Most investors that I meet with do not have a plan when it comes to the tax implications of investing their money. From what I can tell, the main reason is that most investors are not working with a licensed fiduciary who not only makes recommendations that are in their clients’ best interests but can also take into consideration the tax implications of their investments. Responsible financial professionals should provide clients with a checklist or guide to follow to make sure all critical information is discussed to clear up any missing facts or misinformation. When misinformation occurs or critical facts are not discussed, we may start to see money fall through the cracks of a poorly designed portfolio. I often see investors making poor decisions when it comes to their investment account allocations by holding their riskiest assets in the wrong areas from a tax standpoint. Let me share with you an example of what can happen when investors do not consider their investment choices from a tax standpoint.
Consider working with someone who can help identify all the critical facts and misinformation in order to make sound financial decisions that are in your best interest.Getty Images
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Let’s say you bought $50,000 worth of stock in your individual retirement account (IRA) a few years back. That stock was in a well-known blue-chip company called Kodak. We all remember Kodak, right? We know that Kodak filed for bankruptcy back in January 2012, meaning that the $50,000 we invested is not worth anything (assuming we held it until bankruptcy). Knowing this and using the current tax laws, investors cannot deduct losses in an IRA, so not only did you lose your money, but you cannot write off any of the losses from a tax standpoint unless very stringent requirements are met. Now, let’s assume you bought the same stock in an after-tax brokerage account (non-IRA) instead and incurred the same loss of $50,000. Because you bought this stock in a brokerage account, you can typically deduct those losses.
Based on current tax law, individuals can deduct up to $3,000 each year while carrying forward the balance until the entire loss is exhausted. Individuals can also deduct the loss by selling positions they own in a brokerage account at a capital gain up to the entire loss of $50,000 in one year and save money on their tax bill; regardless, losses can be deducted in the brokerage account, whereas they cannot in an IRA. This is all based on the current tax laws, but the point here is that, when discussing losses on our money, we feel that it makes more sense to hold riskier assets in the brokerage account as opposed to an IRA. We want investors to be able to utilize the tax code to their advantage by structuring their investment accounts correctly.
Now let’s discuss this from the standpoint of capital appreciation or growth on our investments. Hypothetically, let’s say you bought a stock several years ago at its initial public offering with $50,000 in your IRA. For the sake of this article, let’s assume that you have seen tremendous growth over the years, and it is now worth over $1 million. We know that an IRA is a tax-deferred vehicle, so we have accumulated all the growth from the stock without having to pay taxes on the gains, but at some point, we will have to start pulling out money from this account. We may have to pull out money for retirement income or to cover a major expense, or we may have to start pulling out money to satisfy the mandated required minimum distributions that begin at age 70 ½. Regardless of the reason for the withdrawal, all distributions coming out of an IRA are taxable at ordinary income tax rates.
Now let’s discuss the same scenario, but say you bought the same stock in an after-tax brokerage account. We have this stock worth $1 million inside our brokerage account with a $50,000 cost basis. If we need to pull out money for any reason, then we know that our distributions are now taxed at a capital gains tax rate, provided they were held over one year, instead of the ordinary income tax rate as with the IRA. For most investors, this may be a lower tax rate than their ordinary income tax rate, so they are now able to pay less in taxes and have more control over their investments. Not only that, but investors do not need to satisfy required minimum distributions from non-qualified brokerage accounts, so if money is not needed, then they do not have to worry about taking a distribution. Again, the point here is, even when discussing gains or growth on our money, we feel that it may make more sense to hold riskier assets in a non-qualified brokerage account, as opposed to an IRA, by leveraging a lower tax rate on distribution and growth. We want investors to be able to utilize the current tax code to their advantage by structuring their non-qualified accounts and their qualified accounts in a manner that allocates risk in the right areas.
Simply put, we feel that IRAs should be structured in a more conservative or lower-risk investment strategy while holding riskier assets in an after-tax, non-qualified brokerage account. This helps minimize the risk of money falling through the cracks by taking advantage of losses when they occur and paying a lower tax rate on distributions and growth.
When planning for retirement or making investment decisions, consider working with someone who focuses on forward tax-planning techniques and can also help identify all the critical facts and misinformation in order to make sound financial decisions that are in your best interest. Make sure to consider the tax implications when investing in risk assets and holding them in the right areas.
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