Caution: Don’t Make This Costly Investment Tax Mistake

Think all retirement accounts are equal? If you do, you could be losing out big on your investments.

You might think you’re in great shape by investing in a tax-deferred 401k through your employer as well as a separate investment account of your own, like an educational IRA. Investing in municipal bonds and REITs in one account and equities in another is fine as long as your overall asset allocation is okay, right?

Wrong, due to one important detail: tax structure. Making the mistake of ignoring tax structure and not allocating investments properly between retirement accounts can make a big difference the future value of your investments. Let’s look at an example for why taxes matter have such a big impact.

A costly example

Silly Sam and Smart Sarah both have identical asset allocation goals. They both have the same total balance ($50,000) in their retirement accounts. Silly Sam doesn’t pay attention to the tax structure of her accounts when she invests. But Smart Sarah wisely pays attention to taxes when deciding which account to hold investments in.

Silly Sam invests $50,000 of her money into a fully-taxable investment, paying taxes at a rate of 25% per year on returns from this investment based on a online tax tool.

Smart Sarah invests $50,000 in a tax-deferred investment account. Her investment grows tax-free, and she only pays taxes once she takes distributions in retirement.

How big of a difference do these tax structures make? Let’s test it with a taxable vs. tax-deferred investment calculator:

(embed calc here) – http://financialmentor.com/calculator/taxable-vs-tax-deferred-calculator

Assuming an 8% annual rate of return and a 25 year investment period, Silly Sam’s investment is worth about $214,000. However, Smart Sarah’s investment grew to almost $330,000 because she didn’t have to pay taxes as her investment returns compounded.

Don’t forget: Sarah still needs to pay taxes on her investment when she receives distributions from her account. But even after taxes, her investment still performs well. Assuming she pays the same 25% tax rate on her $330,000 future investment, she’ll still have $247,500 after paying about $82,500 in taxes. That’s $33,5000 (nearly 16%) more than Sam!

Even better news: Sarah’s tax rate depends on her income when she takes money out of her retirement account. If her income is lower in retirement, she might pay an even lower tax rate. If her tax rate is only 10% in retirement, her investment will be worth $297,000 after taxes and she’ll have $83,000 (about 39%) more than Sam.

If only Sam had been as careful with her retirement savings…

Retirement accounts: How they differ

Now that you’ve seen the difference, you’re probably itching to know more about your retirement account options so you can end up like Smart Sarah instead of Silly Sam.

Retirement accounts fall under three general tax structures: fully-taxable, tax-deferred, and tax-exempt.

Fully-taxable accounts are those that aren’t special retirement accounts like a 401k or IRA. They’re funded with after-tax dollars, and returns from these investments are taxable in the year they’re received. These earnings are taxed as ordinary income (except in cases where the long-term capital gains rate applies). Even if you don’t sell investments held in your taxable account, you may still owe taxes on dividends, interest, or on sale of stocks by a fund manager.

Tax-deferred accounts, which include traditional 401ks and IRAs, are funded with pre-tax dollars. Investments are allowed to grow tax-free until distributions are made from these accounts. The main benefit is the tax-deferred compounding of investments that’s highlighted above.

Tax-exempt accounts, like Roth IRAs, allow your money to grow and typically be withdrawn tax free. The disadvantage is you’ll have to fund your accounts with after-tax dollars. But as long as you follow the rules, you won’t ever have to pay taxes on this type of account.

Special retirement accounts do have more rules than plain, taxable accounts. For 2013, your income must be below $127,000 if filing as single or $188,000 if file a joint return to contribute to a Roth IRA. If you make more than this, a 401(k) is still available as it’s not income restricted.

Both tax-deferred and tax-exempt accounts typically have contribution limits for each tax year. For 2013, total contributions to IRAs is capped at $5,500 ($6,500 if age 50 or older). 401k and similar plans are limited to $17,500 for 2013.

Choosing the right account

Before you decide which accounts to invest in, you’ll need to consider other important factors and  limitations. Some important ones include:

• Employee match. If your employer matches 401(k) contributions, contributing up to the full match almost always makes sense. This is basically free money and is like receiving a 100% return on your investment right from day one.
• Time horizon. If you have decades until retirement, Roth IRAs are often the better option. If you’re early in your career with a lower salary, your income tax rate is likely low than it could be later in your career.
• Tax rate expectations. From the last bullet, the opposite can also be true. If your tax rate is high now but you expect it to be lower when you’re ready to withdraw retirement funds, a 401k may result in less tax owed.
• Flexibility. Taxable accounts typically don’t have any restrictions or penalties for withdrawing your money at any time. For retirement accounts, you may be subject to a 10 percent penalty for withdrawing funds before age 59 1/2.
• Tax diversification. While you can calculate returns and investment returns based on today’s income tax rates, we don’t know what tax rates will in the future. With this uncertainty, having a mix of investments that are tax-deferred and tax-exempt on withdrawal may be a good strategy to protect yourself.

Remember that your decision should be guided by a calculation based on your specific circumstances including your view of future income and taxes.