Portfolio Toolbox
Rodin's Thinker

Deep Thoughts

Successful investing is about managing risk, not avoiding it. Benjamin Graham

I have tried to boil down all of my investment experience over the years into my investment plan. My investment goal is strong growth with managed risk at the same time, or a risk adjusted portfolio in an attempt to outperform the market. This is no small feat. One way to manage risk is to educate yourself on how investing works and the different investment options / strategies available to meet your goals. After much thought, I have come up with some observations on various investment strategies to minimize Federal income taxes over a lifetime.

Death & Taxes

While death and taxes are inevitable, you can mitigate these risks by eating healthy, exercising and having a good accountant. Minimizing the amount of Federal income tax you pay over a lifetime starts when you get your first job. There are three different types of investment vehicles you can use for managing your tax situation each year:

Taxable Tax Deferred Tax Exempt
checking, savings 401k, 403b, 457b, Traditional IRA Roth 401k, Roth IRA

There is no single best vehicle for saving / investing your money for every investor every year. You want to use the investment vehicle that best fits your tax situation each year. Most investors start their careers making a modest amount of income that increases over time. At some point income plateaus and starts decreasing for some, due to job loss, career change, etc. This is why it is important to invest for your future. Since the United States has progressive tax rates that increase with your income, you want to defer taxes during your max earning years and invest after-tax dollars in tax exempt accounts during your lower earning years.

The idea that a tax deferred or a tax exempt account is always superior to the the other is a fallacy. At the end of a lifetime of savings and investment, it becomes clear where you coulda, woulda, shoulda made better choices regarding saving and investing and choosing the right investment vehicle at the right time for the right reasons takes some planning and forethought.

The table below lists the pros and cons of each type of account to help you decide which investment vehicle is right for you:

Pros Cons
Taxable
checking, savings
  • No limits on contributions
  • Lower long-term capital gains tax rates are available
  • Contributions are after taxes paid
  • Short-term capital gains taxed as ordinary income
  • Earnings are taxed each year
Tax Deferred
401k, 403b, 457b, Traditional IRA
  • Current year income taxes are reduced by contributions
  • Contributions are pre-tax earned income
  • Taxes on earnings are deferred until withdrawn
  • Annual limits on contributions
  • Distributions taxed as ordinary income, long-term capital gains rates not available
  • 10% additional tax for withdraws before age 59 ½
  • Required Minimum Distributions (RMDs) required starting at age 72
  • 50% additional tax on insufficient RMD withdraws
Tax Exempt
Roth 401k, Roth IRA
  • No taxes on earnings if held for 5 years
  • Contributions available for withdraw before age 59 ½
  • Annual limits and income limits on contributions
  • Contributions are after tax earned income
  • 5 year waiting period on withdraw of earnings
  • Early distributions of earnings taxable as ordinary income plus 10% additional tax before age 59 ½

Taxes are unavoidable. While you can defer taxes, the tax bill eventually comes due. It's basically a "Pay me now or pay me later" situation. There is a small window where you can pay no tax on income if you save money in a tax deferred account during your working years and then pull it out after age 59 ½ up to your standard deduction. In order to take advantage of this you must use a tax deferred account for some of your income.

In my early investing years I thought that deferring taxes was always the best way to go, however that creates the problem of having a huge retirement nest egg that you must pay taxes on during retirement through RMDs (Required Minimum Distributions). This suggests that you need to contribute some after-tax dollars to your Roth account during your lower earning years when you have a lower marginal tax rate.

It's easy to get discouraged over the thought of paying taxes. The reason you are paying taxes is you made a profit. Had you not made a profit and had no tax, that's the time to be discouraged. You will of course want to minimize the taxes you pay, and at the end of the day paying taxes is a good thing.

Minimizing Income Taxes

There are investment strategies that can help you minimize income taxes. You can rollover your employer-sponsored tax-deferred account (e.g. 401k, 403b, 457b or pension) into a rollover IRA account without causing a taxable event and maintain your tax-deferred status. It's a lot easier to manage your portfolio with one IRA account than to have multiple accounts at different brokerages. When you decide to take a distribution / withdraw from your IRA account, it can go to one of three places:

  1. Roth IRA conversion - distribution is taxable as ordinary income, money continues to grow tax-exempt
  2. Qualified Charitable Distribution - distribution is non-taxable and not included as part of your income
  3. You - distribution is taxable as ordinary income

Depending on where you direct the money, there are different tax consequences. Preferably you want to pay taxes out of pocket, but that might not be an option. If you pay taxes from your IRA distribution it will reduce your portfolio, but in the grand scheme of things so does paying taxes out of pocket. If you are younger than age 59 ½ and you don't qualify for an exception, your distribution will be subject to an additional 10% tax.

Since IRA distributions are taxable as ordinary income, you want to minimize the taxes you pay on distributions. The straightforward approach to this is to spread out taxes across as many years as possible and take distributions from your IRA when your tax rate is lowest. One way to achieve this is to start using the RMD formula when you retire before age 72. For example if you retire at age 55 and your remaining live expectancy is 29 years, you can perform a Roth IRA conversion of 1/29th of your traditional IRA. At age 72, you are required to take RMD distributions from your traditional IRA based on your life expectancy, and if you don't you will be subject to a 50% additional tax on the portion of the RMD you did not take.

The next complication to consider is the longer you defer taxes, the larger your IRA grows and the more you pay in taxes. I ran the numbers and if your effective tax rate is fixed over time, it doesn't matter when you perform a Roth IRA conversion, as long as you stay invested you will end up with the same amount of money after taxes.

Since the United States has progressive tax rates that increase with your income, you want to distribute your Roth conversions over time in order to minimize the taxes you pay each year. There is no way to reliably predict what your maximum tax bracket will be in the future, so you basically need to make an educated guess on when to take your IRA distributions based on historical tax rates. This is a lot to consider when taking distributions from your tax-deferred accounts.

And then one day, I had an epiphany regarding this problem.

Grow your Roth IRA faster than your Traditional IRA.

As with stock investing, this simple goal is somewhat elusive. How do you grow your Roth faster than your traditional IRA? The traditional answer is to hold stocks in your Roth account and bonds in your IRA account, because stocks generally outperform bonds over the long-term. However sometimes bonds outperform stocks, especially long-term bonds. There is no way to predict stock prices, however as a result of the bond investing experience with my dad, I learned that bond funds trade within a range, so you can tell when bonds are priced high or low based on where they are within the 52-week range. One of my most important investment rules is to Always maintain asset allocation. If you maintain a constant asset allocation, there will be times when portions of your portfolio lose value. The goal is to take advantage of the time when your securities are down and realize the loss in your traditional IRA account. This effectively reduces your future RMD amount and your future taxes.

Asset Location

As in real estate, location is very important in investing. Tax-deferred accounts allow you to defer income and income taxes until it is needed in retirement. A Roth IRA / 401k is a special account were investment income is tax-exempt! I have put together some guidelines below on how I use these different accounts to attempt to grow my IRA faster than my Roth IRA:

It is obviously advantageous to make money in these accounts. What is less obvious is taking advantage of losing money in your taxable or traditional IRA accounts. If you realize losses (i.e. sell) in a taxable account, you can deduct losses on your schedule D up to a maximum taxable loss of $3,000 per year. If you realize losses in your traditional IRA, it reduces your overall future tax burden. While Roth IRAs are a fantastic investment vehicle because they are tax-exempt, you never want to realize a loss in a Roth account because there is no way to profit from it.

Using these strategies, I invest in long-term bonds in my Roth account when they are near their 52-week low and sell them when they are near their 52-week high. In my traditional IRA account, I invest in long-term bonds when they are near the top of the range and sell them when they are near the bottom of the range. I buy or sell stocks in the account to fund the bond transaction so that I always maintain my asset allocation and am always in the market.

One optimization to this plan is to reduce my bond holdings from 40% to 20% and hold cash in my IRA instead of buying long-term bonds. This is an effective short trade on bonds while waiting for them to decline in value. Cutting your bond allocation in half and going to cash allows you to profit in bonds if bonds go up and profit in cash (because you sold half bonds) if bonds go down. This causes me to miss some dividends in the IRA account and breaks my "always in the market" rule, however it avoids some losses in a quickly rising interest rate environment. Buying shorter duration bonds can be used as a substitute for cash. Once long-term bonds slow their decline you can fade back into long-term bonds at lower prices / higher yields.

Another optimization is to perform a partial Roth IRA conversion during time periods when the market is down significantly (e.g. 10%-20%). While it is impossible to time the market, you can convert shares while prices are down 20% and pay less in future taxes. For example, you can convert 100 shares of a stock mutual fund from your Traditional IRA to your Roth IRA and not impact your portfolio because you don't change your asset allocation. (This strategy assumes you pay taxes using money from your taxable account and the mutual funds you invest in have a long-term upward trend.)

One last strategy to point out. Since the stock market is unpredictable, if you are unsure of the future direction of a security, purchase it in your IRA or taxable account. Whether the market goes up or down, you have a way to profit from either way it moves.