Utilizing Tax Diversification and Tax Location to Lower Your Tax Bill

April 18th, 2019 by Tanner Wrisley

As an investor, the tax implications of an investment should always be on the forefront of one’s mind. Ignoring the consequences of a trade or opening the wrong type of account can create unintended tax burdens for an investor, sometimes without ever even withdrawing money from an account. If designed correctly, utilizing different financial account types, or “tax diversification” can help save money on taxes.

Know Your Account Type:
There are three basic types of accounts, each having their own set of tax rules:

Taxable – This account is funded with “post-tax” money. In other words, you have already paid income taxes on the money you are going to deposit. Then, after each calendar year, the investor receives a 1099 form detailing what taxable events occurred in the account throughout the year. This can be dividends, interest, or trades resulting in gains or losses. However, any distribution from the account is usually not taxable because the investor has already paid the income tax up front. Taxable accounts include individuals, joints, trusts, and corporate trusts amongst others.

Tax Deferred – This account is funded with “pre-tax” money. In other words, the amount contributed to this account can be taken off of the investor’s taxable income in that year. For example, if an individual has a salary of $50,000 and also contributed $5,000 to an IRA, their taxable income for the year drops to $45,000 (there are some exceptions to this in the higher tax brackets). After the money is in the account, the investments are allowed to grow tax-free so interest, dividends, gains, and losses are not taxed. Once funds are withdrawn, distributions are taxed as ordinary income in the year the money was taken from the account. Tax deferred accounts include IRAs, 401(k)s, 403(b)s, SEPs, and many others.

Tax Exempt – This account is funded with post-tax money like a taxable account, it grows tax-free like a tax deferred account, and has no taxes upon withdrawal. Basically, one pays taxes on the money before contributing, and then they don’t have to ever pay taxes again (as long as the money is withdrawn after the age of 59 ½). Examples of tax exempt accounts are Roth IRAs, Roth 401(k)s and health savings accounts (HSAs). In addition, certain municipal bonds pay tax exempt interest.

What We Do for You:
It is important to know what type of accounts you have and make sure they are appropriate for your goals. Additionally, withdrawing from one account versus another can have drastic tax implications. Tax deferred and exempt accounts have limitations on how much you can contribute, and when you are able to withdraw. If you plan on using the funds in the account before age 59 ½, then it probably best to use a taxable account so that you are not hit with an early withdrawal tax penalty. Even putting certain investments in the wrong accounts can increase a tax bill. So using tax diversification (different tax buckets) and tax location (putting the least tax efficient investments in the tax exempt and tax deferred buckets) can both be effective ways to lower your current and future tax bills.

At Anchor Bay, we take all of this into account when creating your portfolio. Comprehensive financial planning helps us to determine what types of accounts are needed to fit your individual needs and which accounts are best to take withdrawals from. Then the portfolio is designed to be as tax-efficient as possible. Tax efficiency is extremely important to investment success and always part of our financial planning and investing philosophy.