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.
