Managing your accounts to lower taxes
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.
GOOD TO KNOW!
If you have to rebalance within a taxable account, you can minimize the tax impact by adding additional money to your underweighted asset class without selling any existing investments.
This method may take a little longer (if you have to add small amounts over time) but could still be more beneficial than triggering a large tax bill.
GOOD TO KNOW!
In a nutshell, it's a good strategy to pay taxes when you think they'll be lowest. So if you expect your tax rate in retirement to be higher than it is now, you're better off paying taxes on IRA contributions now and avoiding taxes when you withdraw them, which you can do with a Roth IRA.
On the other hand, if you expect your tax rate to be lower when you withdraw your retirement money, you're better off deferring the taxes until then, which you can do with a traditional IRA.
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 $7,000 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).
*When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
**For 2024. If you're age 50 or older, you can add an additional $1,000 for a total of $8,000. The limits are indexed for inflation.
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