How to Reduce Taxable Income by Rearranging Investments

You can shift interest income to retirement accounts to reduce taxes

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Reduce taxable income by following these two rules when putting together your investment portfolio:

  1. Own interest-producing investments inside of tax-free and tax-deferred retirement accounts.
  2. Own capital gain and qualified dividend-producing investments outside of retirement accounts.

This process of choosing which types of accounts to own which investments in is called asset location.

Why Does Shifting Investment Location Reduce Taxable Income?

There are several reasons that asset location strategies work to reduce taxable income:

  • Interest income and short-term capital gains are taxed at a higher rate than long-term capital gains and qualified dividend income.
  • Interest income and short-term capital gains inside of a retirement account are not reported as taxable income each year. The only time you report taxable income from a retirement account is when you take a withdrawal. (Rollovers and transfers when done properly don't count as withdrawals.)
  • When owned outside of retirement accounts, investments having a loss can be sold to generate a capital loss that will offset other capital gains. You cannot generate capital losses from investments when they are owned inside of retirement accounts.
  • When you own investments that generate qualified dividends and long-term capital gains inside of tax-deferred retirement accounts, you never get the advantage of the lower tax rates on this type of investment income, as all withdrawals from tax-deferred retirement accounts are taxed at your ordinary income tax rate.

Below is a simplified example that shows someone who has an allocation of 50% stock/stock mutual funds and 50% bonds/CDs. In this case, they own all the stocks/stock mutual funds in their IRA, and all of their bonds/CD’s in non-retirement accounts.

A Simplified Example of How Asset Location Reduces Your Tax Bill

Location Strategy 1: Non-tax Efficient Portfolio

  • IRA Account: $100,000 in stocks/stock mutual funds.
  • Non-Retirement Account: $100,000 in bonds/CDs yielding on average 5% (Don't you wish for the days when CDs paid 5%?)
    • This $100,000 is producing $5,000 of taxable income that flows through to your tax return each year. You must pay tax on the $5,000.

Location Strategy 2: Tax Efficient Portfolio

  • IRA Account: $100,000 in bonds or CDs yielding on average 5%.
    • Now, no taxable income is reported each year, unless you choose to take withdrawals from your IRA account.
  • Non-Retirement Account: $100,000 in stocks/ stock mutual funds.
    • Capital gains must be reported each year, but now when there are losses they can be used to offset capital gains. At most, you might expect about $3,000 of total long-term gains/qualified dividends per $100k invested in a large-cap index fund.
    • Long-term capital gains are taxed at a lower rate than interest income, and in some cases are not taxed at all.
    • You can use passive index funds which can significantly reduce annual capital gain distributions.

    Assume someone is in the 25% tax bracket. In the first portfolio, they would pay $1,250 a year in taxes on the $5,000 of interest income.

    In the second portfolio, the $3,000 of long-term cap gains/qualified dividends would be taxed at 15%, so you would pay only $450 on the gains. That's $800 a year of savings—and as the accounts grow larger, the tax savings increases.

    But Wait, Keep Your Reserves Set Aside

    Of course, common sense says you would not invest all your non-retirement account money in stocks/stock mutual funds. You must keep an adequate amount of money in cash reserves in non-retirements accounts as an emergency fund.

    Cash reserves/emergency funds are typically invested in things like money markets, CDs and other safe investments that will generate taxable income.