Understanding the tax implications of your investment strategy is as important as the strategy itself.
This article is a follow up to “Want a Great Retirement”. That article went into the pros and cons of common retirement income strategies. This article will go into the tax implications of those common investment strategies.
Buy individual bonds
There are three main tax structures for bonds:
- Treasuries are taxed at the federal level but usually avoid state income taxes.
- Municipals avoid federal tax and usually avoid state income tax if they were issued from the state you reside in. For example, if you live in New York and buy Ohio muni’s, New York will make you pay state income tax on that income.
- Corporate bond income is taxed as ordinary income with no special treatment.
The ideal scenario would be to load up your taxable accounts with muni bonds, hold corporate bonds and treasuries in your tax-deferred accounts, and hold everything to maturity to avoid any capital gains taxes. Muni bonds are tax-efficient, so they are one of the best investments to hold in a taxable account. You’ll end up paying ordinary income taxes on any distributions from tax-deferred accounts, so there’s no harm there and you get to delay paying the taxes for a while.
The main drawbacks? It takes a lot of research/time to choose individual bonds. You’re also going to lose purchasing power as the bonds pay the same coupon payments year after year.
From a tax standpoint, though, it’s a very efficient way to receive income.
Buy a bond mutual fund or ETF
Similar to buying individual bonds above, the income from a bond fund will be taxed based on the bonds the fund holds. Focus on buying funds that only hold one type of bond. A muni bond fund would go in your taxable account, a treasury bond fund or corporate bond fund would go in your tax-deferred accounts. The income tax treatment is pretty much the same as holding individual bonds.
Capital gains will be the difference in this strategy. You have no control over the fund manager. If he decides to sell bonds rather than hold to maturity, you will be responsible for the capital gains taxes. A smart fund manager will maximize the value of the fund in relation to the taxes generated. Even so, you want to hold any high turnover bond funds in your tax-deferred accounts so it doesn’t become an issue. To maximize, look for low-turnover muni funds for your taxable accounts.
Buy growth stocks and sell a certain percentage each year
A growth stock is going to have none or very little dividend income, so the focus here is capital gains. Short-term capital gains (investments held a year or less) are taxed as ordinary income and long-term capital gains (investments held more than a year) get a lower, preferred tax structure.
To maximize exploiting this structure, hold anything you might sell quickly in your tax-deferred accounts to avoid any short-term capital gains. Make sure all of your investments in taxable accounts are long-term before selling to minimize taxes.
If the growth stock does pay a dividend, try to hold it in your tax-deferred account. Even though dividends get a preferred tax rate, you can be more efficient by holding dividend stocks in your tax-deferred account and delaying taxes on the dividend-paying stock. That means putting zero-dividend stocks in your taxable accounts. The numbers end up very close in the end, so I’ll lean towards delaying taxes as the more efficient means.
While I always recommend a long-term mindset and investing for the long-term, I understand that sometimes an investment just doesn’t go the way you expected. If big company news is announced that will result in a huge stock price drop, paying taxes on short-term gains is far better than letting all of the gains evaporate!
With this structure, you’ll pay long-term capital gains on anything sold in your taxable accounts, and ordinary income on anything you withdraw from your tax-deferred accounts.
This strategy isn’t as tax efficient as owning individual bonds but its main risk isn’t tax-related; it’s simply having to sell more and more shares during a down market to sustain your current standard of living.
Buy dividend-paying stocks and live off of the income
With this strategy, we are focusing on dividend income. You want to make sure your investments are paying out qualified dividends. Qualified dividends get the same preferred tax structure as long-term capital gains.
To minimize taxes here, you actually want as much as possible in taxable accounts to take advantage of lower tax rates versus paying ordinary income from tax-deferred withdrawals. You don’t plan on selling any shares so there’s no concern about short-term or long-term capital gains. You just want to minimize the taxes on the dividend income.
This is the Goldilocks strategy in my mind. You get growth from equities without having to sell during market downturns. You pay slightly higher taxes than a bond portfolio but you get increasing payouts each year as a tradeoff. Dividends generally increase by about 6% per year so there’s no purchasing power risk.
Up next, I’ll have a concise outline of which investments should be held in each account type. The outline will help maximize gains and minimize taxes no matter what strategy you are implementing.
Disclosure: I am not a CPA or tax professional. The information presented in this article is for general guidelines. You should seek advice from a tax professional based on your own unique circumstances.