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Investing with your Uncle (Sam)

By Dr. Don Taylor ·
Thursday, May 22, 2014
Posted: 5 pm ET

As a financial planning professional, I work with tax experts and see how tax planning can help clients pay less in taxes. And by doing that, I increase the amount of wealth they get to keep versus transfer to the U.S. Treasury.
Continuing education is a responsibility of most financial services professionals. Over a two-year period, CFP professionals like me have to earn 30 hours in continuing education, with at least two hours of training in ethics, to retain the right to use that designation. Other designations have similar requirements.

Last week's continuing education dealt mostly with managing taxes, especially in client portfolios. Between the Medicare tax on net investment income for high-income families, managing alternate-minimum-tax exposure and managing longevity risk with retirement withdrawal strategies that minimize taxes, it really focused my thinking on how people can improve their after-tax investment returns by managing their tax exposure.

Tax-deferred retirement accounts

I don't dwell on it, but I also don't forget that Uncle Sam is a partner to any success in my tax-deferred retirement accounts, like a 403(b), 401(k) or traditional individual retirement accounts. The pretax contributions to the accounts, along with the investment earnings, are taxed as ordinary income when I take the money out as a distribution. If the distributions aren't classified as early distributions, there's no need to worry about the penalty tax, just the income taxes. I expect between 15 percent and 25 percent of the value of these portfolios actually belongs to Uncle Sam.

Tax-advantaged Roth IRA and Roth 401(k) accounts

While any employer match in a Roth 401(k) isn't tax-free in retirement, the employee contributions to the Roth 401(k) and Roth IRA are tax-free, along with the investment earnings when distributed out of the account, subject to account seasoning and age restrictions.

The account holder front-loads the tax obligation by contributing after-tax dollars to the account. Uncle Sam has partnered with the investor here, too, in this case by taking his money upfront but not taxing the investor on investment returns earned by the after-tax contributions. Roth IRAs also benefit from not having required minimum distributions, or RMDs, during the account holder's lifetime. Howevever, Roth 401(k) accounts are subject to RMD rules.

Taxable accounts

Taxable accounts have some advantages, especially if the investor is buying individual stocks and bonds versus buying mutual funds. Mutual funds have to pass through their investment income and capital gains to investors so the investors can't control the timing of the tax exposure, other than by seeking out tax-efficient funds.

While investors in individual securities can't control the timing of investment income, they can manage capital gains taxes. Investors who plan to bequeath investments held in taxable accounts may benefit from the step up in basis, which reduces capital gains exposure to the beneficiaries. Qualified dividend income is taxed at a lower rate than ordinary income, an advantage to this form of income in taxable accounts.

Tax diversification

A mix among the different types of accounts can help the investor manage his or her tax bracket in retirement. Bracket creep will impact the investor's exposure to longevity risk, the risk of retirement income needs outlasting retirement income sources.

You need a tax guy or gal

Working with a tax professional will help you manage your tax exposure and work toward maximizing the after-tax yield on your investments. Tax policies can and do change over time, but your tax professional will help you adjust to the changes.

How much time do you spend thinking about taxes when you decide where and how to invest? Do you work with a tax professional?

Read Kay Bell's "Reporting your investment income" for more on the topic.

Follow me on Twitter: @drdonsays.

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