Imagine you had to fit all of your investments into one of three buckets: The Non-Qualified bucket; the Tax-Deferred bucket; or the Tax-Free bucket.
The Non-Qualified bucket generally includes any type of investment for which you receive a 1099 on an annual basis. These funds receive no special tax treatment, and you will typically be taxed on interest and dividends as they are paid, in addition to any gains you make upon sale of investments in this bucket.
The Tax-Deferred bucket includes any retirement accounts to which you have contributed money on a tax-deductible or pre-tax basis, such as most IRAs, 401(k)s, 403(b)s, and others. These accounts typically allow for tax-deferred growth, which means that you are not taxed on income or gains as they occur, but when you eventually take retirement income the funds you withdraw will be taxed as ordinary income.
Finally, the Tax-Free bucket includes accounts to which you contribute after-tax money, such as Roth IRAs, Roth 401(k)s, and others. You do not get any special tax breaks up front in this bucket, but all contributions and growth can be withdrawn income tax-free for qualified reasons (which is generally once you are at least 59 ½ years old and the account has been established for at least 5 years).
Each of these different buckets has their own unique characteristics. Some are more suited for certain needs than others, so it is important to plan accordingly.
Which Bucket is Most Tax-Efficient?
Most financial professionals would probably agree that the Taxable bucket is the least tax-efficient place to grow a retirement nest egg. Not only do you pay taxes on any interest and dividends each year, but you may also owe capital gains taxes upon selling an investment.
As for the other two buckets, Tax-Deferred and Tax-Free, investment professionals differ in opinion as to which is better to use. Why?
The trouble is, which bucket to use depends in part upon what will happen in the future. In order to seek to utilize the different buckets most efficiently, we believe you should not only understand how much you are paying in income taxes while contributing, but also what your income taxes may be in the future when withdrawing from the accounts. Based on the income sources you anticipate being available to you in retirement, you may be able to estimate what your future income taxes will be; however, there is the possibility that income tax rates may change in the future.
If you were able to predict your future tax bracket, and your income tax rates were going to be lower in retirement than they are now, it may make sense to invest in a tax-deferred account during your higher income-earning years and claim the deduction to reduce your current Non-Qualified income. The intent then would be that when you begin an income stream from this tax-deferred account in the future, you would pay a lower rate of income taxes upon withdrawal than you would have owed earlier if you hadn’t been able to claim the initial deduction.
However, if you believe that your income will be higher in retirement or that tax rates will increase, it may make sense to invest in the tax-free account during your earning years (and pay taxes on the funds upfront) so that you can withdraw funds in retirement tax-free.
Unfortunately, there is no crystal ball available to know what the future will hold. Some investors choose to hedge their bets and invest into both of these buckets, giving them flexibility and tax diversification in their retirement years.
Let’s Talk More About the Non-Qualified Bucket – Capital Gains and Income
When an asset appreciates in value within the Non-Qualified bucket and that investment is sold, you may pay either short-term or long-term capital gains taxes, depending on whether or not the asset was held for more than one year.
Long-term capital gains, as well as certain dividends, receive a tax break with rates that are more favorable than ordinary income tax rates. For example, if you experience a long-term capital gain and your federal taxable income is under $38,600 (if a single filer), you may have zero tax liability on the sale of that security; if you earn higher amounts, you may pay 15 or 20 percent federal tax on the sale of that security, but this rate will still usually be lower than your ordinary income tax rate (higher-income taxpayers may also need to pay an additional “net investment income tax”).
Below is a chart which illustrates how long-term capital gains and qualified dividends are taxed as of 2018, based on your taxable income level (note that these income brackets will be indexed to inflation).
|Single||Joint||Head of Household|
|0% Tax Bracket||$0 – $38,600||$0 – $77,200||$0 – $51,700|
|Beginning of 15% Tax Bracket||$38,601||$77,201||$51,701|
|Beginning of 20% Tax Bracket||$425,801||$479,001||$452,401|
When investing in the Non-Qualified bucket, not only do you need to be aware of the potential capital gains taxes you may owe upon selling an appreciated asset, but you also need to be aware of how capital gains are passed down to the investor through a fund; this is especially relevant when owning actively-managed funds and certain types of bond funds. This is referred to as potential capital gains exposure (PCGE). According to the Morningstar Investment Glossary, PCGE is: “an estimate of the percent of a fund’s assets that represent gains. PCGE measures how much the fund’s assets have appreciated, and it can be an indicator of possible future capital gain distributions.”
For example, if the fund manager places a trade which results in a capital gain, that gain (and tax liability) is passed down and split amongst all investors of that fund – even if you, personally, did not benefit from the gain or sell your fund shares.
Interest earned from bonds is generally taxed at ordinary income tax rates. For this reason, it is most tax-efficient to avoid owning certain bonds in the Non-Qualified bucket. Generally, Corporate bonds will be the least tax-efficient, while federal government bonds usually are exempt from state and local income taxes. Municipal bonds are generally the most tax-friendly, as they are often exempt from all income taxes.
Stocks are one of the most favorable investments to hold in the Non-Qualified bucket, because qualified dividends receive preferential tax treatment. There are also certain types of investments that have minimal capital gains pass-through that should be explored when investing in the Non-Qualified bucket.
Building a Plan
Due to contribution limitations for work retirement plans, IRAs, and Roth IRAs, it may not be feasible to avoid the Non-Qualified bucket altogether. However, as long as you or your financial advisor are aware of the tax ramifications of the different types of accounts you have available to you and the types of investments owned in each account (including the potential capital gains created inside your taxable accounts), you can use this knowledge to build strategies designed to minimize your tax burden. When creating the plan, you should consider your estimated future income needs and the total long-term effects of each action, rather than solely whatever provides the most immediate benefit. For more on this type of planning, see our Tax Diversification Strategies article in this series.
Projecting Future Tax Rates
Finally, as we touched on above, an important variable in determining your tax strategy is attempting to make reasonable projections about the future of tax rates. Many people have concerns with the future tax climate due to factors like the high U.S. national debt, significant unfunded Medicare promises starting in 2026, and the fact that the Social Security trust fund is projected to be depleted by 2034.
While no one can absolutely predict the future, we believe it is important to incorporate reasonable assumptions on the future of our country’s tax environment to help design and implement tax minimization strategies. Look for more on these assumptions in our Headwinds Facing America’s Wealthy article in this series.
Tax Minimization is one of the four key areas of our Holistic Wealth Management series. Other topics in this series include Investment Management, Income Planning for Retirement, and Estate Planning. To request more articles in this series, contact us at 715-832-1173 or go to education.bernicke.com to subscribe.