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After an overall asset allocation is determined, minimize the impact of taxation on your investments by locating more tax-efficient holdings (low dividend, high capital gain, tax exempt and index funds) in your taxable accounts and least tax-efficient (high dividend and high interest bearing) holdings in your tax-deferred accounts. For example, if your overall asset allocation were 50% bonds and 50% stock, you would consider having your IRA hold all the bonds and your taxable brokerage account hold all the stocks. Since most people do not have equal amounts in each account and all stock strategies are not equivalent, it is not that easy. You will see the principle will be useful in efficiently allocating across investment vehicles.
Rebalancing your portfolio can also result in tax consequences. If a trade would result in a capital gain, executing it in your tax-deferred account will not have an immediate tax event. Taking losses in your taxable account will create immediate tax deductions. Paying attention to where you trade will result in substantial tax savings over the life of your investment portfolio.
Maximize your tax-deferred retirement contributions
The goal of wealth management is to achieve a preferred standard of living through time. We invest in education to generate higher future earnings (a better life for you and your family). We promise some of our future earnings in a home mortgage so we can have a higher standard of living today (smoothing consumption over time). Saving for retirement is giving up some spending today to supplement a lifestyle after we retire, and our labor income is unavailable.
Retirement income can be generated from multiple sources. Liquidating real assets (i.e., selling, downsizing, or taking equity out of a home), principal and income from after-tax investments and pre-tax retirement plans (401K, 403b, IRA, etc.). These qualified pre-tax retirement plans have a unique set of incentives. If there were a set of commandments for investing, maximizing qualified tax-deferred retirement contributions would be number one. Some of the reasons are:
- Instantaneous high rate of return: If your 401K maximum contribution is $15,000 and you are in a 35% marginal federal, state and local tax bracket, you save $5,250 in taxes. You may also think of investing this $5,250 tax saving in a taxable account. Now you have instantly turned $15,000 into $20,250 of investment wealth in two accounts.
- Future tax avoidance options: Note that you will owe ordinary income taxes on your 401K withdrawals in retirement, but you can strategically take withdrawals in the future. Timing options include managing to a lower tax bracket via drawing from multiple after-tax sources at the same time, have offsetting losses, tax credits, borrowing from the account, direct charitable contributions and a bequest. In the meantime, earnings in the fund are accumulating tax-free. The taxable investment ($5,250), however, will only have tax liability on interest, dividends and capital gains/losses as they realized.
I should note that I am not a fan of Roth plans. It isn’t a no-brainer. One might think it makes sense when you are in a low tax bracket and the immediate tax savings of a tax-deferred plan is negligible. The benefit is that many years later the accumulation will be tax free. That makes some sense, especially for disciplined savings. However, if you are in that low a tax bracket, taxes on dividends and capital gains will be initially negligible. Why deal with the constraint of waiting until retirement to access the accumulation when it will be more likely that you will need the money sooner for a down payment on a house, education expenses or a business venture. The latter two motivations will add human capital and increase income faster. In this case, accumulating wealth sooner and having a bigger tax problem is a good thing! In a high tax bracket, a traditional tax-deferred plan with the immediate tax saving generally dominates the Roth alternatives. Paying the tax now and investing in a Roth plan is forgoing both the current tax savings and future tax options of managing to lower rates or never paying the tax at all. Examples of never paying the income tax include charitable contributions directly out of the plan that also count toward your required minimum distribution; using the plan to pay tax-deductible medical expenses when they are likely to be high; outliving your plan to be rolled over into your heirs plan and when the investment ends up worth less in the future. This last possibility is more likely for those converting to a Roth near or in retirement. Paying taxes in advance on a gain at the ordinary rate really hurts when the reinvestment ends up in a loss. Like all options, the tax option is worth more alive than dead!
- Employer matching programs: Many employers encourage employee contributions with matching or profit-sharing programs. Contributing at least enough to capture an employer matching contribution is the ultimate no brainer! During my time at the University of Michigan, 5% of salary contributions by a professor to a 403b plan were rewarded with another 10% contribution from the university. That is an instantaneous 200% return with no risk! There is no other investment opportunity I know of that can beat that! As department chairman, I made it clear to new faculty (fresh Ph.D.) that not taking this investment opportunity because of a cash flow excuse would result in removal from the classroom (unfit to teach finance). Find a way to use the financial markets to solve your cash flow problem (i.e., short-term borrowing to finance the investment).
- Supplementary plans: Use available supplementary plans to reach the maximum dollar contribution allowable.
- Disciplined savings: Regular contributions to your tax-deferred retirement plan is a savings commitment that requires little maintenance and will typically be sufficient until your labor income reaches a level for additional savings in taxable investment vehicles.
- Asset protection in personal bankruptcy: Qualified retirement plans are generally exempt from creditors. This is very important for sole proprietors and entrepreneurs. It is also a form of downside risk management in our litigious society.
- Minimize market-timing risk: An employee’s 401k payments are typically made out of regular paychecks. This avoids the lump-sum risk of having to move a large percent of your personal wealth from cash to risky assets just prior to a major downturn or out of the market prior to a large upturn in the market.