Nobody likes to pay taxes, especially on your investments. If you know the in’s and out’s of the different types of investment accounts you can minimize your taxes. This is called advanced tax deferral.
What is tax deferral?
Tax deferral is postponing the payment of tax on income, interest, dividends, and capital gains until the investor take possession of them.
The simplest way to defer paying taxes is to put pre-tax money in your retirement accounts such as a 401k, 403b or IRA. This is literally paying yourself first. We do this so that we can use that money for income later in retirement. That’s basic tax deferral. What’s advanced tax deferral?
Advance Tax Deferral
Advanced tax deferral is when you place highly taxable investments in your tax deferral accounts and tax-efficient investments in your taxable accounts.
Highly taxable investments
Highly taxable investments include bonds that pay taxable interest and dividends paying stocks and REITs that pay a lot of dividends. In a TOD, joint taxable investment account or trust, these investments create current tax burdens that you pay tax on NOW. When placed in an IRA or 401k, you delay paying taxes on these investments until you withdraw them.
This is best explained with an example. For simplicity, we’ll use round figures.
A Tax Deferral Example
You’re a millionaire. You have a two million dollar portfolio exactly and your asset allocation is 50% equity and 50% bonds. The bond fund pays 4%.
Your portfolio is divided into two accounts: an IRA, and a taxable joint account with your wife. Each account has $1,000,000 in it.
Most people would put 50% bonds and 50% equity in both IRA and joint account. This would mean that $500,000 is invested in bonds in a taxable account. At 4% interest, the bonds would generate $20,000 of interest. This 1099 INT income is added to your tax return at the end of the year.
Someone in the 24% tax bracket would owe $4,800 extra in taxes that year.Â More importantly, after taxes, you’d only make $15,200 on your bond fund, which is equivalent to a real after-tax return of 3%, NOT 4%.
An Advanced Tax Deferral Example
Using an advanced tax deferral strategy you’d allocate all of your fixed portion of your investments in your IRA account. This equals $1,000,000 which would pay dividends of $40,000 ($1,000,000 x 4%), none of which would be added to your taxes this year. Your real after-tax return is the FULL 4%. Advanced tax deferral saved you $4,800 in taxes AND increased your return by 1%.
Taxes aren’t easy. And they work against wealth building. But smart investing with taxes in mind can increase your after-tax return and grow your wealth faster.
Want to lower your taxes even further? Check out
Editorâ€™s Note: This post was originally published on July 15th, 2011 and has been revamped and updated for accuracy and completeness.Â