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Consider Tax Benefits When Investing Retirement Assets

By Rick Imhoff, CFP ®

A significant amount of money can be invested into a retirement plan, such as a 401(k) plan which in most instances will be matched by the employer.  Over time, this can build up to quite a sum and for many, a large portion of their investment portfolio may be held in their retirement plan.  The contribution by an employee provide a current income tax deduction that accumulate tax deferred and are included in taxable income when withdrawn.

To balance a long-term investment goal like retirement, it is good idea to also accumulate funds in a personal investment account.  You don’t get a current income tax deduction when you place the funds in the account and you pay a little tax along the way, but you can provide yourself another source of income that is not fully taxed like distributions from a retirement plan or IRA.

As you are accumulating money, you must decide how to invest the funds and develop an asset allocation strategy for dividing your investment portfolio among different asset types.  When considering the affects of income taxes, the asset allocation strategy decision-making process can be even more difficult.   

Taxpayers in the 10% or 12% federal income tax brackets do not pay income tax on qualifying dividends and realized long term capital gains.  Taxpayers in the 22% or higher tax bracket will only pay tax at a 15% rate and those in the top tax bracket will only pay tax at a 20% rate.  Considering this tax break, it might make more sense to invest retirement plan and IRA assets in taxable fixed-income securities and invest assets held outside of retirement plans and IRA’s in equities.  The answer will depend on how much of the investor’s total assets are inside and outside of a retirement plan and the investor’s asset allocation strategy.

As an example, if Susan has $100,000 in her 401(k) plan and $300,000 in a personal investment account, and her asset allocation strategy is 75% equities and 25% fixed-income.  One consideration would be for Susan to invest the entire 401(k) plan account balance in fixed-income securities and all her personal investments in equities to meet her asset allocation strategy.

The benefits of this arrangement would be to defer taxation of the interest earned on the fixed-income securities since earnings on 401(k) plan assets are not currently taxed.  Assuming an average 2% yield on her $100,000 401(k) plan account, Susan would keep $2,000 in interest from being currently taxed since the securities were held in her 401(k) plan instead of her personal investment account.  If Susan is in the 22% federal income tax bracket, Susan could potentially save over $400 in income taxes by implementing this strategy.

By having her equities in her personal investment account, Susan can take advantage of the 15% tax rate on realized long term capital gains and qualifying dividends, which is lower than her federal income tax bracket.  In addition, if one of Susan’s equity selections did not fair well, she could sell it and take the loss on her income tax return.  These benefits would not be available to Susan is her equity investments were in her 401(k) plan.  Fixed-income securities typically do not generate much in the way of capital gains or losses, as compared to equities.  In addition, interest earned on fixed-income securities do not qualify as dividends for the special lower capital gains tax rate.

In another example, Bill has $200,000 in his IRA and $200,000 in a personal investment account and his asset allocation strategy is the same as Susan’s.  Bill may consider investing half of his IRA assets in fixed-income securities and the other half in equities.  His personal investment account would be invested 100% in equities.  As with Susan, Bill would be able to invest all his fixed-income securities in his IRA and have a more favorable tax treatment on his earnings.

This division of assets among retirement plans and personal investment accounts is not necessarily recommended for everyone.  Each individual investor has different financial goals, investment objectives, and risk tolerance that must be considered when developing a proper asset allocation strategy.  The bottom line is to take advantage of all the tax benefits available and to maximize your after-tax return.