Make sure your Financial Advisor is a Tax Expert (Geek)
Those of us with tax expertise don’t get much respect. Seriously! What comes to your mind when somebody mentions “Tax accountant?” You think of the tax accountant in GhostBusters! OK, I get it! No offense taken. When I was a full-time tax professional working for Price Waterhouse in Pittsburgh, my older siblings referred to me (lovingly, of course) as “Tax Geek.” No respect. I know exactly how Rodney Dangerfield felt.
Occasionally, we Tax Geeks do gain a little mojo, and that typically is when we can save our clients some money through tax planning. These simple steps show you how you can lower your effective tax rate on your investment income by 50%. All numbers below assume a married filing jointly couple with an income between $77,400 and $315,000. First, a quick tax primer.
Taxation of Investment Income in a Taxable (Investment or Brokerage) Account
Long-term capital gains and most dividends are taxed at 15% (0% if taxable income is less than $77,200). Interest income is taxed at ordinary income tax rates, which for our couple above would be 22% or 24%. If your investment earnings are not in a tax-deferred account, your tax rate would be 50% higher on interest income versus capital gain or dividend income.
Mutual Funds vs Exchange Traded Funds (ETF) in Taxable Accounts
If you do hold investments in a taxable account, does it make any difference if you hold your equities in a mutual fund or an ETF? Actually, it does. Mutual funds are a managed by a portfolio manager who buys and sells securities within the fund to achieve the fund’s goals. But these transactions trigger taxable events (capital gains) within the fund, most of which are distributed to shareholders and are taxable. With ETFs, the fund manager purchases securities to replicate an index such as the S&P 500 or Dow Jones Industrials. Unlike mutual funds, ETF managers hold onto the securities that comprise the index and have fewer taxable events. As such, most ETF capital gains are generated only when you sell your holdings. Therefore, ETFs are more tax efficient than mutual funds inside taxable accounts.
How is investment income inside IRAs or 401(k)s taxed?
Any investment income generated inside your IRA or 401(k) is not taxed, as these are qualified accounts. Any interest, dividends, and capital gains generated inside these accounts grow tax-free until you begin to make withdrawals. At that point, all of your withdrawals from a regular IRA or 401(k) will be taxed as ordinary income, regardless if the account consisted of 100% of equities or 100% of bonds.
So what should I hold and where?
Most importantly, make sure your overall holdings comply with an allocation that will help you to accrue enough money to comfortably get you through retirement. Once that mix is established, hold your interest generating funds inside your 401(k) or IRA to avoid the high tax rate on interest. Hold your equities in your taxable accounts, because if you have to pay tax on your investment income, it’s better to pay at 15% vs 24%. Further, consider ETFs for your taxable accounts, as they will not trigger as much capital gain income as mutual funds. If you need to hold equities in your qualified accounts, mutual funds or ETFs will defer any capital gains generated.
Tax Accountants want you to plan too!
Financial advisors and CFP® Professionals want you to plan so that you are comfortable in retirement. But they shouldn’t get all the credit. You need to complement that financial advice with good tax planning, and that may not happen if your tax person is different from your Financial Advisor. Financial and tax advice should be generated simultaneously as part of a coherent strategy to maximize your nest egg. If you are lucky enough to have a financial advisor who is also a tax expert, you know you are getting an integrated strategy and getting 2 valuable services for the price of 1. If your financial advisor is not a tax professional, be sure to get both professionals on the same page (and in the same meetings). It may cost you more up front, but integrating tax planning into your portfolio strategy will most likely leave you with a bigger nest egg at retirement.
By taking steps to maximize the tax efficiency of your investments in taxable or qualified accounts, you can become the Keymaster of your retirement.