A “Goldilocks Dilemma”: Which account type is “just right”?

If you’ve heard the advice to contribute as much as you can to your employer retirement plan or to your traditional IRA, take a moment to consider why that might not always be the best place for your dollars. “Why?”, you might ask. The act of contributing to a tax-deferred account benefits you now, but those dollars will still be taxed in the future when they’re withdrawn, and at an unknown (and potentially higher) tax rate. While no one knows what future tax rates will be, some careful consideration and planning can better position your portfolio when the time comes to take distributions. In this blog – the second part of our three-part series on the elements of portfolio taxation – we’ll cover the difference between pre-tax dollars, taxable dollars, and after-tax dollars. We’ll then examine some scenarios that demonstrate how the varying types of taxable statuses can provide flexibility when you’re ready to put your money to work.

Generally speaking, investment portfolios fall into three categories of taxable status. Maybe you have the majority of your portfolio in an IRA, which is taxed upon withdrawal from the account. Alternatively, you could also have most of it in an individual or joint account, generating taxable events with every buy and sell order. Investment account types are separated into pre-tax, taxable, and post-tax. Pre-tax or “tax-deferred” accounts such as IRAs and 401ks allow the account owner to deduct the contribution from their taxable income from the year, therefore lowering the tax owed. There are limits to how much can be contributed in a given year, but this blog will focus on the tax perspectives of distributions from accounts. Taxable accounts like individual or joint accounts cause real-time taxation, meaning that any sale of a security for a loss or gain will be reflected on the tax return in the year of the transaction. There are fewer limitations around taking withdrawals from taxable accounts than retirement accounts, meaning that while your tax bottom line is more sensitive to withdrawing funds from a taxable account, they’re easier to take distributions from, which we’ll discuss in more detail later. Finally, post-tax accounts (known most commonly as Roth IRAs) are accounts whose contributions were taxed in the year they were made, allowing for withdrawals with no tax implications. Each of the three types of accounts have their advantages, weaknesses, and limitations, which means that each plays an important role in the greater context of an individual’s portfolio.

Consider two distinct but very real scenarios: One individual’s portfolio held almost entirely in pre-tax accounts, and another individual with few retirement accounts but large, highly appreciated stock positions in their taxable accounts. In retirement, the individual with their net worth largely in retirement accounts faces the dilemma of taking distributions. While the benefit of contributing to those accounts initially was that they could deduct those amounts from their taxable income at the time, they must claim the distributions as taxable income when the money comes out. Additionally, these accounts may only be withdrawn from without penalty after age 59 ½, further limiting the ability to use the funds during working years.  If this is the only retirement income the person has, one can see how the tax liability of claiming all distributions on their tax return can generate a significant tax bill. Alternatively, an individual with stock that has increased in value over time in a taxable account must confront the scenario of selling the stock and incurring or “realizing” the difference between the price it was purchased at and the higher price it was sold for. All of these factors contribute to taxable income in the current year regardless of how the proceeds were used.

A more ideal situation can arise in retirement with some planning, mindfulness and building a portfolio consisting of nearly equal parts taxable, pre-tax, and post-tax dollars. This allows far greater flexibility when pulling funds from accounts based on the year’s tax rates, their earned income, and other influential situations, resulting in better management of the tax burden.

Bottom line, there’s no time like the present to evaluate the composition of your portfolio to best plan your future tax situation, and with the help of a financial planner, you can work to put yourself in an advantageous position in the future.

Stay tuned for the final part of this blog series, where we’ll discuss the optimization of investment type within account types.

“While no one knows what future tax rates will be, some careful consideration and planning can better position your portfolio when the time comes to take distributions.

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