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Best Time to Make Decisions is Before Tax Season

| April 09, 2019
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In the first quarter of every year, without fail, I get a flood of calls from people looking to open an IRA to take the tax deduction for the previous year.  When you couple the last minute tax planning with the inevitable question "What are your IRAs paying? I know that helping these individuals is going to be a lot more difficult than opening a simple account.

I feel strongly that a good financial planner educates clients, allowing them to make smart decisions.  The best way to make the decisions is not at the last minute, during tax season.  Furthermore, not knowing that IRAs do not pay anything, rather their rate of return is based on the underlying investments, shows that the individual on the phone has a lot of learning to do.

The first thing people need to understand is what is meant by IRA, Roth IRA, 401(k), deferred compensation, 403(b), etc. is it's not investment; it is a tax status.

Each tax status can be funded with a myriad of financial products, from stocks and bonds to CDs and annuities.  The rate of return you receive from the account is based on the underlying investment.  

So when you see the sign at the bank that read 2% IRAs, what they are really talking about is a CD that has a current rate of 2% that is held in an account with the tax status of an IRA.

Each tax status has its own special rules and regulations, but they can be broken down into three basic categories: taxable, tax-qualified and tax-deferred/tax-free.

Taxable accounts

Taxable accounts otherwise known as nonqualified, have many variations, but most commonly they are when you own an asset in an account directly.  Your checking account, savings account, a CD at the bank and most brokerage account are considered taxable.  What this means is that you will owe taxes on any realized gains each year.

I want to make it clear that I said realized gains, because if you buy a stock in a nonqualified account and do not sell it, you do not owe taxes on the gain.  If that stock paid dividends throughout the year, you owe taxes on the dividend but you will only owe taxes on the gain once you sell that stock.

In the case of CDs, because the interest is credit to your account each year, it is fully taxable because you realized the gain.

Tax-Qualified Plans

The next category of tax status is known as qualified.  Variations of this status are IRAs, 401(k)s, 403(b)s and deferred compensation.  In this category, you earn income and are eligible to make a contribution into the account (pretax) before you pay income taxes. Once in the account, you select your underlying investment and over time it has the potential to grow. Once you reach certain requirements, such as age or retirement, you can take a distribution of money from the account.  Your distribution is subject to ordinary income tax rate at the time you take it.

Conventional wisdom tells us that your income will be at its highest during your working years, meaning you will be in a higher tax bracket; but once you retire, your overall income will go down, thus a lower tax bracket.  Keep in mind, however, that if you lead an active lifestyle in retirement, you could end up pulling money from your qualified plan-and that could lead to having to pay in a higher tax bracket.

Second, tax rates and tax brackets are not static.  There will be changes in the tax code, usually raising tax rates.  This leas many people to actually pay a higher tax rate in retirement.  When deciding how much to put into your 401(k) or IRA, you need to consider how that money will be used.

Once in retirement, you want to have a diversified tax strategy.  The last thing you want is to find yourself retired and have an unexpected cost arise, such as replacing your roof, and have to draw even more money from your IRA that year than planned.  This withdrawal can very well place you into a higher tax bracket, thus taking an even bigger bite out of your hard earned savings.

Tax-Deferred/Tax-Free Plans

The third main category of tax status is known as tax-deferred, commonly known as a Roth IRA.

A Roth IRA's earnings can also be considered tax-free if certain provisions are met.  Among those provisions are, any withdrawals must be made after the account has been held for at least five years and the owner of the account has attained the age of 59 1/2.  There might be other considerations regarding the taxes associated with a Roth IRA; consult your tax professional.

For the purpose of this post, I will refer to these accounts as tax-free.

With a Roth IRA, when you earn money, you pay the tax on those earnings (after tax) and then place the funds into the Roth IRA.  Just like with the other tax statuses, once into the account you can choose your underlying investment. This means that if you had to pay for that unexpected roof, you could pull money from your Roth IRA and not have to worry about the distributions (RMDs), like with a qualified plan.  

By having a diversified tax strategy in retirement, you have better control of your taxes. From a financial planning point of view, diversification of your tax strategy is just as important as diversification of your investment portfolio.  By planning your strategy, you give yourself big tax savings as well as avoiding the April rush to find whose IRA is "paying the best!"

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