Ask a high income earner who works in the medical field and they’ll likely say that taxes are one of their biggest financial concerns.
Accounts like a Traditional IRA, 401k, 403b, deferred comp and Roth IRAs (aka “tax shelters”) give investors tax benefits for investing in them. Does that mean that a regular taxable account is bad for medical professionals?
The short answer is not necessarily; it all depends on your individual circumstances and how you manage it.
Advantages of Taxable Accounts
The biggest advantage to a taxable account is liquidity. A taxable account is most commonly going to be an individual or joint account and can be liquidated at any time. The only “penalties” for liquidating a taxable account would be associated with the specific investments themselves. Therefore, if the money was invested in no load mutual funds or indexes, there shouldn’t be any penalties. You may have taxes to pay, but not penalties.
Liquidity is very limited with tax sheltered accounts. There are a few ways to access money through tax sheltered accounts such as a loan, or return of principal (with a Roth IRA), but neither are ideal.
3 Ways to Improve Tax Efficiency
There are a few ways that an investor can greatly improve the tax efficiency on their taxable account.
- Invest for long term gains
- Perform annual tax loss harvesting
- Perform charitable giving with appreciated investments
Generally speaking there are two different types of taxes that are paid on taxable accounts:
- Short term capital gains – Short term gains are taxed at your ordinary income rate. Short term gains include gains on investments not held for at least 12 months and interest from corporate bonds.
- Long term capital gains – Long term gains are taxed at a different rate and include stock dividends and gains on investments held longer than 12 months. The long term gains rate is either 0, 15, or 20% depending on your tax bracket. Then if you have household income over $250,000 (married filing jointly) you must pay an additional 3.8% on your gains.
Ideally you would want to have all of your taxable gains fall in to the long term category because of the lower rates. Investments such as index funds and mutual funds with low turnover rates hold investments longer, therefore increasing your chances of paying long term gains vs. short term.
Stocks and mutual funds that don’t pay a dividend at all can be even more tax efficient.
Let’s say you have a choice to hold a stock that pays $50 of dividends per quarter or a stock that pays none. By holding the dividend paying stock, you get $200 in income, but you are liable to pay taxes on that income.
Tax loss harvesting helps lower taxes
Tax loss harvesting is a way to reduce your income and offset investment gains.
The tax code allows you to deduct $3,000 of investment losses per year from your income. You can also use losses to offset gains and carry forward what excess losses that aren’t used. For example, if you have $11,000 of losses in a year and no gains, you can deduct $3,000 of income on your tax return and carry the other $8,000 forward for future years.
When doing tax loss harvesting, you always want to be careful of the wash sale rule. The wash sale rule basically says that if you take a loss on an investment and buy it back within 30 days you don’t get to deduct the loss. If you sell a fund you want to make sure you don’t buy the same fund back, but instead buy a similar one. This way, you still get exposure to the market forces you are seeking, but you avoid a wash sale.
Strategic charitable giving can help minimize taxes
Most individuals give cash or write a check to charities, however, gifting appreciated investments can be more advantageous. If you gift appreciated investments to charity you receive two financial benefits:
- You don’t have to pay taxes on the investment’s appreciation
- You get to deduct the entire amount (subject to IRS limits) on your taxes
Gifting appreciated assets to charities can help you keep more of your money by essentially gifting the same amount but avoiding paying taxes on asset appreciation.
Taxable accounts have a number of advantages that tax shelters do not. A taxable account shouldn’t be a substitute for tax shelters but is definitely something to consider. Asset location is something we take into careful consideration when doing financial planning with medical professionals.
When implementing any tax strategies mentioned above you should consult your accounting professional.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.