In the last blog entry (I know, I know; it’s been a bit), we discussed the importance of tax diversity in retirement savings through the use of tax-free accounts, such as Roth IRAs and Roth 401(k) plans. But those accounts are just the first step in creating lower tax liabilities over the long haul. For those who are already using Roth options and are searching for additional ways to save, consider adding taxable brokerage accounts to your portfolio.
In addition to tax-free assets, a taxable brokerage investment account will help avoid ordinary-income tax exposure in retirement. In this scenario, the account holder buys an investment – say a mutual fund or exchange-traded fund – and the purchase price becomes their cost basis. The investment holder is then taxed if they sell the asset at a gain. Those gains would be subject to capital-gains tax rates, which are more favorable than ordinary-income rates, with most filers subject to a zero or 15-percent capital gains tax rate. This type of account also allows owners to take advantage of losses, as those tax losses can be harvested to moderate current or future tax liabilities. That is a topic for another day.
Let’s put this to numbers by looking at two examples. The first investor has $1 million saved entirely in a tax-deferred IRA. The second individual also has $1 million, with $500,000 in a tax-deferred IRA, $300,000 in a taxable brokerage account and $200,000 in a Roth IRA. To keep things simple, assume both investors are married and file a joint tax return. Also, we will keep the example apples-to-apples by assuming each investor distributes $100,000 (net of income taxes) out of their investment accounts to cover retirement living expenses. Assume both investors (and their partners) are age 60 and not yet drawing Social Security benefits and have no other sources of income.
For the first investor, taking $100,000 out of a tax-deferred IRA would generate roughly $8,500 of federal income tax in 2021. In reality, Investor No. 1 would need to pull out around $110,000 to net out an after-tax total of $100,000 necessary for living expenses. By comparison, Investor 2 could draw off three different types of investments to limit their income tax exposure. Specifically, if Investor No. 2 distributed $30,000 from their tax-deferred IRA and created the remaining $70,000 in cash from a Roth IRA and taxable investments, it would potentially reduce their federal income tax liability to less than $500. That equates to approximately $9,500 that the investor maintained in their account versus paying in tax to the government.
Keep in mind: though taxable brokerage assets are generally subject to capital-gains tax if sold, investments such as mutual funds and stocks can pay capital gain distributions or dividends that can also create income subject to capital-gains tax in the current year. Also, the scenarios outlined above are just examples. Talk to your financial planner or tax advisor to determine what is best for your situation.
Saving is essential. But make sure you are saving in a way that will create the best possible tax situation for you long term. If you have simply been stowing money in a tax-deferred account, consider the tax-free Roth option and adding a taxable brokerage account to help alleviate your bill to the government in the future.
Tim Neuenschwander, CPA, CFP® is the managing member of Neuenschwander Asset Management, LLC. Click on his name to visit his LinkedIn profile, or contact him via email at tim@namadvisors.com.
Christine joined the NAM team in 2020, along with her six-plus years of Administrative and Executive Assistant experience. She was born and raised in Wisconsin. She has a love for film, comedy writing, and music, particularly between the 50’s and 80’s.
During my salad days, I studied business at the University of Minnesota and the Carlson School of Management. Taking this route seemed to make sense when I graduated high school, as it offered the opportunity to pursue a career in business. However, the experience didn’t go as planned. I found myself disillusioned by the focus and teachings of business school, with many of the lessons revolving around detached relationships focused solely on profit. I eventually concluded that this was not my personal path. I chose instead to purse a passion – writing – and veered off into journalism for the next six years of my life.