Use All 3 Tax Structures for Your Long-Term Portfolio

By: Joe Morgan

Jul 15, 2021 | Long-Term PortfolioTaxesTax-deferredAlready-TaxedTaxableRoth401k

There are three tax structures under which you can invest:

  1. Taxable
  2. Tax-Deferred
  3. Already-Taxed or Roth.

We want to use all three of these when investing our Long-Term Portfolio and I’ll tell you why in a moment. But first, I want to talk through how each of them works.

1. Taxable

First, a Taxable portfolio is like your regular brokerage or revocable family trust account. It’s called a Taxable account because the IRS does not offer any special tax treatment for it. In other words, everything that happens in a Taxable account is potentially taxed today.

So, if you sell stock at a gain, you will owe tax in the current tax year. Your RSUs, when they vest, are placed in a Taxable account. The good thing about a Taxable account is that you are paying taxes today, so you won’t have to pay them in the future. When your RSUs vest, you are automatically taxed by the IRS so that the only future taxes on your stock would be any gains that you realize in the future.

2. Tax-Deferred

A Tax-Deferred account is one where you don’t have any tax to pay today, but you will owe tax later. A traditional IRA or 401k is a Tax-Deferred account.

Here, you actually get to deduct from your income any contributions you make to the account leaving those funds as non-taxable today. You can invest them and have them grow over the years, but when it comes time to take the money out, the IRS will tax you on the entire balance. Not only that, but they will also tax it all as if it were income. There is no capital gains treatment for all the gains you build up over time in a tax deferred account.

3. Already-Taxed or Roth

This can be either in the form of a Roth IRA or a Roth option inside your 401k. With the Roth, you do not get a tax deduction for money that goes in. In other words, the money you put in comes from earnings that are taxed today.

However, when you take money out of a Roth, assuming you follow all the withdrawal rules, which basically amount to using it for retirement, you do not pay any tax on those withdrawals.

This means you can invest the money in your Roth, have it grow, and not pay any tax on the growth in the Roth.

This is one of the few areas where you can invest and truly have your earnings completely avoid being taxed.

Not everyone can use a Roth IRA. In order to contribute, you have to have an income that is lower than about $200,000 as a family. However, if your employer has a Roth 401k option, there is no income limit to be able to contribute to it. So, you can put all your 401k contributions into your Roth 401k up to the annual limit each year. Your employer contributions will always go to the tax deferred or traditional 401k because they want the tax deduction today.

So, those are the three structures.

  • You can pay tax today on the performance of your account in a taxable account.
  • You can defer today’s income tax to later years in a tax deferred account.
  • And you can never pay tax again in a Roth account by paying tax today on your contributions to the account.
Which Should You Use?

I believe most people should use all three types of accounts, and there’s two reasons why.

First, your circumstances can change over time and it’s your withdrawal and use of the funds that will determine how much you end up paying in taxes. Keep flexibility on your side by retaining some balances in all three types of accounts.

Second, the tax laws themselves will change. We’ve seen major changes in the tax code frequently over the last several administrations and I don’t think that’s going to settle any time soon. Also, given our country’s need to always keep taxes in the neighborhood of spending, Congress can’t help but be tempted by all the money in retirement plans living under these tax incentives.

Again, you want flexibility when it comes to what the future tax laws will be.

Here’s this week’s Best Financial Life tip of the week: Use all three tax structures for your Long-Term Portfolio.

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