Most financial advisors advocate maximizing employer-sponsored 401(k) accounts or municipal 403(b)s. Generally, we agree. However, you could be missing out on tax savings if you aren’t careful.

Before going any further, let’s be clear on what we mean by tax efficient. According to Wikipedia, a financial process is said to be tax efficient[1] if it is taxed at a lower rate than an alternative financial process that achieves the same end.

The collaborative encyclopedia offers two tax efficient examples:

#1 – Passing one’s assets on to one’s heirs using a Grantor Retained Annuity Trust, for example, is potentially more tax efficient than simply letting the heirs inherit the assets.

#2 – An exchange-traded fund (ETF) that follows the S&P 500 Index generates fewer “taxable events” than a mutual fund that follows the same index.

Another Viewpoint

Financial educational portal The Balance[2] uses the term tax diversification and offers the following definition: Tax diversification is a financial term that refers to the allocation of investment dollars to more than one account type.

The Balance clarifies the term further by adding, “Tax diversification is similar to asset location (not to be confused with asset allocation), which refers to spreading investment dollars among various account types (the location of the investment assets) and choosing the best investment types that work best in those accounts.”

Tax Efficient or Tax Diversification

For the purposes of this post, we’ll use the two terms interchangeably, since they both seek the same end result. To help you more effectively evaluate tax efficient strategies, we asked Gratus Capital Director of Financial Planning Kevin Woods, CFP® for some advice.

Lack of Tax Diversification Negatively Impacts Retirement

“One of the reasons tax diversification is important for investment portfolios is due to the need to minimize paying taxes during retirement,” says Woods. “Keep in mind that if you place all of your money in tax-deferred investment vehicles, such as a 401(k) or Individual Retirement Account (IRA), you could end up paying more in taxes as compared to if you’d placed some money in taxable accounts today.”

Avoidable Yet Common Mistake

According to Woods, there are many people who only save for retirement using a traditional tax-deferred retirement account, such as an IRA, and never accumulate savings through an additional investment brokerage account.

“Placing all your money in tax-deferred retirement accounts imposes a built-in liability,” says Woods. “Essentially, a percentage of your retirement savings must go towards paying taxes.”

On the flip side is someone who invests in both traditional tax-deferred retirement accounts as well as other investments through a brokerage account. The investor who only saved using an IRA has to pay ordinary income tax on all of their withdrawals during retirement. Not true for an individual who saved using both an IRA and an investment brokerage account. This investor has a more tax efficient retirement portfolio, since he or she has saved their money in different types of investment accounts that have varying tax implications.

For example, the investor now has the ability to withdraw 50 percent from their IRA and the balance of what they need from a brokerage account and only pay taxes on what they withdrew from their IRA.

Detailed Scenario:

The White Coat Investor[3] provides a detailed example of two retired physicians who each draw $100,000 for the year from their financial savings vehicles. One physician placed all his money in a tax-deferred IRA account, and the other used a mix of tax-deferred and taxed accounts. Ultimately, the physician who used both tax-deferred and taxed accounts ends up paying less in taxes. The end result of the example is: One doctor pays an overall tax rate of 12.5 percent, while the tax-diversified doctor pays 1.9 percent.  

4 Different Tax Planning Investment Accounts

To build a tax-efficient investment portfolio, it’s important to distinguish among the four different types of investment accounts used for tax diversification, says Woods.

These include:

Taxed-Deferred (Pre-Taxed) – such as a 401(k) or 403(b). These vehicles are considered qualified investment accounts and have several benefits. Investopedia provides a simple explanation to help differentiate between qualified and non-qualified[4] investment accounts.

Why are tax-deferred accounts so popular? Woods isolates three key benefits:

“First, tax-deferred accounts enable you to lower the amount of income you pay taxes on now, increasing your take-home pay,” says Woods. “Second, since you’re deferring taxes until you withdraw funds during retirement, your investments grow tax-free during the years you’re making contributions. Finally, most retired investors are in a lower tax bracket as compared to when they were working, lowering their tax obligations when they begin withdrawing.”

After-Tax – such as a Roth IRA, Roth 401(k) or Variable Annuity. There are no upfront tax deductions when you contribute to these retirement accounts; however, you pay no taxes on withdrawals during retirement, and investment growth is tax-free.

“As a rule-of-thumb, if you’re age 55 or younger, a Roth 401(k) or Roth IRA makes sense to the extent that you’re not in the highest tax bracket,” says Woods. “Roths generally make more sense when you have more time to invest before retiring and you’re in a lower tax bracket.”

Taxable – such as stocks, mutual funds, bonds, CDs and money markets. Contributing to these taxable accounts means that you pay taxes each year on the dividends, interest and realized capital gains, rather than when you withdraw these funds during retirement.

Tax-Advantaged – such as municipal bonds or life insurance. These financial vehicles typically include a mix of tax-deductible, tax-deferred, and tax-free as well as other tax benefits.

Possible Diversification Strategies

“There are a number of strategies you can use with your portfolio management to strive for tax efficiency,” says Woods. “One approach is to have all your income-producing investments in your retirement account, thereby not requiring you to pay taxes on your interest each year. What’s more, you can also put all your stocks in taxable accounts, helping to provide a preferred lower tax rate on your dividends and long-term capital gains.”

In Closing

While saving for retirement may seem like a straightforward process, complexities arise when it comes to tax liabilities. “There are a myriad of variables to consider when trying to lower your tax liability both for today and during retirement,” says Woods. “I encourage all individual investors to seek the help of both a CPA and a financial advisor.”

Why both?

Because a CPA is an expert in tax laws and the tax preparation process, whereas a financial advisor is an expert at looking at an individual’s overall financial life. The latter includes financial and estate planning, as well as risk and investment management. Investors need both advocates to help ensure a tax efficient financial portfolio, says Woods.

Woods’ number one recommendation for investors, “Have more than just an employer-sponsored retirement account,” says Woods. “If that’s all you have, then it’s likely your portfolio is not tax efficient.”

At Gratus Capital, our team is made up of CPAs, MBAs and Certified Financial Planners. We believe that it takes a well-diversified skill set and team approach to ultimately guide individuals to financial freedom while lowering their tax burden. If you have questions regarding tax diversification or any other financial concerns, please contact us.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

[1] https://en.wikipedia.org/wiki/Tax_efficiency

[2] https://www.thebalance.com/tax-diversification-with-investing-2466705

[3] https://www.whitecoatinvestor.com/taxes/tax-diversification-2/

[4] http://www.investopedia.com/ask/answers/206.asp