Is Your Portfolio Tax Efficient?
Investors often spend decades focusing on how much to save, only to reach retirement and realize they have very little control over how much they keep after paying taxes. That's where tax diversification comes in.
What is tax diversification? It involves using a mix of account types with different tax treatments to help pursue long-term goals. By strategically managing your taxable, tax-deferred, and tax-free accounts today, you're building in flexibility to help navigate your future tax situation, whatever it may be.
How many account types do you need?
The three basic types of accounts that all investors can consider for improving their tax diversification are taxable, tax-deferred, and tax-free.
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Taxable accounts
Taxable accounts include ordinary brokerage investment accounts, as well as most bank savings accounts. You fund these accounts with after-tax dollars, and you pay taxes on any capital gains or investment income realized each year. Taxable gains and income generated by your taxable accounts can potentially be offset by losses or other adjustments to your income for the year.
Tax-deferred accounts
Tax-deferred accounts include traditional IRAs and 401(k)s that you fund with pre-tax dollars. Your balances have the potential to grow tax-deferred over time. When you make a qualified withdrawal (including a Roth conversion), you pay ordinary income tax rates on the entire amount.
Tax-free accounts
In a tax-free account, your earnings grow tax-free and qualified withdrawals are also tax-free. Contributions, however, are not always tax deductible. Some tax-free accounts are funded with after-tax dollars, such as Roth IRAs and Roth 401(k)s.
Other tax-free accounts are funded with pre-tax or tax-deductible dollars, such as health savings accounts (HSAs). HSA contributions are deductible from your federal income taxes, although not all states offer a state income tax deduction for contributions.
Finally, 529 college savings plans are a type of tax-advantaged account offering tax-free account growth and tax-free qualified withdrawals. Keep in mind that 529 contributions are not deductible from your federal income taxes but may be tax-deductible from your state income taxes (if applicable).
Where should you put diverse types of assets to maximize tax efficiency?
Generally, your most tax-efficient assets should be held in your least tax-efficient accounts, and vice versa. Here's where tax-smart investors typically put their investments.
Taxable brokerage accounts (less tax-efficient)
- Individual stocks you plan to hold for more than one year
- Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds
- Stock or mutual funds that pay qualified dividends
- Municipal bonds, I bonds (savings bonds)
Tax-deferred and tax-free accounts (more tax-efficient)
- Individual stocks you plan to hold for one year or less
- Actively managed funds that may generate significant short-term capital gains
- Taxable bond funds, zero-coupon bonds, inflation-protected bonds, high-yield bond funds
- Real estate investment trusts
Which accounts should you fund first?
Many of us are saving for multiple goals, including funding a comfortable retirement and helping our kids pay for college. When juggling competing priorities, consider funding your savings and investing accounts in this order:
- Start with your company match. Save enough in your employer-sponsored retirement plan to get the full company match, if your employer offers one.
- Consider HSAs next. If you have an HSA tied to your high-deductible health insurance plan, consider maxing it out to fully realize its tax benefits.
- Max out your retirement savings. Contribute the full annual maximum to your tax-advantaged retirement accounts, including 401(k)s or traditional IRAs. Or increase contributions 1% – 2% a year until you reach the max.
- If you're younger, in a relatively low tax bracket, and your employer offers a Roth 401(k) option, chat with your tax advisor about whether a Roth 401(k) might be a good fit for your situation.
- If you're over 50 and want to make catch-up contributions to your 401(k), your catch-up contributions may need to be made to a Roth 401(k) if you have a higher income. Ask your tax advisor about directing your catch-up savings to a Roth 401(k) or a taxable brokerage account. Both could be good options.
- Contribute to taxable accounts. Consider a taxable brokerage account to invest even more. There's no up-front tax break, and income is taxed in the year you earn it. But if you hold assets for more than a year, you may qualify for a lower long-term capital gains tax rate.
- If you have kids or grandkids who might go to college, consider college-savings options last. Retirement should be your top priority before saving for other goals. Once you've maxed out your retirement accounts, then you can earmark any additional savings toward a 529 college savings plan if it makes sense for your tax situation and education funding goals.
How can you minimize capital gains taxes?
Tax-loss harvesting—offsetting capital gains with capital losses—can lower your tax bill and better position your portfolio going forward. To harvest losses, you would typically sell an investment that's underperforming and losing money. Then, you use that loss to reduce your taxable capital gains and potentially offset up to $3,000 of your ordinary income. Finally, you reinvest the proceeds from the sale in a different security that meets your investment needs and asset-allocation strategy.
Keep in mind that tax-loss harvesting is only applicable toward your taxable accounts—you don't need to harvest losses in your 401(k) or IRA accounts. Also, beware that wash sale rules apply.
When should you consider Roth IRA conversions?
A Roth IRA conversion involves moving assets from tax-deferred retirement plans into your Roth IRA. You pay ordinary income taxes on the amount being converted, with a goal of saving on future taxes down the road. It can be especially useful for people who expect to fall in a higher tax bracket in retirement, who want to maximize the value of their estate to their heirs, or who are experiencing lower-than-usual income in the current tax year.
It's a good idea to meet with a tax advisor or a CFP before executing a Roth conversion, as there are many complex considerations and conversions cannot be undone.
There can also be good reasons to avoid doing a Roth IRA conversion. For example, if you need to withdraw the money in the near future to cover living expenses, you may not have time to recoup the taxes you would pay for the Roth conversion. Also, it's usually better if you can pay any taxes associated with a Roth conversion with cash on hand, rather than selling assets to pay the taxes. Finally, if you're planning to donate a substantial portion of your traditional IRA to charity, you could use a Qualified Charitable Distribution in lieu of doing a Roth conversion if you are over age 70-1/2. Qualified Charitable Distributions can be complex, so it's a good idea to meet with a tax advisor before initiating any Qualified Charitable Distributions from an IRA.
Tax planning is an ongoing practice
Building a tax-efficient portfolio is not a one-time event, but rather an ongoing practice. The next article in our series, Is Your Tax Strategy Keeping Up With Your Life?, discusses the importance of reviewing your tax plan at least annually, as well as anytime you experience a major life event. By periodically reviewing and updating your tax plan, you can potentially grow your net worth over a lifetime.
Read next
Next article: Is Your Tax Strategy Keeping Up With Your Life?
Return to series homepage: How to Manage Taxes Over a Lifetime
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This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The securities, investment products and investment strategies mentioned are not suitable for everyone.
Each investor needs to review an investment strategy for his or her own particular situation before making any investment decisions.
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Charles Schwab & Co., Inc. does not represent that any particular tax consequences will be obtained. Before executing any tax strategies ensure you understand the technicalities and certain risks including unintended tax implications. Investors should consult with their tax advisors and refer to the Internal Revenue Service (“IRS”) website at http://www.irs.gov about the potential tax consequences.
Withdrawals from an IRA prior to age 59½ may be subject to a 10% Federal tax penalty. Some states may also withhold taxes or apply penalties for early or nonqualified withdrawals. For a Roth IRA, tax-free withdrawals of earnings are permitted five years after first contribution creating account if one or more of the following conditions are met: the account holder is 59-1/2 or older at the time of the withdrawal; the account holder is permanently disabled; distributed assets (up to $10,000) are used toward the purchase or rebuilding of a first home for the account holder or a qualified family member. Earnings withdrawn prior to that may be subject to ordinary income taxes and a 10% Federal tax penalty, and state taxes and penalties may also apply.
Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own 5-year holding period. In addition, earnings distributions prior to age 59 1/2 are subject to an early withdrawal penalty.
Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.
Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Charles Schwab & Co., Inc. does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
Treasury Inflation Protected Securities are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation. Treasury Inflation-Protected Securities are guaranteed by the US Government, but inflation-protected bond funds do not provide such a guarantee.
Real Estate Investment Trusts (REITs)- Risks of the REITs are similar to those associated with direct ownership of real estate, such as changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer. Investing in REITs may pose additional risks such as real estate industry risk, interest rate risk, risks related to the uncertainty of and compliance with certain tax regime rules, and liquidity risk.
There are risks associated with investing in dividend paying stocks, including but not limited to the risk that stocks may reduce or stop paying dividends.
Neither the tax-loss harvesting strategy, nor any discussion herein, is intended as tax advice and Charles Schwab & Co., Inc. does not represent that any particular tax consequences will be obtained. Tax-loss harvesting involves certain risks including unintended tax implications. Investors should consult with their tax advisors and refer to the Internal Revenue Service (IRS) website at www.irs.gov about the consequences of tax-loss harvesting.
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