Planning a Tax-Deferral Strategy for your Pre- and Post-Tax Investment Accounts

By Roger Wohlner

Tax planning should be a key element in your overall financial planning. However, it is only one tactic, not an end unto itself. Investment decisions made for tax purposes only are often not good decisions. Your financial goals and asset-allocation strategy should govern your overall investing strategy.

For many of us, our investment strategy includes both pre- and post-tax investment accounts.

Pre-tax investment accounts include traditional IRAs and work-related retirement plans, such as 401(k)s, profit-sharing plans, 403(b)s, and defined-benefit pension plans.

With pre-tax accounts, federal and state income taxes have not been paid. If you contribute to an account like a 401(k) from your paycheck, you’ll see this reflected. (Note: Tax-deferred contributions are still subject to Social Security and Medicare tax withholdings.)

Tax deferral is a key concept here. Using a non-Roth 401(k) account as an example, money is deferred each pay period and invested according to your instructions. The money grows over time, and no income taxes are due on it, including any gains.

When you begin to withdraw the funds, this money is subject to full income taxation. There is no preferential treatment of capital gains. Your money is fully taxed, even if your investments are worth less than what you have contributed over the years.

For example, if your income is $50,000 in a given year and you withdraw $10,000 from a tax-deferred account, your taxable income is now $60,000, and this amount will then flow through your tax return.

Post-tax investment accounts are typically accounts where the money deposited has already been subject to income taxes. Examples include a taxable brokerage account or a taxable account with a mutual fund company.

With a post-tax account, all capital gains and income distributions are subject to taxes in the year received, based on the type of income they represent. Investment losses can also be deducted.

Some types of accounts have characteristics of both camps. Let’s call them hybrids. Examples of hybrids are a Roth IRA, an after-tax IRA, and a 529 college savings plan.

I am often asked which types of investments are right for various investment accounts. The answer depends on a number of factors, including your individual needs.

Assuming that your investment strategy includes taxable, tax-deferred, and perhaps some hybrid accounts, here are a few things to consider when deciding which type of account should hold a particular investment:

  • At least through 2012, capital gains tax rates will remain at historically low levels.
  • The tax rate on qualified dividends remains capped at 15 percent. Nonqualified dividends are taxed at your ordinary income tax rate.
  • Annuities already allow tax-deferred growth of your investments until withdrawal. There may be a good reason to hold an annuity in a tax-deferred account, but I’ve never come across that reason. Your stockbroker or other commissioned financial sales professional might try to convince you otherwise.

The answer as to which account should hold which investment may vary over time based on your current and projected tax situation:

  • Is your income variable?
  • Do you have any large losses to carry forward?

While some of my financial planning colleagues may disagree, there is no hard-and-fast rule to determine which specific investment to hold in a certain account. Again, and I can’t stress this enough, tax planning is an important aspect of your overall financial planning, but it’s not the only one. I have seen far too many folks get so hung up on the tax impact that they make decisions that hurt them over the long term.

The biggest unknown in all of this is the future direction of income tax rates.

Roger Wohlner, CFP® is a fee-only financial advisor at Asset Strategy Consultants. Roger provides advice to individual clients, retirement plan sponsors and participants, foundations, and endowments.
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