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Tax registration

From a tax and regulatory standpoint, one financial account is different from another based on its registration. Some examples:

If an account is registered as “Joint with Rights of Survivorship,” we know that account is jointly held by multiple parties, all of whom will owe annual taxes each year on taxable events within that account.

An account registered as a Savings Account will earn interest taxable at State and Federal levels annually. It won’t be allowed to hold anything but cash, and it won’t have check-writing capability.

An account registered as an Individual Retirement Arrangement (IRA) can only be held by a single account owner, and funds can only be withdrawn without penalty after age 60. There are exceptions to this, which you can read about here. Arguably the most important aspects of an IRA are that funds may be tax deductible when they are contributed into the account, grow tax deferred, and are fully taxable as ordinary income when withdrawn.

Roth IRAs follow many of the same rules as Traditional IRAs but have major exceptions. There is no deduction for contributing funds to the account, but funds can be withdrawn tax-free after age 60, as long as you follow the rules specific to the Roth IRA registration.

The point of all of this is that knowing what kind of tax benefits or liabilities an account has can help determine what kind of rate of return the account may need, and therefore how the account can be invested.

Let’s start with taxable brokerage accounts, such as a Joint with Rights of Survivorship (JTWROS) account. These accounts can be managed so that investors accumulate capital losses that offset future capital gains within the account. This means that, if an account has been tax-managed wisely, an investor can potentially reduce or eliminate tax liability on future withdrawals.

Taxable events within the account may be exposed to capital gains tax rates, which may be more favorable than ordinary income tax rates for a given investor. Qualified dividends and long term capital gains may be taxed as low as 0% based on the investor’s total income.

Furthermore, these accounts can hold municipal bonds. These bonds avoid Federal Taxes. If the municipal bonds in question are issued by the investor’s home state, they will avoid taxation at all levels.

Lastly, taxable investment accounts, if the account value is large enough, can be leveraged using a Securities Backed Line of Credit. The line of credit allows an investor to access his or her account value without selling investments, and therefore without creating a taxable event. Loans don’t count as income and are therefore not taxed.

On the other hand, if you need money to come out of a Traditional IRA, you are going to pay taxes at ordinary income tax rates. For many people, there’s no way around this. If you need the money out of your IRA, you’ll pay taxes on that money (unless your deductions wipe out any taxes due on the distribution). You can’t use holdings within an IRA as leverage, so there is no tax free loan income that can come from one of these accounts.

This means that IRAs may have more drag on net performance for the investor. If an IRA has a balance of $1,000,000, the account owner does not have $1,000,000. The government has earmarked a certain percent of that money, depending on how much of it the investor needs at one time, and there is very little most taxpayers can do to legally avoid those taxes.

When it comes to distributing funds from the account, it is tough to beat the tax efficiency of a Roth IRA. As long as the investor has held any Roth account for five years, and is over age 59 1/2, he or she can withdraw contributions and growth from the account without taxes or penalties.

What does all of this tell us about rates of return?

If we know how much of a piece of our account the government is going to take for itself, we can gauge how aggressively these accounts need to grow relative to our aggregate (average of all accounts) return requirements.

Of the accounts discussed above, Traditional IRAs may, for most people, have the biggest tax bill when the account owner needs to access the account’s funds. In order to make up the loss of money due to taxes, these accounts need to grow more than tax-efficient accounts. That means that, as long as the investor can tolerate the risk, he or she may consider holding investments in an IRA with more upside potential and, therefore, more risk.

If an investor has a required rate of return across his or her portfolio of, for example, 7%, the IRA would, ideally, be invested in such a way to maximize the potential of earning a greater than 7% rate of return. This would help offset the tax bill when the investor starts withdrawing funds.

By contrast, the tax benefits of taxable brokerage accounts, such as JTWROS accounts, make them, for some investors, more tax efficient than IRAs. For these people, taxable accounts can be invested more conservatively because they don’t need as much growth to offset as large of a tax bill.

If an investor needs to take risk out of his or her overall portfolio, looking at taxable accounts to hold more fixed income instruments – namely municipal bonds – while holding more equities in Traditional IRA or 401(k) accounts, may be a smart strategy.

However, be wary of putting annuities of any sort in a taxable account. Any growth within an annuity is taxable at ordinary income rates. This wipes out the annual potential tax benefits of the taxable account registration. It also wipes out the legacy benefits of these accounts. Taxable investment accounts receive a step up in basis at the account owner’s death. Annuities receive no such treatment. This doesn’t mean that annuities in a taxable account are always a bad idea. It simply means to be careful.

Investorts can also consider looking at value stocks in their taxable accounts. Value stocks are generally considered safer investments during a volatile market. They are potentially less likely to have the kind of meteoric growth investors may experience from investing in new technology companies, but they may also be less likely to experience catastrophic losses. This year has been a demonstration of this logic.

Roth IRAs present an interesting dilemma. They are extremely tax efficient. Following the Roth rules, an investor as well as his or her beneficiaries will have no tax bill for funds withdrawn from a Roth IRA account.

This means that a Roth IRA may be the most conservatively invested account in an investor’s portfolio, right? No tax bill means lower required returns, right? Not so fast.

Since the value of the Roth IRA lies in its tax-free distributions, the account becomes more valuable the higher the prevailing tax rates are. Taxes are as low now as they have been since the 1930s. To maximize the value of the Roth IRA, it is generally considered best practices to wait to withdraw funds for as long as it takes for the account owner’s tax rate to be significantly higher than it was when those funds were contributed. This may even mean using the account strictly as a legacy benefit to beneficiaries.

If the investor doesn’t touch a Roth account for a long time, maybe the longest of any account in his or her portfolio, the account owner has the longest amount of time to recover from market losses within the account. This implies that Roth IRAs, as long as the investor doesn’t need the funds soon, and has the risk tolerance for it, can invest the Roth more aggressively than any other account.

In fact, for investors with large Roth IRAs, the potential outperformance from an aggressively invested Roth can take pressure off the entire portfolio, allowing investments within IRAs and taxable accounts to be more conservative and stable.

The point of all of this is that the tax and regulatory structure of the accounts available to American investors can provide a framework for how these accounts may be invested.

Of course, people may disagree with the opinions above and use these accounts differently. But if you have questions about how to use the accounts available to you, these ideas may at least provide a helpful starting point.

If you have questions about how to use the accounts in your portfolio to maximize tax efficiency without taking unnecessary risks, please schedule time with us. We’d be happy to speak with you.