Minimizing Taxes on Your Investments: Part 2

by Paul R. Ruedi, CFP®

Last week I covered some of the easiest options to minimize taxes on your investment portfolio like holding tax efficient investments and investing in retirement accounts. Today I will move on to a couple slightly more complicated options.

Asset location, or how you divide your assets between taxable and tax-advantaged accounts, is another tool you can use to lower your taxes on your investment portfolio. You can minimize the impact of taxes on your portfolio by holding tax-efficient broad-market equity investments in taxable accounts, and by holding taxable bonds and less tax-efficient asset classes like REITs within tax-advantaged accounts, such as your 401(k) or IRA. You may also want to consider holding the highest returning assets in a Roth IRA to maximize tax-free growth.

Another way to minimize taxes on your investments is by withdrawing from your various accounts in the correct order. Conventional wisdom suggests that it is best to withdraw funds from your accounts in the following order: Required Minimum Distributions (RMDs) first, then taxable accounts (personal brokerage accounts), then tax-deferred accounts (Traditional 401k/IRA) and finally, tax-free accounts (Roth 401k/IRA.)

You take any Required Minimum Distributions (if applicable) from your accounts first because they are required to be taken by law. If you do not take them, you will receive a tax penalty of 25% (reduced to 10% if corrected within two years) of the required minimum distribution amount. You would then withdraw from your taxable accounts before spending from your tax-deferred accounts because it lowers the amount of income taxes paid in the beginning years of retirement, and enables as much of your portfolio as possible to continue to benefit from tax-deferred/tax-free growth.

However, this is one of those situations where conventional wisdom isn’t always the best strategy. It can lead to low taxes in the early years of retirement, but very high taxes at the end of retirement. If you’re in a low tax bracket (15% or below) in the early years of retirement, you may be better off taking a portion of your withdrawals from your IRA even if you have enough assets in taxable accounts to cover all of your spending needs. This allows you to pay taxes at your current low tax rate and avoid being taxed at potentially higher tax rates in the future.

As you can see, the above strategies are somewhat complicated. There are a lot of moving parts and “it-depends” decisions to be made that require factoring in all of one’s financial variables. Though not impossible to implement yourself, they will likely require the assistance of a professional.

Paul R. Ruedi is a Certified Financial Planner™ professional with Ruedi Wealth Management in Champaign, Illinois.