Here are four tips to help you decide where to stash your investments.
Unfortunately, you can’t access the old video right now, but I’m working on an updated version that should be available by the end of July 2014.
1. Mind Your Tax Rate
In general there are two types of taxes you’ll experience: Ordinary income taxes, which you pay on income producing assets and assets held under one year, and long term capital gains, which is the tax you pay on the price appreciation of an investment that is held for longer than one year. Long term capital gains are taxed at a lower rate than ordinary income.
The max federal rate for ordinary income is 39.6% and the max for capital gains is 20%. Most professionals will likely be taxed at a 25-28% marginal tax rate and a 15% capital gains rate.
Based on that knowledge, the first thing you should consider is whether an asset is income producing. Bonds, mortgage REITs (real estate investment trusts), short term trades (holding a stock under 1 year), and non-qualified dividends, will be taxed at normal income rates.
For this reason it may make more sense to buy these types of assets in an IRA or Roth IRA. An IRA would allow you to wait to pay taxes until retirement, while a Roth IRA would allow you to have both tax free growth and distributions.
However, there are some other considerations you need to ponder before you simply place all of your income producing assets into your IRA.
2. Consider The Frequency of Trading
Say you’re an active trader. You consistently hold your investments for less than a year, so your investments will be subject to ordinary income taxes. It makes more sense to trade these investments in an IRA so you don’t pay taxes after every trade.
Active trading in a taxable account can seriously damage your returns.
Let’s say 25% you are in the 25% tax bracket, so you’ll sacrifice 25% of your gains to taxes every time you make a trade.
If you get to instead trade those investments in an IRA, your gains aren’t taxable until you withdraw them, so 100% of your gains are added to the capital in your account. This is the difference between growing your account at 10% before taxes and 7.5% after taxes.
After 20 years your investment would have grown 60% less than in the tax deferred account. As you can see, the impact of taxes will cause a MASSIVE difference.
If your account is more passive and few trades occur, then you may not have to worry about your tax rate as much.
3. Look At The Structure Of The Investment.
Some of the more popular investment companies people invest in are mutual funds, ETFs and master limited partnerships. Each is taxed by Uncle Sam in a different, making some better than others for an IRA account.
Today I’m just going to highlight one investment company that can cause you grief come tax time.
Master Limited Partnerships (MLPs) are taxed differently than mutual funds or ETFs. MLPs invest in less business ventures such as oil and gas production, commodities trading, or real estate management. In mutual fund you’re considered a shareholder of the fund and taxes flow through the fund to you as an individual.
In an MLP you’re treated as a limited partner of the firm. At the end of the year, your share of the income and capital gains from the partnership is treated as partnership (K-1) income.
In a taxable account, this only causes you to have some more paperwork.
But, MLPs can cause trouble in an IRA by generating income considered Unrelated Business Taxable Income (UBTI).
UBTI “breaks” the tax deferred advantage of the IRA and causes the distributions to be taxed at normal income rates within the IRA. Unfortunately, you don’t get credit for paying these taxes, so when you retire, you’ll be taxed AGAIN on this money.
Sometimes, the shortcomings of an MLP in an IRA can be overlooked, other times they should be avoided. But as a rule, if you don’t know how to deal with the tax consequences of an investment, it’s better to avoid it or seek professional advice.
4. Determine Your Stage of Life
In this section I’ll assume the investor has a Roth IRA (after tax contributions, tax-free withdrawals.)
Pre-retirement is often considered the accumulation stage of life for investors.
If you have a long time to invest and need higher returns, it may make more sense to place the majority of riskier items in your IRA. Putting your stocks into a Roth account allow you to grow your capital at a higher expected rate, meaning more tax-free dollars in your account come retirement.
Once you hit your retirement years, you don’t have to pay taxes on your Roth Account, so it could make more sense to buy your income producing assets in that account, that the income can be paid out tax free instead of being taxed at normal rates.
If you only make a few stock trades each year, you can place your stocks in a taxable account and enjoy the lower capital gains taxes when you sell them.
This isn’t a comprehensive list, but it’s a good place to get started.
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