Video: Invest With a Tax Focus

Thanks for turning in the final video on our tax planning series.
This is Kieran Byrne, I'm the founder and lead advisor here at MK Byrne & Co.

In this video, we'll discuss how you can invest with a focus on reducing your taxes and preserving your wealth.

How Are Investments Taxed?

Why don't we start today by discussing how different types of investments are taxed.

If you refer to the chart above, you will see the impact of realizing $50,000 of different types of investment income.

In this specific scenario, we assume the client is a married couple with $80,000 in social security income and $95,000 in pension income.

The first important observation is the impact that an extra $50,000 would have on the couple's Medicare cost as any income over $194,000 would result in an increase in their Medicare premium. So right away, you can see how investment income can impact not only your tax return but also your Medicare costs.

Next, we see the receipt of stock dividends and US government interest results in lower tax bills than the receipt of regular interest and pre-tax IRA withdrawals.

The reason for the lower tax bill is that dividends and capital gains are taxed at more favorable federal tax rates and US government bond interest is not taxed at all by New Jersey.

We next turn our attention to tax-free bond interest on the right side of the page. As you can see, a tax-free bond will pay much less interest than a taxable bond with an identical risk profile.

In the example on the top right, I show a $1 million investment in a taxable bond paying 5% interest, and a $1 million investment in a tax-free bond paying 3% interest. After accounting for the $20,000 in taxes due, both the taxable bond and the tax-free bond provide an investor with the same after-tax return of 3%.

The key point here is that tax-free bonds can be valuable planning tools for high-income taxpayers as the interest rate between a tax-free bond and a taxable bond assumes that the investor is exposed to the highest tax rates. This means that most taxpayers, and certainly most retirees, are better off owning a fully taxable bond, which will pay a higher rate of after-tax interest.

We illustrate this point in the bottom right corner where the investor with $200,000 of annual income is $9,000 better off by investing in the taxable bond and paying tax at the 22% federal tax rate.

How Are Specific Investment Accounts Taxed?

The next topic to discuss is the taxation of specific investment accounts. We start with a review of a taxable brokerage account where all interest, dividends, and realized gains are taxed each year. While electing to pay tax seems counterintuitive, at times it can make sense to do so.

The tax advantages of a taxable brokerage account include the application of lower tax rates on certain types of stock and bond income as well as the ability to realize tax deductions on periodic investment losses.

Another major benefit of this account is that the beneficiaries of your estate will avoid having to pay capital gains tax on any highly appreciated assets inherited from this account. So, if you invested $100,000 in Apple, and it grew to $1.1 million at your date of death, neither you nor your beneficiaries will pay any tax on that $1 million of stock appreciation.

With these considerations in mind, you generally want to own stocks, tax-free bonds, and US government bonds within a taxable brokerage account due to the favorable tax rules that apply to these specific investments.

Next, we have pre-tax IRAs in which all investment taxation is deferred until you withdraw the funds. At that time, any withdrawal would be taxed at regular income tax rates. Within a pre-tax IRA, you want to hold investments such as corporate bonds, mortgage bonds, or even bank CDs since these types of investments are taxed at unfavorable tax rates.

Another key planning point is that owning stocks with any pre-tax IRA is not ideal, as a stock's favorably taxed dividends and capital gains will end up being taxed at the IRA's higher tax rates.

However, this negative tax consequence is small compared to the consequence of holding highly appreciated stocks within a pre-tax IRA.

A Real World Example: Apple Stock

To illustrate this point, let's revisit the Apple stock example. However, this time you make that same $100,000 investment into Apple within your pre-tax IRA. In this scenario, because the investment was made within a pre-tax IRA, your beneficiaries will end up inheriting the $1.1 million of Apple stock as well as the associated tax liability on all $1 million of that gain. Shockingly, by simply making a great investment in the wrong account, your beneficiaries would end up paying hundreds of thousands in taxes that could have been entirely avoided.

Next, a Roth IRA is perhaps the most straightforward account type since no tax deduction was received when you contributed to this type of account, the funds will grow tax-free.

Since the Roth IRA grows tax-free, it can be helpful to place higher returning investments within this account to help accelerate its growth over time. However, it's important to avoid speculating in high-risk boom or bust investment ideas within a Roth IRA, as you want to avoid taking sizable losses in such a valuable account.

The last type of account I discussed is a non-qualified annuity, which is an account that is used to defer the taxation of funds normally held in a taxable brokerage account.

A non-qualified annuity is often used when a client has a large taxable brokerage account that is creating tax complications due to the sizable amount of taxable investment income that is generated each year. A client in that situation could invest some of those taxable brokerage funds into the annuity and immediately achieve tax deferral on that investment income.

Now, let's review how these various tax concepts might be used in practice.

So What Does This Look Like in Practice?

In this planning scenario, we have a married couple who have $1.2 million in a taxable brokerage account of $1.5 million in a pre-tax IRA and $300,000 in a Roth IRA.

Right after evaluating the retirement objectives, the couple decided to invest 70% of their savings in a diversified portfolio of bonds, and 30% in stocks.

We also know that the couple has 2 children who both earn high levels of income, so we want to be mindful of the future tax liabilities inherited by each child. In this scenario, we've recommended an asset allocation that places stocks and US government bonds within the taxable brokerage account. Within the pre-tax IRA, we've placed the taxable bond positions. We round out the asset allocation by placing high-yield bonds in the Roth IRA as these types of bonds have historically exhibited stock-like returns, but have achieved such returns with far less volatility than stocks.

So how will the client benefit from this recommendation?

First, we’ve placed the stocks and US government bond investments within the taxable brokerage account. This reduces the client's annual tax bill as these investments are taxed at more favorable rates.

Second, we've concentrated lower growth investments inside the pre-tax IRA. By locating these assets here, we can better control the pre-tax IRA growth, and this helps manage the size of future required distributions. Had we placed high-growth assets here, it could have created a dramatic increase in the size of the client's future required distributions, and that would only lead to more taxes being paid.

Third, we've placed higher-growth assets within the Roth IRA account, where those assets will grow tax-free, as well as within the taxable brokerage account, where highly appreciated assets can be inherited by the client's children without the need to pay capital gains tax. By allocating the higher growth assets to investment accounts with the most favorable tax rules, we can help ensure that the client's high-income children will inherit most of the client's assets without also inheriting large tax bills in the process.

In total, a client with this type of financial profile could easily save several hundred thousand dollars in taxes for themselves and their children by implementing just a few of these planning ideas.

This concludes our video series on the retirement tax strategies that we use each day with our clients. To the extent that you're interested in learning more about the specific ways that we might help you, please feel free to reach out to schedule a complimentary consultation.

We thank you once more for your interest in our firm.