gains accounts, which have a more favorable tax rate for taxpayers, especially for those in higher tax brackets. There are also government, local, or state bonds, which are not taxed when interest is earned.
You also have tax-deferred accounts, such as IRAs or 401K retirement accounts, annuities, and other types of accounts. All the investment earnings in these accounts compound tax-free, but are treated as taxable income when you pull out those funds in retirement. Finally, there are tax-free accounts, like a Roth IRA, Roth 401K, or HSA. The investment earnings in these accounts compound tax-free and can be pulled out without being taxed as well.
To get the most out of your savings, you want to hold your assets in the most tax-efficient accounts possible. This will look different for every investor, but the idea is to choose the right asset and allocation for your situation. Then, to the extent you can, based on the amount you have in each account, plan to hold each investment in the type of account that is optimal for you. This is our rule-of-thumb for optimum asset class and optimum asset allocation, which we recommend to all our clients.
Key Exceptions to Enhance Your After-Tax Returns
Even so, there are some key exceptions that can enhance your after tax returns. The first general rule is that investments with their own tax advantages should be held in taxable accounts. For example, bonds that generate tax-free interest should be in your taxable accounts. Similarly, qualified dividends with tax-advantages, such as a maximum 20% tax rate, and master limited partnerships should be held in taxable accounts.
For stocks, exchange traded funds, and mutual funds should be held in taxable accounts if possible. This is because they earn long-term capital gains, which are taxed at a maximum 20% rate when held for at least one year. If you hold these in taxable accounts, losses can be deducted against other capital gains. In fact, up to $3000 of the capital loss that exceeds capital gains can be carried forward and deducted from other types of income.
On the other hand, tax-deferred accounts should hold investments that generate ordinary income. When the earnings come out of tax-deferred accounts, they will be taxed. However, when they are growing in your tax-deferred accounts, they will compound tax deferred to a higher amount than they would if they were in a taxable account. In this case, you are effectively converting tax advantaged investment returns into ordinary income, since all distributions from these accounts always appear as ordinary income. This holds true even if the investments would be tax-favored in the long-term, such as capital gains and preferred dividends, since they will never be as optimal as a Roth IRA.
The Roth IRA and Roth 401 K are our favorite types of investments, since your money grows tax-deferred in these types of accounts and distributions from these accounts are tax-free in retirement. This means they won’t impact your tax bracket or Medicare premiums. This means you can maximize your tax-free income by having your highest returning investments in a tax-free account.
Maximize Your Returns by Minimizing Taxes
At REAP Financial, a retirement planner in Austin, Texas, we help our clients to consider their risk profile across their investments. Generally, we want to see the most aggressive investments held in the Roth IRA and Roth 401K, so the most growth potential is tax-free. The reality is if you’ve planned well for retirement, you won’t have cash-flow problems; instead, you’ll have tax problems. If you’re not planning correctly, you may not see these issues arise until you’re in retirement. We help our clients accumulate actual wealth and minimize taxes to protect that wealth. If you’re interested in this topic, you should check out our 2024 Tax Strategies for Retirement Guide. You can get your free copy by emailing us at retire@reapfinancial.com!
