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How to Reduce Taxable Income By Rearranging Investments

Shift Interest Income To Retirement Accounts To Reduce Taxable Income


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

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

Why Does Shifting Investments Reduce Taxable Income?

There are 3 reasons this strategy works to reduce taxable income.

  • Interest income is taxed at a higher rate than capital gain and qualified dividend income.
  • Interest income inside of a retirement account is not reported as taxable income to you each year. The only time you report taxable income from a retirement account is when you take a withdrawal.
  • 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.

Below is a simplified example showing someone who has an allocation of 50% stock/stock mutual funds and 50% bonds/CD’s. 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.

Simplified Example Of How To Rearrange Investments To Reduce Taxable Income

Non tax efficient portfolio:

  • IRA Account: $100,000 in stocks/stock mutual funds.
  • Non Retirement Account: $100,000 in bonds/ CD’s yielding on average 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.

Tax efficient portfolio:

  • IRA Account: $100,000 in bonds or CD’s 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.
    Capital gains are taxed at a lower rate than interest income.
    Using passive index funds can significantly reduce annual capital gains distributions.

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.

Cash reserves are typically invested in things like money markets, CD’s and other safe investments that will generate taxable income.

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