Tax structures are taxing enough to give you an A-Grade headache, but they are a necessary partner to a successful asset allocation strategy. Managed poorly, it will corrupt your investment performance; so a tax-efficient technique is critical to your financial health. Tax-free and tax-deferred are two concepts that could help you manage, defer and reduce taxes.

Tax-deferred applies to any amount that you will ultimately be taxed on, whereas tax-free accounts will never be visited by Uncle Sam.  Traditional IRAs are used to provide a tax-deductible contribution giving you tax-deferred growth until withdrawal. When you enter your retirement years, those funds will generally be taxed at a lower rate because post-retirement income is likely to be much lower than a pre-retirement income and subsequent tax rate.

Tax-Free:  Accumulating your assets in a Roth IRA allows tax-free asset accumulation since you have already paid taxes on these funds.  Therefore you avoid paying taxes on the earnings provided you don’t withdraw the assets until you’re 59.5 years old or the account has been open for a minimum of five years. 

Tax Efficiency

There are three tax treatment categories:

  1. Roth IRA or Roth 401k (tax-free)
  2. Brokerage accounts (fully taxable)
  3. 401(k), traditional IRA, and 403 b (tax-deferred accounts)

For example, you have one of each type of account, a tax-deferred Traditional IRA, a tax-free ROTH IRA, and a taxable brokerage account.   Your portfolio is purely there to provide for your retirement years, assigning an allocation in equities (stocks), fixed income (bonds), and alternative investments as appropriate to each of the three accounts.  While this asset allocation mix may seem appropriate, on the contrary, some asset types would be more appropriate in certain accounts and would be more tax efficient in others.

Looking at a ROTH IRA capital gains and qualified dividends would not be subject to their usual astronomical tax rates.  Another benefit would be when the investor dies her spouse or heirs will make a considerable tax saving.

Asset classes with the highest growth rates are best assigned to tax-free Roth accounts that don’t tax withdrawals.  Since you won’t need additional income during your working, years fixed income investments, which pay dividends are better off in tax-deferred accounts.  Generally speaking, sky-high tax efficiency ratios usually come with reduced tax bills.

Asset location 

Here is an overview of the characteristics of six asset classes.  You can use this as a guide to determine where they should be held. 

  • Large-caps U.S. equities: High growth likely to pay dividends
  • Small-caps U.S. equities: Higher average growth, may pay dividends
  • Foreign equities: Mostly growth with some dividends
  • Emerging markets: Most volatile of the assets classes
  • Real Estate Investment Trusts: Best performers over time, pays high annual dividends
  • U.S. and foreign bonds: Less volatile than equities and pays dividends 

There is no single asset location strategy for every investor. Your risk and return characteristics need to be assessed according to your financial profile, tax law, and your portfolio’s time horizon.

Withdrawal Tactics

Your withdrawal strategy is just as influential on your tax efficiency as your asset allocation is. For example, if you withdraw from a Roth account to pay for a large medical bill, it counts as a qualified withdrawal, which comes without tax liability. Roth accounts are also excellent estate planning vehicles given their reduced federal income tax distributions. Your withdrawals need to be planned at the beginning of each tax year. Expected deductions and gross income will determine which accounts you should withdraw from.

Taxes make a big difference

Let’s take a look at two people who invest $5,000 each year for 30 years.  One of them invests in a Roth 401(k) and earns 6% each year, the other person invests in a brokerage account that earns 6% every year. With a tax rate of 28%, the tax-free account (Roth 401(k) will be worth $395,291 in 30 years.  The taxable account (brokerage account) will be worth $295,896.  A difference of $99,395. 

This hypothetical example is for illustrative purposes only, and its results are not representative of any specific investment or a mix of investments. Actual results will vary. The taxable account balance assumes that earnings are taxed as ordinary income and does not reflect possible lower maximum tax rates on capital gains and dividends, as well as the tax treatment of investment losses, which would make the taxable investment return more favorable, thereby reducing the difference in performance between the accounts shown. Investment fees and expenses have not been deducted. If they had been, the results would have been lower. You should consider consulting with your tax representative for tax advice.

Tax Loss Harvesting

Losses over taxable gains can be used to offset future capital gains. $3,000 of your losses are deductible even if you have no taxable gains to offset. Strategizing losses in this way are called ‘tax loss harvesting’, which has its benefits. 

Your retirement is supposed to be one of the freest phases of your life, but taxes do not simply evaporate after you stop working. Do not allow capital gains and taxes on withdrawals darken the investments you have worked so hard to grow. Long-term capital gains rates can reach an astronomical 20%, (as of this year) so the risk is simply not worth it.



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