By Robert D. Flach, MainStreet.com
NEW YORK (MainStreet) — Careful planning of how you invest your retirement savings can help to maximize your net after-tax yield, both for yourself and your beneficiaries.
Let’s look at the various types of investment accounts.
First there is the currently taxable liquid investment account. Interest and dividends on this type of account are fully taxed when earned, except for tax-exempt municipal bond interest and dividends from muni bond funds. Capital gains, and losses, are taxed, or deducted, when an investment is sold.
Next there are the multitude of traditional retirement accounts - IRA, 401(k), 403(b), 457, SEP, Keogh, SIMPLE, etc.
Contributions are usually currently tax deductible, at least on the federal level, either by way of being “pre-tax” or via a deduction on the Form 1040. Current earnings are tax-deferred. Distributions from these accounts are usually fully taxed. If there is a basis in the account from non-deductible contributions distributions will be partially tax free. Premature withdrawals, taken prior to reaching age 59.5, and excess contributions are penalized.
And finally there are ROTH IRA, 401(k), and 403(b) accounts. Contributions are never tax deductible, but, as with traditional retirement accounts, current earnings are exempt. If the account is held for at least five years distributions are totally tax free.
Now let us look at how different types of investment income are taxed.
Interest, dividends, and short-term capital gains (on the sale of investments held one year or less) are generally taxed as ordinary income. The tax on this type of income depends on your “regular” income tax rate – from 10% to 39.6%. If you are in the 25% federal tax bracket you will pay $250 in tax on income of $1,000. If you are a victim of the dreaded Alternative Minimum Tax (AMT) you will pay either 26% or 28% tax on this income.
“Qualified” dividends are taxed at special lower capital gains tax rates, as are “capital gain distributions” from mutual fund investments. Depending on your “regular” tax bracket the rate is 0%, 15%, or 20%.
Long-term capital gains on the sale of investments are also taxed at the capital gains tax rates. You have a long-term gain if you held the investment sold for more than one year – at least a year and a day.
Qualified dividends, capital gain distributions, and long-term capital gains are also taxed at the special rates under AMT, but the income from these categories increases net taxable income, and therefore increases Alternative Minimum Taxable Income, and may cause you to become a victim of the dreaded alternative tax.
If your Adjusted Gross Income is more than $200,000 if Single or Head of Household, $250,000 if Married filing jointly or Qualifying Widow(er), or $125,000 if Married filing separately, you may be subject to an additional flat 3.8% tax on current net investment income.
Earnings from municipal bonds and funds investing in tax-exempt municipal bonds (but not capital gains, both short and long term, from the sale or capital gain distributions) are exempt from federal income tax. However, otherwise tax-exempt interest and dividends from “private activity bonds” are taxable in the calculation of AMT. And it is possible that the amount of tax-exempt interest can cause more of your Social Security or Railroad Retirement benefits to be taxed at ordinary income rates.
Taxable distributions from retirement accounts are taxed as ordinary income at “regular” tax rates, regardless of the source of the income that has accumulated within the account. Qualified dividends, capital gain distributions, long-term capital gains, and tax-exempt municipal income earned within a tax-deferred retirement account are all taxed as ordinary income when the money is withdrawn from the account.
Distributions from retirement accounts are not subject to the 3.8% tax on net investment income. But since the 3.8% tax is paid on the lesser of net investment income or the amount your AGI exceeds the threshold for your filing status, retirement account distributions may push your AGI over the income threshold and end up being subject to the tax.
Let’s say you are married and your AGI is $260,000, which includes a $12,000 taxable IRA distribution. Let’s say your net investment income is $15,000. $10,000 of the IRA distribution will be subject to the 3.8% tax. Without the $12,000 distribution your AGI would have been $248,000, and you would not have been subject to any Net Investment Income tax.
Beneficiaries who inherit assets such as stocks, bonds, mutual fund shares and real estate receive a “stepped-up” basis. The beneficiary’s cost basis for an inherited investment is generally the value of the investment on the date of death, which is the value of the investment reported on the estate or inheritance tax return(s). If my father bought 100 shares of XYZ Corp for $100 in 1980, and these shares were worth $1,000 on his date of death, if I inherit the shares and then sell them for $1,100 I have a long-term capital gain of $100 and not $1,000.
Beneficiaries who inherit retirement accounts are subject to federal income tax on distributions in the same way the deceased would have been taxed if distributions were made prior to death, regardless of the value of the account on the date of death.
For example, when a traditional IRA owner passes with a “basis” in the IRA from non-deductible contributions that has been documented on IRS Form 8606, the remaining basis is inherited by the beneficiary in proportion to the percentage of the IRA the beneficiary inherits, and the beneficiary continues to compute the taxable portion of subsequent distributions on Form 8606.
Distributions to beneficiaries from inherited ROTH accounts are totally tax free.
Strictly from a tax point of view, traditional retirement accounts should contain “fixed income” investments and investments that you anticipate will generate short-term capital gains. These investments produce income that is taxed at ordinary income tax rates. And the best place for “appreciating” investments, like stocks and mutual funds, and investments that produce “qualified” dividends and capital gain distributions is in taxable investment accounts. This way you will be able to take advantage of the tax benefit provided by the lower capital gains tax rates.
I must point out that tax-deferred accrual of income will cause money invested in traditional retirement accounts to grow faster than investments in currently taxable accounts, assuming that the taxes on current earnings are paid from the investment. And it is usually better to pay taxes tomorrow than today.
You should never invest traditional retirement account money in tax-exempt municipal bonds or mutual funds that invest in tax exempt municipal bonds. This income is, for the most part, exempt from federal income tax, while, as pointed out above, earnings accrued within a traditional retirement account will be taxed at ordinary income rates when money is taken out of the account, even if some of the earnings are from tax-exempt municipal bonds.
With ROTH accounts your goal should be to get the greatest return on investment, regardless of the type of investment. Qualified distributions from ROTH accounts are totally tax free. And they pass totally income tax free to your beneficiaries.
Of course the tax treatment of investments that I have discussed above apply to current tax law. And my discussion assumes that tax law will not change drastically in the future. However tax rates and treatments are subject to the whim of the members of Congress, and with Congress anything is possible.
Your first consideration in any financial transaction should always be economic. Taxes are second. However it is important to be aware of the tax treatment and consequences of the various types of investments and investment accounts when making financial decisions.
It is also very important to run investment recommendations from a broker or a banker past your tax professional before making any decisions. Never assume that a broker or a banker knows anything about tax law, or even takes tax consequences into consideration when recommending investments. You must always remember that a broker and a banker are basically salesmen.
To Your Successful Retirement!
Michael Ginsberg, JD, CFP®