The Three Tax Buckets for Investors

Trust account, brokerage account, IRA, 401(k), 403(b), tax-deferred, Roth IRA: what do all these account titles mean, and why should they matter to you? In a word, taxes.

Taxes are one of the major financial challenges faced by investors when seeking to grow their long-term wealth. To improve one’s after-tax return, investors need to determine the optimal types of accounts in which to hold particular securities (also known as “asset location”).

At Corient, our goal is to use the tax attributes of each account type to place each investment in the most tax-efficient bucket. We tend to place securities that have low amounts of ordinary income (e.g., municipal bonds, broad index funds, tax-managed funds, individual stocks) in taxable accounts. Conversely, securities that generate higher levels of income (e.g., real estate investment trusts) would be held in tax-deferred or tax-free accounts.

In general, there are three broad categories (“buckets”) of investment accounts:

• Taxable accounts (e.g., bank account, brokerage account, family trust account)
• Tax-deferred accounts (e.g., 401(k), 403(b), traditional IRA)
• Tax-free accounts (e.g., Roth IRA, Roth 401k)

Taxable Accounts Bucket

Examples of a “taxable account” include a brokerage account and a living trust account. The investments held within these types of accounts are often taxed differently than assets in your retirement accounts (e.g., 401(k) or rollover IRA). Investment assets in a taxable account may produce income that is taxed as ordinary income or, more preferentially, as capital gains (or even tax-free). The taxation on these accounts is driven by two factors:  the type of investments and how long the investments are held.

Asset selection: Within a taxable account, we prefer investing in securities that are taxed preferentially, such as municipal bonds or low-yielding assets. For example, California municipal bonds are double-tax-free for California residents (i.e., earned interest isn’t taxed at the federal or state levels).

Investment holding period: If you hold a security for more than one year, the gain recognized on that sale will receive capital gain treatment (which is substantially lower than marginal ordinary income tax rates). Should the security be sold before the one-year anniversary, any gain would be treated as ordinary income.

Unique opportunities in taxable accounts: There are special occasions to further enhance the tax efficiency of taxable accounts. From time to time, securities in a taxable account may be valued below the price at which they were purchased. This is called an “unrealized loss” because the securities have not yet been sold. 

Tax-loss harvesting: This is a disciplined approach to realizing such losses as noted directly above, by replacing the sold position with a similar security (e.g., replacing Coca-Cola with PepsiCo). This type of realized capital loss may be used to offset capital gains or partially offset ordinary income.

Example: In a taxable account, an investor holds Stock ABC, which was purchased at $50 per share more than a year ago. Stock ABC is now worth $45 per share. The stock can be sold with a $5 per share loss recognized and available to offset future capital gains. Using the sale proceeds, the investor can purchase a similar security to maintain comparable exposure to that particular asset class. For example—and with all things being equal—the “harvested” loss can save a Californian taxpayer in the 30% capital gain bracket (20% federal, 10% for California) $1.50 in taxes per share sold. As you can imagine, this can be a highly productive strategy when done proactively and throughout the tax year.

Tax-Deferred Bucket

Tax-deferred accounts are funded with contributions that haven’t been subject to income tax (therefore, they are tax-deferred). They are commonly pre-tax contributions from earnings and come in the form of 401(k), 403(b) and individual retirement accounts (IRAs). Contributions to these accounts may receive an income tax deduction and will grow over time without being taxed. However, every dollar that is distributed later will be taxed as ordinary income. Also, you must typically begin taking required minimum distributions (RMDs) from tax-deferred accounts at age 72, which could lead to “forced” withdrawals and a corresponding tax burden.

Qualified charitable distribution: A tax-advantaged way for IRA owners older than 70 ½ to support their favorite charities is to make qualified charitable distributions (QCDs). By making direct gifts to qualified charities from an IRA, the taxpayer will benefit because the donation is excluded when determining their adjusted gross income (AGI). AGI is an important metric used in various tax calculations. Reducing AGI by making IRA QCDs may produce tax-saving opportunities.

Tax-Free Bucket

Roth IRAs are the most popular income-tax-free assets whereby you make contributions with after-tax dollars. Unlike a taxable account, every dollar taken out of a tax-free account is, as the name suggests, not taxed. This is one of the most powerful wealth accumulation accounts you can have since the earnings and growth held within Roth accounts will never be subject to income tax. RMDs are not typically required, allowing wealth to compound for future beneficiaries (who will then be subject to withdrawal rules).

Roth conversions: You may be able to execute a “Roth conversion” whereby you pay tax on a withdrawal from a tax-deferred account (traditional IRA) in a low-tax year and then “convert” the funds into an after-tax Roth IRA. This is a proven strategy that takes advantage of compounding tax-free growth over future years.

As you can see, an asset location strategy across “tax buckets” is integral to long-term portfolio performance and tax efficiency. We place an emphasis on tax efficiency with each investment choice and its placement in the respective tax bucket. Just as the positive impact of compound returns on wealth is true, so is the negative impact of poor or non-existent tax planning within your investment strategy.

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