“It’s not how much you make, but how much you keep.” Are your investments set up with this wisdom in mind? Many of the people we meet with who manage their investments themselves often have their stocks, bonds and other investments in the wrong accounts.

Having your investments in the right accounts is a simple concept when tax treatment of investments and accounts is reviewed.

To help you determine if you have your investments in the right accounts let’s see how you will be taxed on savings accounts, corporate bonds, municipal bonds, and U.S. stocks. While there are many other types of investments, these are some of the most common ones that you are likely to have in your investments.

• Savings Accounts — Each year your bank pays you a stated interest rate
  • The interest fully taxable at your current tax bracket

• Corporate Bonds — Each year the bond issuer pays you a stated interest rate
  • This interest is fully taxable each year at your current tax bracket
  • If you sell the bond before maturity the difference between what you lent the bond issuer initially and the sold value is a capital gain or loss
  • If you owned the bond less than one year, the capital gain is fully taxable at your current tax bracket
  • If you owned the bond for a year or more the capital gain is taxed at a special rate lower than your current tax bracket and will range from 0-20% based on your annual income

• Municipal Bonds — Each year the municipality issuer pays you a stated interest rate
  • When you purchase these correctly the interest can be tax-free on your Federal and state tax return
  • It may also be tax-free if your city has a local tax
  • If the bond is sold before maturity the difference between what you paid initially and the sold value is a capital gain or loss
  • If you owned the bond less than one year, the capital gain is fully taxable at your current tax bracket
  • If you owned the bond for a year or more the capital gain is taxed at a special rate lower than your current tax bracket and will range from 0-20% based on your annual income

• U.S. Stocks — Stocks can have two investment return components — dividends and capital gains
  • Stock that qualifies for special tax treatment have dividends that are taxed like long-term capital gains at the preferential tax rates stated above
  • Gains in stocks held less than a year — short-term — are fully taxed at your current tax bracket
  • Gains in stocks held a year or more — long-term — receive the special tax rate that ranges from 0-20% based on your annual income

Now that we have reviewed how some of your most common investments will be taxed in a regular account, let’s also review how the tax treatments of two other account structures may affect how much of your retirement savings you keep. Tax rules for these account types supersede the tax rules of individual investments. We are happy to help you figure this out. Give us a ring.

• 401(k), 403(b), and Traditional IRA — Monies deposited in these accounts are saved pre-tax
  • money grows inside the account tax-deferred
  • when any money is withdrawn (after age 59.5) every dollar is fully taxable at your current tax bracket

• Roth 401(k), Roth 403(b), and Roth IRA — Dollars deposited in these accounts are saved after tax
  • money grows in the account it is tax-deferred
  • when any money is withdrawn (after age 59.5) every dollar is fully tax free on the Federal level and in most cases state tax free (Consult your tax advisor for your state’s tax rules)

Funding a Roth type account typically makes a lot of sense when your income today is lower than your future earnings will be — typically your early career years. Paying tax at a lower rate when you know that your future tax rate is going to be higher, is simply to your advantage mathematically. And by funding a traditional 401(k), 403(b), or IRA account you can defer taxation. If you have additional savings beyond IRS limitations for saving into tax-qualified plans, it will naturally spill over to a savings or investment account — a very good thing.

Putting it All Together

Households with high income should pay extra attention to the amount of cash savings they accumulate since interest from savings accounts will add directly to their tax bill. Also, cash reserves greater than a recommended 3 to 6 months of expenses warrants considering additional tax relief investments. We help our clients evaluate municipal bonds and tax-free money market funds that fit their investment comfort level every day. We often find our top earning clients are sitting on “too much cash” — either because they like the feeling or because they are earning it faster than they can think about investing it.

Corporate bonds larger investment return component is current year income. We can defer that income to a later date by placing these investments in a 401(k), 403(b) or Traditional IRA. If we have a Roth type account, then placing high income paying corporate bonds in it can turn an annually taxable investment into one that is potentially tax free.

Because qualifying stocks receive preferential tax treatment on dividends and because tax is deferred on capital gains until the stock is sold, placing stocks in a regular investment account ‘makes more sense’ than a tax-qualified account where it would actually be increasing taxation on investment growth.

How can I use this info to keep more of my money?

OK, so create a list of your accounts by tax status — and asset type — to identify opportunities to relocate assets to accounts that will get a further benefit from a tax perspective.

There is some good news: if you find that you have more bonds in regular accounts and more stocks in tax-qualified accounts then the cost to relocate assets may be reasonable. Because high quality bonds often trade rather close to their purchase price, selling may only cost you a commission or fee with low capital gains release. In tax-qualified accounts selling stocks to buy bonds has no tax implication so only the cost of a trade would apply.

If you don’t have the time to do this exercise on your own or simply want to ensure that you are set up right, please reach out to us at Rightirement Wealth Partners. You may schedule a 15-minute phone meeting on our website or call in or write. We look forward to speaking with you.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investorís yield may differ from the advertised yield. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.

No investment strategy assures a profit or protects against loss. Investing involves risks including possible loss of principal.

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 1/2 may result in a 10% IRS penalty tax in addition to current income tax.

The Roth IRA withdrawals may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 1/2 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

An investment in the money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.