To navigate your
Tax wilderness, learn about
Your account’s tax rules

In a brisk 70,000+ pages, the United States Tax Code outlines how our financial system works. It lays out a landscape of opportunities, obstacles, and dangers. It also describes a set of tools available to certain people in certain circumstances.

You might be a 14 year-old earning your first paycheck. You might be a retiree concerned about a safe withdrawal rate to make your portfolio last 30+ years. In either case, understanding the tax code will provide invaluable insight into what your accounts, and the assets they hold, can and cannot do.

For the purpose of this article, we’ll focus on two common account types: taxable investment accounts (also called brokerage accounts), and Roth IRAs.

(Keep in mind this is only a bird’s-eye view)

Taxable Investment Accounts:

When many people think of saving and investing, it’s often confined to savings accounts, CDs, IRAs, and 401(k)s. Each of these account types has strict limits on its use. A savings account or CD can only hold cash. IRA and 401(k) accounts can only be used without penalty in specific situations (like reaching age 59.5).

Meanwhile, all of us have a multitool available that can hold a wide range of assets and be used without age-based penalties: the taxable account.

When selling an asset from inside a taxable account, you create a taxable event. But these accounts are exposed to the favorable Capital Gains section of the tax code. That event can produce a tax deduction if you are realizing a capital loss (selling an asset for less than what you paid for it). This is called tax loss harvesting. If you sell an asset for more than what you paid for it, you will create a tax bill.

Right away, you might spot an advantage that these accounts have that you won’t find in an IRA or 401(k): depending on the assets within your account, you may be able to free up cash by selecting an asset to sell that will generate the biggest tax advantage (or the smallest disadvantage). This gives you a measure of control over the tax implications involved when you need money from the account.

With Traditional IRAs, no matter what you sell to free up cash to distribute, or how long you’ve owned it, the distribution will be taxed at ordinary income rates.

Taxable accounts provide taxpayers a means of creating tax-efficient distribution schemes. How many options you have may depend on how many assets you own within the account. To have more options for tax advantaged income, a taxable account would need to have a variety of assets to choose from.

Owning a single, broadly diversified fund in an IRA has no impact on the tax implications of an IRA. But, using this approach in a taxable account limits the tax advantages available to you.

In contrast, you can buy individual stocks representing an index, a strategy known as direct indexing. The individual stock positions allow you to sell positions when they have lost money. These sales generate deductible losses that, when they exceed $3000 per year, carry forward into future years. Your money, meanwhile, can stay invested by buying shares of a new stock after selling the loser. In this way, you can accumulate losses that can offset gains when distributions or changes are needed down the road.

If you’ve tax-efficiently managed a taxable account over years, the tax cost of distributing funds from the account may be lower than the cost of distributing funds from an IRA or 401(k). This means an investor may be able to afford a lower rate of return in these accounts.

With a lower expectation of returns, you can prioritize risk-management (aka limiting losses), and tax-planning within these accounts.

Taxable Account Summary:

When to own it: As soon as you have money to invest

What it should hold: Individual stocks and bonds; funds specific to a certain style, sector, or industry

How to manage it: Active management for tax loss harvesting and risk management

Benefits: Variety of tax rates available for income, indefinite carryforward of losses over $3000, step-up in basis at death, long term gains rates for assets held over 1 year, ability to leverage account assets for Securities Backed Lines of Credit, ability to gift accounts during lifetime

When to take distributions: Lifetime, as needed

Roth IRAs:

Funds invested in Roth IRAs grow tax deferred. Growth within the account can be withdrawn tax-free after age 59 1/2. But there is no such thing as a free lunch in our financial system.

The only funds that can be deposited into a Roth IRA are funds that have already been taxed. Knowing this information, anyone putting money into a Roth IRA is making a bet that their future tax rate will be higher than their tax rate today.

This means that Roth IRAs are ideal accounts for people already in a low tax environment. For such people, putting money in a Roth IRA effectively locks their low tax rate in forever.

Assume a person pays taxes at a top rate of 10% and invests in a Roth IRA. That small amount of tax on their earnings has already been paid and will never have to be paid again. If the investor in question has a retirement tax rate that tops out over 20%, the 10% tax they paid on their Roth contributions is a great deal. They’ve generated a tax savings of at least 10% on every withdrawal they take from the Roth account in retirement.

But someone with high earnings might be taxed at a rate of 32% or higher. The tax code gives such people a hint that they should look at other accounts for their investments. A household taxed at a rate over 32% likely earns too much to be able to directly contribute to a Roth IRA account.

On the surface this looks like a limiting regulatory restriction. How dare the government tell me that I can’t contribute to my Roth IRA if I earn a certain amount of money!

Another way of looking at this restriction is that the government is putting up a guardrail to help you avoid a potentially unwise financial decision.

For example, someone paying tax at an effective rate of 32% during their earning years may have a rate of 12% - 22% during retirement. How might this happen? For many people, 15% of Social Security income is tax free. Retirees may be able to generate tax-free income through Municipal Bonds, or long term capital gain income from Qualified Dividends. Above all, retirement income is based on living expenses, which may diminish during the middle years of retirement. Less income means lower taxes.

If a high income earner used Roth accounts during their peak earning years, they may have paid taxes at a top rate of 32% or more in order to save taxes at a potentially lower rate in retirement. If that sounds like a bad trade, that’s because it is. You wouldn’t trade a dollar for fifty cents. Don’t trade a high tax rate while contributing to a Roth for a low one when you take Roth distributions.

There is broad consensus that taxes must eventually increase from their current historic lows. The tax-free nature of Roth distributions for people over 59 ½ means that the higher the tax environment, the more valuable the Roth IRA becomes. If tax rates do climb, the Roth investor wins. This means holding these accounts until the end of a financial plan or saving them as a legacy benefit may be a wise bet.

If an investor intends to not touch his or her Roth account for some years, they may consider being more aggressively invested in the account.

Roth IRA Summary:

When to own: As soon as you have taxable earnings (check state rules for earliest allowable age)

What it should hold:

Growth phase: passive growth-focused investments
Distribution phase: risk-managed investments

Management style:
Accumulation phase: passive
Distribution phase: active

Benefits: Tax free distributions, no tax implications on trades within the account, tax free legacy to beneficiaries

When to take distributions: Not before age 59 ½, ideally waiting until taxes are higher than they were when funds were contributed to the account.

Wrapping Up:

The ideas presented above don’t apply to everyone. Hopefully, they shed some light on how the tax code gives us a bread crumb trail through the financial wilderness.

No matter where you are in your stage of life, the tools described in the tax code can help you navigate your financial landscape. The more you understand those tools, the more wealth you may be able to create, maintain, and pass to the next generation.

If you want to know what tools are available to you at your stage of life, and how they can be used to reduce your lifetime tax bill while preserving and potentially enhancing your wealth, we’d love to hear from you.