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Control What You Can (Part 3 of 3)--Be Aware of Tax Impacts.

One of the financial philosophies listed on my website is: “don’t let the tax tail wag the investment dog”. This means that tax benefits/drawbacks can be a reason, but should not be the only reason to make an investment (or, for that matter, any) personal finance decision.

Neither we (nor Congress, it seems) has any idea what taxes will look like next year, let alone 10, 20 or more years down the road. But there are a couple ways to control your taxes on investments:

#1 Tax Diversification: Diversify your investments across different types of accounts that are taxed differently.

#2 Tax Location: Locate your investments in the type of account that favors their tax characteristics.

#1. Investments in 401ks and Traditional IRAs grow tax-deferred, but are taxed as ordinary income when you withdrawal them in retirement. Money in taxable brokerage accounts is taxable every year, “as you go” and investments in Roth 401ks and Roth IRAs are after-tax money when they go in, but completely tax-free when you withdrawal them in retirement. So if you have some savings in tax-deferred accounts, some in taxable accounts and some in tax-free accounts, you’ll have substantial flexibility in retirement when it comes to maximizing your after-tax returns and the retirement income you need from your portfolio.

#2. Taxable bond funds are best placed in tax-deferred accounts, because even as taxable bond interest is earned throughout the year, you won’t have to pay taxes on it as long as it’s inside a tax-deferred account. Tax-exempt municipal bond funds are best placed in taxable accounts, because they are federal (and possibly state) tax-free by their nature. And potentially higher return stock funds and things like REIT funds are best placed in tax-free accounts where they can grow and be completely tax-free.
It’s usually illegal to completely evade taxes. However, by using account tax diversification and investment tax location strategies you can provide yourself greater tax flexibility and minimize taxes at the same time.