Retirement asset diversification by tax treatment

We have all heard the conventional wisdom of “don’t put all your eggs in one basket” when referring to one’s investments. But what does this really mean? In the past, I had written about some investment basics like investing in many different companies, many different regions geographically, different sectors of the economy and even by the sizes of companies that you are investing in. All of these items are very important, but what is typically overlooked by many investors is their diversification by the tax treatment.

There is no assurance that the government will keep the tax system as is and the exit strategy is just as important as the entrance strategy.

Pre-Tax Retirement Accounts (i.e. 401k, 403b, 457, 401A, Traditional IRAs, etc)

The money that you contribute to these accounts is not hit with income tax that year, it grows tax deferred…but then when you take the money out (post age 59.5 to avoid a 10% penalty) the money and all growth are then taxed at your income tax rate at that time.

Post-Tax Retirement Accounts (i.e. Anything with ROTH in front of it – Roth IRA, Roth 401k, Roth 403b, etc.)

These accounts do not get a tax break upfront when you contribute to them. However, the money then grows tax deferred and then entire account value is not taxed upon withdrawal. Investors’ anticipated tax bracket in retirement will determine where or not a Roth IRA versus a traditional IRA will provide more money in retirement. Generally investors who are in a higher tax bracket at retirement relative to their current tax bracket while making contributions to a Roth IRA benefit more than an investor who is in a lower tax bracket at retirement.

Capital Gains Treatment of non-retirement accounts

This is technically called a non-qualified account or non-retirement brokerage account. The money in these accounts are not qualified for retirement tax breaks, but in return the money in most cases is liquid and not tied to being withdrawn after age 59.5. You do not get a tax break for your contributions, but the money is only hit at capital gains tax which currently relates to what your marginal tax bracket is if it is long-term capital gains (i.e. you have to hold the investment for 12 months or more). Short-term capital gains (investments held for 12 months or less) are just added to your ordinary income and taxed the same way your wages are taxed. Here are long-term capital gains rates:

As of 2016:

If you are in the 10% or 15% Ordinary income bracket, your long-term capital gains are hit at 0%.

If you are in the 25%, 28%, 33% or 35% brackets, your LT Capital gains are taxed at a rate of 15%.

If you are in the 39.6% bracket, your LT capital gains are taxed at 20%.

Additionally, if your income is over $250k for married filing jointly, or $200k filing single, you also get hit for an additional 3.8% on top of the normal gains tax.

A general thought is that you should be plowing money into pre-tax retirement accounts when in peak earning years and taking it out in retirement years when you assumedly are in a lower tax bracket. Once you “fill up” the lower brackets (which in today’s system would likely be the 10% and 15% tiers), then you would want to turn to withdrawing out of your Roth accounts or other post-tax funding vehicles. Overall, the idea would be to never be pulling money out in retirement years over the 15% bracket at a maximum. Proper preparation on the front end of your retirement planning has the potential to save you thousands of dollars of your net worth on the back end. Additionally, having money in several different types of tax buckets also makes you well-positioned for any potential tax law changes by the government.

Jon Ylinen

Author: Jon Ylinen

Jon works with several hundred physicians starting as early as their final year of medical school, through residency and fellowship, in practice, and through retirement.

Registered Representative of Cetera Advisor Networks, LLC and Investment Advisor Representative of Cetera Investment Advisers, LLC.

Please consult a financial professional for specific advice in relation to your individual circumstances. This should not be considered as tax, specific loan repayment for an individual or legal advice. This is not a recommendation of any strategy or product in particular. 2767165/DOFU 10-2019