As you know, taxes are one of those consequences that are hard to avoid. However, there are ways you can reduce your tax burden by lowering your taxable income from interest, dividends, and capital gains. There are two main ways to organize your investments that will reduce the taxes you pay.
Suitable Assets for Retirement Accounts
There are several reasons why asset allocation strategies work to reduce taxable income. First, interest income and short-term capital gains are taxed at a higher rate than long-term capital gains and qualified dividends. Therefore, assets that generate interest income or short-term capital gains should be allocated to retirement accounts.
Benefits of Short-Term Gains in Retirement Accounts
When you have investments that pay interest income or realize short-term capital gains within a retirement account, you create savings. Mutual funds are a good example of these types of investments – even if the individual investor holds shares in their mutual fund, the fund may distribute short-term gains to investors throughout the year.
The investor will have to pay income tax on distributions from investment funds if held in a brokerage account, but it is not considered taxable income when held within a tax-advantaged retirement account. The only time you report this income and pay taxes on it is when you withdraw it. Since these are retirement accounts, the withdrawal will typically be at a lower tax rate later in life.
Note: Transfers from one retirement account to another – such as when you change jobs – are not considered withdrawals and do not create a tax event as long as they are done correctly.
Investments That Are Suitable Outside of Retirement Accounts
As long-term capital gains are exempted by tax-advantaged retirement accounts, these investments may be suitable for a taxable brokerage account. Standard brokerage accounts do not offer the same tax benefits available in retirement accounts, but you have greater flexibility regarding how taxes affect your investments.
In addition to the ability to control when you sell assets to benefit from long-term capital gains, you can also take advantage of losses. Any assets that incur a loss can be sold to generate a capital loss. Capital losses can be used to offset other capital gains realized in the same tax year. If you have more losses than gains, you can use losses to offset income, but this is limited to a deduction of no more than $3,000 in a tax year.
Note: You cannot offset gains with capital losses from investments when the losses occur in retirement accounts.
A Simplified Example of How to Reduce Your Tax Bill
Here is a simplified example showing how to reduce your tax bill through asset placement:
In this case, the owner keeps all stocks and equity mutual funds in a Traditional IRA and keeps all bonds and certificates of deposit (CDs) in a taxable brokerage account.
Strategy Placement 1: A Tax-Inefficient Portfolio
IRA Account: $100,000 in stocks and equity mutual funds
Non-Retirement Account: $100,000 in bonds / CDs yielding 5% on average
The bonds / CDs in the non-retirement account produce $5,000 in taxable income that flows into the tax return annually.
Strategy Placement 2: A Tax-Efficient Portfolio
IRA Account: $100,000 in bonds or CDs yielding 5% on average
Non-Retirement Account: $100,000 in stocks and equity mutual funds
From
When placing bonds and certificates of deposit in a retirement account, no interest income is reported as taxable income for the year (unless you choose to withdraw from your IRA).
Capital gains must be reported each year, but when there are losses, they can be used to offset capital gains. When you have long-term capital gains in a non-retirement account, they are taxed at a lower rate than interest income and in some cases may not be taxed at all.
Note: You can use negative index funds to reduce annual capital gains distributions. You can also transfer mutual funds to a retirement account and keep stocks only in your brokerage account – deferring any taxes on fund distributions and giving you complete control over the profits you realize in your brokerage account (and the taxes you pay on them).
Comparing Tax Liability
Let’s assume you have an annual income of $81,000 in 2021, placing you in the 22% tax bracket. In the first portfolio, with $5,000 of taxable interest income, you will pay $1,100 in taxes on the interest income.
In the second portfolio, the earnings for the year will depend on market performance that year. Let’s say stocks and stock funds returned $5,000 in the non-retirement account, but all the gains came from long-term assets. Therefore, instead of the 22% tax rate you would pay on ordinary income, these gains will be subject to the lower capital gains tax rate of 15%. This means the total tax bill on those $5,000 gains would be $750 – a tax saving of $350 compared to the first portfolio.
Keep Your Cash Reserves
Of course, common sense dictates that you should not invest all your funds from your non-retirement account in stocks and stock mutual funds. You should keep a sufficient amount of cash in cash reserves in non-retirement accounts as an emergency fund.
Cash reserves in emergency accounts typically invest in things like money markets, certificates of deposit, and other safe investments that will generate taxable income. While this may not be ideal from an asset allocation perspective, it is much easier to withdraw money from non-retirement accounts, so it’s best to keep cash reserves there.
The Balance does not offer tax, investment or financial services advice. Information is provided without regard to the investment goals, risk tolerance or financial circumstances of any specific investor and may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risks, including the risk of loss of principal.
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Sources:
Internal Revenue Service. “Topic No. 409 Capital Gains and Losses.”
Internal Revenue Service. “Mutual Funds (Costs, Distributions, etc.).”
Tax Foundation. “2021 Tax Brackets.”
Source: https://www.thebalancemoney.com/how-to-reduce-taxable-income-by-rearranging-investments-2388986
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