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Is Your Retirement Investing Strategy Tax Efficient?

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When it comes to retirement, I feel that even though I’ve saved quite a bit into 401k’s and Roth IRAs, I generally don’t have a clear sense of how I should be using these accounts and how much I will need in retirement. My personality is such that I generally try to focus on one area of my personal finances and try to put the others on autopilot until I can give them their due time and concentration. Retirement autopilot consisted of putting away as much as I could into my 401K and contributing the maximum to my Roth IRA, then selecting a nice mix of high growth funds and stocks in both. I thought I was being relatively tax efficient (and I am, relatively), but I wasn’t being the absolute most efficient.

In between your investment income and your pocket is a little organization known as the Internal Revenue Service. The fee the IRS charges for you to keep both of your legs in working order is known as a tax and that tax comes in three forms: tax-free, short term capital gains, and long term capital gains (more on capital gains taxes). In a Roth IRA, you get distributions tax free. In a 401K and Traditional IRA, you effectively are taxed at the short term capital gains rate on withdrawals because the disbursements are treated as income. None of your retirement assets come out as long term capital gains.

So what does this mean? Put your most tax inefficient investments (day-trading, short term holdings) in your 401K because it can’t be taxed more than short term capital gains. Now, that’s a concept everyone understands once they’ve heard it, but it’s also important to understand the other side: don’t put tax efficient investments in your retirement accounts. (Roth excluded, since it’s tax free growth)

What happens with a lot of people is that they see their nest egg as something that shouldn’t be played with so they put it in nice safe index funds and mutual funds. They then have another brokerage account where they’re investing in the latest hot energy stock, IPO, or tech company; which they fund with their “play” money. For sanity’s sake, that may be a good idea but it’s terrible from a tax perspective (which isn’t the only consideration when it comes to investing, but it happens to be the focus of this post).

What should you do instead? Buy those high flying stocks in your 401k and Traditional IRA because no matter what happens you’ll still be taxed at the highest rate (or go with the Roth because you won’t be taxed on it). Save the “safer” investments to your brokerage account where you can benefit from long term capital gains tax rates.

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15 Responses to “Is Your Retirement Investing Strategy Tax Efficient?”

  1. Jeremy says:

    Good point. A lot of people ignore the tax efficiency of their investments completely. One thing to note is even though you want to put tax inefficient investments in your retirement accounts you also want to keep your investment allocation in check. So don’t throw all of your index funds out the window and simply invest in funds with high turnover and individual stocks. That could spell disaster.

    But, when you do feel like buying 100 shares of that new pharmaceutical company that you think will have some cancer curing drug in 30 years, throw it in a retirement account instead of your regular brokerage account. Better yet, throw it in a Roth. For all you know 30 years from now that stock could have split 20 times and appreciated in value by 10,000%. That would be a lot of tax-free money. Leave that in your brokerage account and who knows what tax rates will be 30 years from now. You could end up seeing half of your money eaten by the IRS.

  2. Anonymous says:

    Hi,

    What is your opinion on contributing your savings to the cash value of a Universal Life Policy? My understanding is that it will grow tax free, similar to a Roth, but does not have a dollar limitation of $4,000.00 annually. Then, when you are ready to withdraw money for retirement, you can either take out a portion or borrow a portion, all tax-free. Also, what do you think about transferring money from a tax-deferred account (IRA or 401K) to the cash value, pay tax on the money while you still have large deductions to claim on your 1040 and then be able to withdraw that money at a later date without paying tax?

  3. Neha says:

    Actually, you’re missing an important point and possibly giving bad advice — one reason you *don’t* want to put your high-risk investments in a tax sheltered account (like a 401k or roth ira) is because you can’t harvest the losses.

  4. jim says:

    Jeremy – I agree, you certainly don’t want to ignore the other tenets of prudent investing like asset allocation and feel like you should “gamble” with your retirement account.

    Neha – No advice is correct in all situations and scenarios, I’m only seeking to give my own thoughts so that they can be critiqued (as you’ve done, I welcome all comments, negative or positive) because I can easily be wrong (i’m a novice after all!). Yes, keeping a risky investment in a retirement account does mean that if you do lose money, you can’t offset gains… a very good point. However, you must balance that with the fact that you could be taxed less on increases if you put it in a Roth. It’s a trade-off, like everything in life. :)

  5. samerwriter says:

    Many (perhaps most or all?) 401k plans don’t allow trading of individual stocks, and the funds are generally fairly conservative. So it’s unlikely that most people will have considerable short-term gains in these accounts.

    Of course IRAs are considerably more flexible in the investment choices.

    If you have both tax-advantaged and taxable accounts and want to own a mix of bonds and stocks, the choice is simple; put your coupon-bearing bonds in a tax-advantaged account (or they’ll be taxed at income tax rates) and your stocks in the taxable account (where the capital gains and dividends benefit from lower tax rates).

    Of course all that assumes that you’re still making sure your allocation is appropriate.

  6. I’ve never thought much about how taxes at your ordinary rate could very be higher than the long-term capital gains rate. That’s true today, but it could change in the future. Assuming it doesn’t change in the future, is there a way to move shares out of a traditional IRA, hold them for the required time to be long term capital gains and then sell them with the minimal tax penalty? I think the answer is no, but I feel like that would be something that could change over the next 30 years or so.

    I definitely have to think about this some because it seems that long term it could make more sense to NOT fund a 401K and get taxed at the expensive rate at the end. Instead just using the after tax money to buy and hold an ETF (minimize the expenses by using something like Zecco) and paying the long-term capital gains. It seems close enough to me that I should do the math.

  7. Jeremy says:

    Well you could just buy an ETF in a taxable account and focus on long-term gains, but who says there will be a long-term capital gains tax in 20 or 30 years? Will it be 15%, 20%, 5%? Nobody knows, maybe in 30 years we don’t even have income tax in the same form it is today. Too many unknown variables I think to use a buy and hold for the lower long-term cap gains tax as a retirement strategy.

    Plus by funding a retirement account like a 401k or traditional IRA you have the reduction of taxable income each year with contributions. If you are maxing out a 401k and IRA every year (assuming 15,500 and 4,500 limits were to remain flat for 30 years just for simple math) you have the ability to reduce your income by $20k each year for say 30 years, or a total of $600,000 less in income over your lifetime. If you were in the 30% tax rate for that time you would have saved $180,000 in taxes.

    That is quite a bit of money saved in taxes. Of course this could be a good or bad thing depending on tax rates when you begin to withdraw the money, but personally I’d like to take advantage of as many of the existing tax breaks that are available and knowing exactly what the benefit is rather than rely on something completely unknown.

    I think the best solution is a good mix of retirement accounts and taxable accounts and leverage the benefits of each. Then when you do reach retirement you can structure your withdrawals from the various accounts to minimize the tax burden during those years and as our tax rates and laws change (they undoubtedly will).

  8. Steve says:

    Trading with a retirement account sounds very risky.

  9. EMF says:

    Jim, while I agree with your basic point about tax efficiency, I have a couple of points of difference.

    First, I don’t think the Roth is really any different from a 401k from a tax efficiency point if you have gains. On the other hand, if you have losses might be better to have them in the 401k since you never paid taxes on them in the first place. (A point to Neha’s comment III above, also considering that losses can only be used to offset gains).

    The other point is that this strategy is useful for someone whose ability to save exceeds the contribution limits for tax-advantaged savings. For myself, my savings can be absorbed within the contribution limits of my 401k and a Roth IRA. I think this factor is significant for most people, who save less than the $15K 2006 contribution limit to a 401k. If I had capability to make extra contributions beyond that, I could invest them for long term capital gains and make some short term trades with a _portion_ of my total funds in a brokerage account under a self-directed traditional IRA. I think it’s OK to put a portion of your money in risky investments in a diversified portfolio that also includes conservative investments.

  10. Jeremy, I agree, we can’t imagine what the future tax rates may be. Like assuming that the dealer has a 10 hidden in blackjack, I make the assumption that it’s going to be like it is today. You are right that there are a lot of tax savings today, but when you take 1M (which is easily conceivable after compounding) out the difference between that 30% tax bracket and 15% is $150,000. Granted those are future dollars which are worth less due to inflation.

    That 1M amount I suggested may have been conservative, however. If you are really going to be putting 20K a year for 30 years, you may have more than 2M in there.

    In the end, I wouldn’t be surprised if sometime in the not to distant future someone changes a policy to allow people to sell and transfer shares out at the long-term capital gains rate.

  11. Weekly Roundup – 12/29/06

    Here’s a quick look at some of the articles that caught my eye over the past week:
    Jim wants to know if your retirement investing strategy is tax efficient.
    MBH applies lessons learned from crocheting to his investing life.
    FMF has a tip for savi…

  12. rv_ca says:

    I was reading the January Issue of Fortune and found a short article saying “go and use your IRA account for Bonds and non-retirement account for Large cap and other stock based investments – this is the most tax effiecient way” – This completely threw out my prior understanding of tax efficiency.

  13. moominoid says:

    If you plan on accessing all your account simultaneously at some retirement date it makes sense to put tax inefficient investments like bonds into the retirement account and tax efficient ones into a taxable account. If you plan to retire early and use taxable accounts for this you may want a different strategy. I do active trading in my Roth IRA as well as in taxable accounts. My 403b has limited choices and I am more or less buy and hold funds there (same with my Australian retirement account).

  14. Bob says:

    Our federal government has gone into debt to the tune of $12 trillion plus another $100 trillion in unfunded liability for Social inSecurity, Medicare, Medicaid and federal pensions. We are near historical lows with federal tax rates. Tax rates obviously have to go up.

    Does it make sense to take a tax deduction for a traditional IRA or 401K? Of course not. We need tax free income at retirement. Roth IRA and Roth 401K plans are good. Another great plan is an Index Universal Life policy, which provides tax free growth and withdrawals, with no market losses.

  15. Peter says:

    Interesting discussion. However, there are many programs that will help you determine what dollar amounts you need at retirement. Depending on your heir goals, your traditional pension checks, i.e. defined benefit checks, and your retirement needs, it could be a wide variety of numbers, such as 1 million, 2 million, 3 million,etc. Peter


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