Jason Stipp: I am Jason Stipp for Morningstar. Although tax considerations shouldn't drive your investment portfolio, getting your tax plan right can certainly save you a lot of money come tax time. And as with anything, a good tax plan can be almost as much about what you don't do, the mistakes you avoid, as all those details you do get right. So here to help us avoid some common tax blunders is Morningstar's Christine Benz, our director of personal finance. Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: The first mistake to avoid is thinking I am saving in my 401(k), I am maxing out that account, and I am doing everything I need to do for retirement, so I am not going to worry about the other sorts of accounts, just 401(K).
Benz: Well, you know, that might be the obvious decision to make, in part because you are able to put pretax contributions into your 401(k) and that helps lower your adjusted gross income. So that's gratifying when you are in accumulation mode, but this concept of tax diversification is a really important one that becomes only apparent when you are retired because if you do have a tax-diversified pool of assets meaning that you've got some traditional accounts like traditional IRAs and traditional 401(k)s, some Roth accounts and some taxable accounts, you are actually able to exert some control over where you go for income on a year-to-year basis.
If you have all your money saved in a traditional type account like a traditional IRA or 401(k), all that money will be taxed upon withdrawal. With the other categories, the Roth category as well as the taxable categories, the tax penalties or the taxes upon withdrawal are much less. And in fact in the case of Roths, there is no tax at all. So it's important to build that well-diversified pool when you're in accumulation mode.
Stipp: And Roths also have the benefit with required minimum distributions, you don't have to take them from a Roth whereas a traditional 401(k) or IRA, you will be required to take the money out. So there is some flexibility [with Roths], as well.
Benz: Exactly. So if you are able to not have to take those withdrawals, you can reduce your tax bill on a year-to-year basis, and obviously if you have taxable accounts, you don't have to take any withdrawals there if you don't want to either. So if you are someone who doesn't expect to need all of the assets from a particular account during retirement, you get a nice level of control.
Stipp: The other reason you may want to look outside of your 401(k) is that even maxing out a 401(k) might not be enough for you for retirement.
Benz: That's exactly right. So people often say, "Well, I am maxing out my 401(k). I am OK." Chances are if you are at a higher-income level, just putting the maximum into your 401(k) may not give you enough of the income that you'll need to replace during retirement. You may need to additionally make that Roth IRA contribution if you can; you may need to put money into taxable accounts, as well.
Stipp: So you say this is something that maybe doesn't make itself apparent until retirement, but it's really crucial at that time. Something else you really need to think about in retirement is asset location. Not minding asset location is a second mistake that investors definitely want to avoid.
Benz: Right. And I would say it's a mistake actually investors make in accumulation mode as well as in decumulation mode. So you want to just be attuned to some basic rules of the road here. The key concept to bear in mind is that if you have taxable accounts, you want to keep out of them any investments that kick off a lot of either dividend income or bond income on a year-to-year basis. Those are better off stashed in your tax-sheltered accounts where you won't pay taxes on those distributions as you go along. So that's the key overarching concept.
Instead, within those taxable accounts you want to think about municipal bonds, which do deliver income, but it's not federally taxable and may not be taxable at the state level, if it's income issued by a bond from your home state.
And then you also want to think about tax-efficient stock vehicles there, as well. So that can be individual stocks, that can be tax-managed mutual funds, and that can be exchanged-traded funds that have historically done a good job of limiting taxable capital gains.
Stipp: And you say, right now because income from bonds has been so low, this might not be something that you really notice if you happen to have those in your taxable accounts?
Benz: That's the thing. Right now income even from higher-yielding bonds is at a relatively low level, and so it doesn't feel like a big deal. But if we do indeed see higher yields down the line, it will be apparent why you would want to have them stashed within your tax-sheltered accounts.
Stipp: Mistake number three is me thinking I don't want to really invest more than I need to in a retirement account because I might want to have to access that money or might need to access that money before retirement. But there are some accounts that have more flexibility.
Benz: They do, and this is another benefit in favor of a Roth IRA in particular because you are able to withdraw your contributions without any taxes or penalties or anything else. So for people who say "I need to keep my money liquid maybe, so I don't want to invest within the confines of one of these accounts," the Roth is really your answer there because you are allowed a lot of flexibility in terms of pulling money out.
And also for the investment-earnings piece of the Roth, there are certain circumstances such as education and first-time home purchase, where you are actually able to pull out the investment earnings piece. You will owe taxes, but you won't owe a penalty on that withdrawal. So, the Roth is a good go-to vehicle for people who are on the fence about whether they want to lock up their money for a long time or not.
Stipp: So Roth can be very flexible. Roth gives you some important tax diversification. There are income limits about who can contribute money to a Roth. If your adjusted gross income is above a certain amount, you may get phased out of contributions or not be able to contribute at all, but it's a mistake to think Roth is completely off the table for me.
Benz: That's right, since 2010 there is no limit on converting traditional IRA assets to Roth. So a lot of planners have been talking about what's called the backdoor Roth IRA maneuver.
That means that you open a traditional IRA; your contribution won't be deductible because you probably are above the income level that would qualify you for deductible contributions. But you are able to convert that money that you've put into the traditional IRA to a Roth IRA, and you are able to do that regardless of income limits. So, this backdoor IRA maneuver can be really attractive for people who think "I earn too much to contribute to a Roth." Yes, you cannot make the direct contribution, but you can do this maneuver on a year-to-year basis.
Stipp: So that backdoor option is an important for some investors who do want to convert assets to a Roth. But you say an important mistake to avoid is if you have put money into a nondeductible IRA, before you convert you need to be aware of other IRA assets that you have out there.
Benz: Right. So it's a perfect maneuver if all you've got is this little nondeductible IRA, you want to convert it, and you have no other traditional IRA assets. That's fine because the taxes you'll owe when you do that conversion will be on only the investment appreciation since you originally opened that IRA.
If you have other traditional IRA assets in the mix and you also want to do this backdoor maneuver, the taxes that you'll pay upon that conversion will be based on your ratio of deductible IRA contributions relative to these nondeductible IRA contributions. So you could inadvertently trigger a big tax bill by trying to execute one of these backdoor conversions.
Stipp: It's Tax-Relief Week, so we're talking about different ways that investors can be tax-efficient. ETFs come to mind as a vehicle that traditionally has been pretty tax-efficient, but it's a mistake to think it's always going to be tax-efficient.
Benz: Right. So it depends on what that ETF is investing in. If it's investing in something with a lot of bond income or dividend income, the tax treatment will be identical to what you will have with a mutual fund.
Where ETFs' tax benefits come in is in relation to capital gains. So because of their structure and because the person running the ETF is not having to sell securities to meet shareholder redemptions, that allows ETFs to be much more tax-efficient or at least somewhat more tax-efficient than traditional mutual funds in terms of limiting capital gains.
Stipp: And speaking of traditional mutual funds, there's a big tax blunder that investors can make, if they purchase a fund near the end of the year. Can you explain that?
Benz: Yes. That is called buying the distribution. And funds do have to pay out any capital gains that they've realized in each calendar year and they have to pay them out to shareholders. That activity typically goes on in the fourth quarter of a calendar year. So a big mistake is to buy a fund for the first time, just before it's about to pay this distribution.
And the hitch there is that you will owe taxes on that capital gain, even though you weren't around for the appreciation of the securities. So I wish that tax treatment of traditional mutual funds were different, but for right now that's what is it is. And that's one reason why you want to be very careful, do your homework and see if any capital gains are pending before you buy a fund, particularly if it's around year-end.
Stipp: Something else that sometimes happens around year-end but maybe not as much as it could is something called tax-loss harvesting. You say it would be a mistake not to really think about tax-loss harvesting because it could really help you out.
Benz: I think so. And I there are some psychological impediments in the mix. So, if you are doing tax-loss harvesting, it's kind of tantamount to admitting "I got something wrong or maybe something went down since I purchased it." Tax-loss harvesting means that you acknowledge that; you actually sell the fund or the stock and realize that tax loss.
The benefit and one reason that everyone should consider it is that within your taxable accounts if you realize a tax loss, you are able to use that to offset up to $3,000 in ordinary income on your portfolio and also capital gains. So you really ought to take a look at that maneuver if the goal is to improve your take-home return from your taxable account.
Stipp: Christine, not getting things wrong on the tax front can certainly help investors, just as much as getting things right, as well. Thanks for helping us to avoid those pitfalls today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.