Why Thinking Outside the Box Might Be Your Best Tax Strategy

Why Thinking Outside the Box Might Be Your Best Tax Strategy

The following is adapted from FOOLISH.

Have you stopped and thought about the effect taxes have on your investment returns? I’m guessing you haven’t, at least not like you should. That’s probably because you’re used to paying taxes on the returns you garner… but what would you say if I told you there are ways to gain superior tax treatment? However, taking advantage of them requires you to think outside of the conventional strategy of “tax deferral.”

I know what you’re thinking: “Surely, putting off taxes is always a good idea…” My response? Often, it is a good idea, but it certainly shouldn’t drive all your investment decisions.

So how do you build a tax strategy that keeps the most money in your pocket? Let’s take a look, so you can create a strategy that will work for you. Of course, this is general advice, but you can tweak it according to your individual situation and create a realistic strategy that doesn’t drag down your returns as much as a more-traditional strategy might.

The Basic Strategy

When you’re thinking about your tax strategy, start with the general structure. At a basic level, you should weigh the tax rate that will apply in your accumulation years against that which will apply in your retirement. This is especially true when you’re considering whether a tax-deferral strategy is right for you.

The only way tax deferral can be a great benefit to you is if you are in a high tax bracket during accumulation and a low tax bracket during retirement. Any other combination has much less benefit, if any. This combination is rare anyway, since very high earners tend to be those whose investment earnings (and ordinary income tax rate) remain high in retirement. 

It is possible to optimally allocate your assets among your tax-deferred and taxable account types. Remember, tax advice is unique in each situation. So, I’ll give you just one example of a case in which practical advice flouts conventional wisdom, in the hopes this will make you assess your own situation a little more vigorously.

Flip Conventional Strategy on Its Head

Convention dictates that high-growth vehicles should be placed in a tax-deferred account, such as an IRA, which is protected from taxes for most of your lifetime. That means you can reinvest any gains you earn so they compound over time, without the drag of taxes. This works well, of course, until it’s time to pay the IRS. At that point, all gains distributed from an IRA are taxed at your ordinary income tax rate, which can be as high as 39.8 percent!

So what if, instead, you put your low-growth assets in your IRA, and your high-growth assets in a regular taxable account? In that case, your high-growth assets might be exposed to occasional capital gains taxation at a maximum tax rate of 23.8 percent, but that’s much lower than 39.8 percent. Plus, if you follow a passive management investment strategy, even these occasional capital gains taxes shouldn’t be a huge concern. 

Plus, when you die, the IRS has a rule in place (the Step-Up in Basis Rule) that passes all of the assets in your taxable accounts (but not your IRAs) to your inheritors tax-free. I’m sure you can imagine the profound advantage of having your highest growth assets shooting for a step-up at death. You wouldn’t want that advantage to be lost on low-growth assets like bonds.

Following this strategy (high-growth assets in a taxable account and low-growth assets in a tax-deferred account) and assuming 8 percent growth and death in 30 years, if you start with $100,000 in each account, your heirs will inherit 30 percent more (nearly $250,000) than if you followed the conventional allocation method (high-growth assets in the IRA). That’s a pretty big deal, if you ask me.

Sometimes, Unconventional is Best

The example above shows what a huge difference it can make to think unconventionally. There’s nothing illegal or difficult about it. It just takes a realistic perspective on what your situation is, what it’s likely to be in the future, and then taking steps to maximize the benefits of each.

So now, I challenge you to sit down and think through your own individual situation. What tax bracket are you currently in? Do you expect that to change significantly when you retire? If so, by how much? Thinking through these types of questions may very well lead to a massive reduction in taxes over time.

For more advice on how to minimize your tax liability and maximize your returns, you can find FOOLISH on Amazon.

Gil Baumgarten, one of the nation’s top financial advisors, is the Founder and President of Segment Wealth Management, an RIA financial advisory firm. Since its inception in 2010, Segment Wealth Management has grown to a top-ten firm in Houston, as recognized by the Houston Business Journal, with over a billion dollars in client assets under advisement. Gil is also a nine-time recipient of the Top 1,200 Financial Advisors distinction and has been ranked among the thirty-five best advisors in Texas by Barron’s. Distinctions aside, Gil’s affinity for precision and detail reveals itself in his daily life as well. He is an avid outdoorsman, award-winning woodworker, and attentive family man, friend, and colleague.