I look at all investments as falling into three Buckets and each of these buckets have unique characteristics, so it is important to plan accordingly.
- Taxable Bucket: Any investment for which you receive a 1099 and can be taxed. For instance a liquid mutual fund, stock or bond portfolio, bank account and even real estate could fit in this bucket, (although real estate has other great tax benefits). You’ll be taxed on dividends, interest, and rent and they are paid, and any gains made from a sale. Most financial professionals would agree that the Taxable bucket is the least tax-efficient place to grow your assets because you could lose 20% – 50% of your profits in taxes every year.
- Tax-Deferred Bucket: Pre-tax retirement accounts like most IRAs, 401(k)s, SEPs, 403b’s, etc. that you have invested with pre-tax dollars or on a tax-deductible basis. You won’t be taxed on income or gains as these funds grow, but you will be taxed when you withdraw your funds in Retirement, and your heirs will pay income taxes on whatever is left over for them. Non-Qualified Deferred Annuities would also fall into this category, as they are tax deferred and built for retirement.
- Tax-Free Bucket: Accounts that you contribute after-tax money to, like Roth IRAs, Roth 401(k)s, 529\’s, and LIRP’s. You are generally not taxed as these funds grow or when you withdraw your funds. If you believe that your income in retirement will be higher than your current income or that tax rates will increase, then the Tax-Free bucket may be a good option for you. Investing in the Tax-Free bucket during your earning years and enabling you to withdraw your funds tax-free in Retirement. Investors in high tax brackets also utilize Municipal Bonds which can provide tax free income.
Which Bucket is the Best for you?
Many financial professionals differ in opinion on whether the Tax-Deferred bucket or the Tax-Free bucket is better to use. In order to properly decided which bucket you are going to use, you need to consider your current and future income taxes, especially when you want to withdraw from accounts. If you have been successful in accumulating assets during your working years, and/or will have a good pension during your retirement, you most likely will be in a high or even higher tax bracket during retirement than your working years. Many smart investors will use both of these buckets for the flexibility and tax diversification during their working and retirement years.
However, it is important to note the possibility of much higher tax rates in the future, especially in light of the coronavirus multi-trillion dollar government stimulus. In addition, many economists have had concerns for years about the future tax climate due to factors such as the high US national debt, underfunded Medicare promises, and the depletion of the Social Security trust fund.
One of our mantras is “Why pay taxes on money you are not using?” This could include money in both tax deferred and tax-free buckets. I recall a famous quote “Nothing hurts more then having to pay an income tax, unless it’s not having to pay in income tax” Baron Thomas Dewar (of Dewar Scottish Whiskey fame). Dewar obviously was worried about folks who did not make any money, but he also did not have access to the incredibly powerful Roth’s and what some professionals call Jumbo Roth’s that we have today. My thoughts would be: “Nothing is sweeter than having to pay a lot of income taxes, except receiving a lot of that income tax free.” Jeff Gurman. Is it possible to reduce your taxable income to $0? Possibly, as careful planning could significantly reduce your tax bill to almost nothing even with fairly high income.
As we’ve seen this year, no one can accurately predict the future, so it’s extremely important to reasonably assume and anticipate future tax changes to properly use tax minimization strategies.
As always call me if you have any questions or would like to speak about strategies to start growing your assets in the tax deferred and tax-free buckets.
-Jeff Gurman
The information above is not to be construed as tax, legal or investment advice. That advice can only be provided by independent tax, legal or investment advisors. CA Insurance License #0815028