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Managing your accounts to lower taxes

If you own several types of accounts with differing tax treatment, you may have opportunities to reduce your tax bite. Here are 4 of them.

POINTS TO KNOW

  • Divide your investments into different account types based on how tax-efficient they are.
  • If you need to sell shares when rebalancing, do so in tax-advantaged accounts.
  • Think about putting IRA assets in a Roth.
  • Be thoughtful about the order in which you withdraw money from your accounts in retirement.

Locate different investment types in the right accounts

Some investments are naturally more tax-efficient, while others tend to have a lot of distributions subject to higher tax rates. You can put tax-efficient investments into taxable accounts and investments with a heavier tax burden into tax-advantaged accounts, a strategy known as "asset location."

For example, taxable bonds make a lot of income payments, and actively managed funds have frequent transactions that can result in higher capital gains. You can hold these investments in IRAs or 401(k)s so that these distributions don't result in an immediate tax burden.

On the other hand, stocks tend to have distributions that are subject to more favorable tax treatment, and index funds buy and sell less frequently. You can hold these investments (as well as tax-exempt bonds) in taxable accounts because they tend to be more tax-efficient by nature.

Rebalance in tax-advantaged accounts

Because rebalancing can involve selling assets, it often results in a tax burden—but only if it's done within a taxable account.

Selling these assets within a tax-advantaged account instead won't have any tax impact.

For example, imagine your retirement savings consist of a taxable account and a traditional IRA. Your target bond allocation is 30%, but you've become overweighted in bonds and you need to sell some of them in order to buy stocks and get back into balance.

If you sell bonds from your traditional IRA, there won't be any tax impact. If you sold bonds from your taxable account, on the other hand, you could owe taxes on any gain in the value of the bond since you bought it.

Consider a Roth IRA

One of the most important investing concepts is that diversifying your investments can lower your risk. Similarly, having different types of IRAs can lower one type of risk—the risk of your tax bracket in retirement being different than you expected.

Many people just aren't sure what their situation will be—and of course, tax laws are always subject to change. So it might make sense to own both Roth and traditional IRAs.*

If you already own a traditional IRA but think a Roth is right for you, you can open one and start making contributions anytime. Just remember that the annual contribution limit for all IRAs you own—Roth and traditional—is $5,500 a year.**

Or, if you want a larger amount in Roth assets, you do have the ability to convert your traditional IRA assets into Roth IRA assets. You'll have to pay income taxes on the amount you convert, but it could be beneficial in the long run.

Think about which retirement assets to withdraw first

If you're retired and have a variety of account types, withdraw money from them in the most tax-efficient way.

For most people, that means taking distributions in cash (rather than reinvesting them). You should also withdraw from your taxable accounts first, if you need more than the amount of your annual required minimum distribution (RMD).


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REFERENCE CONTENT

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Capital gain

An increase in the value of an investment over the initial purchase price. A capital gain is "unrealized" until the investment is sold, when it becomes a realized gain. Realized gains are taxable and they may be considered short-term (if the investment was owned one year or less) or long-term (if the investment was owned for more than one year).

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Stock

Usually refers to common stock, which is an investment that represents part ownership in a corporation. Each share of stock is a proportional stake in the corporation's assets and profits.

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Taxable accounts

Accounts that don't receive special tax treatment, so all interest, dividends, and capital gains are subject to taxation in the year they're received.

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Rebalance

To move money in your account so that your overall portfolio aligns with the asset mix you selected, usually after market movements have caused it to change.

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IRA (individual retirement account)

A type of account created by the IRS that offers tax benefits when you use it to save for retirement.

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Bond

A bond represents a loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market.

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Diversification

The strategy of investing in multiple asset classes and among many securities in an attempt to lower overall investment risk.

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Risk

Usually refers to investment risk, which is a measure of how likely it is that you could lose money in an investment. However, there are other types of risk when it comes to investing.

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Roth IRA

A type of IRA that allows you to make after-tax contributions (so you don't get an immediate tax deduction) and then withdraw money in retirement tax-free as long as you meet the requirements.

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Required minimum distributions (RMDs)

Annual withdrawals required by the IRS from certain retirement accounts, beginning at age 70½. RMDs are intended to ensure that the assets in these types of accounts are eventually subject to taxation.