Imagine you buy your family an all-included cruise ship vacation. You bought the plan that included all the shows, the best rooms, and the most exclusive amenities. Excitement within your family builds in the weeks prior to your trip. When you’re finally on the ship, you’re astounded by it’s features, the meals are incredible, and the shows are fantastic.
You make a remark to nearby families that the trip is well worth the investment. Conversations ensue and you and the others are astounded to realized that you all paid different prices for the same exact package. You never would have known if you hadn’t brought the topic up. Each family’s package is identical but each package cost a different amount for the same destination and features.
The family who paid the most for the cruise is probably not laughing and the one who paid the lowest probably feels lucky. However, both families would suffer if, instead of a cruise, the situation was about taxes that had accrued in their investment accounts.
Buying the Right Package
Generally, people are sure that their investment will grow at a rather steady pace as time progresses, thanks to compound interest; they know the investment will appreciate or depreciate over the course time. However, people fail to realize that when you’re only thinking of gains you won’t notice the increasing tax liabilities associated to them. The actions that you take to address tax liability will significantly impact the price of your investment. Your tax liability will determine one of the costs you will pay for your package. When you figure out that you paid too much, it will probably be too late.
Rolling earnings into the same taxable account increases the account value and the tax liability. There are three options to help reduce the tax tax liability on these type of accounts:
Flat Tax Strategy
Move only the earnings. The problem is not the investment account but how the government taxes the account. Keep the principal in the taxable account, earn the interest, and pay the tax on the gain. Move the after tax gain to a tax favored account where those dollars can compound interest uninterrupted by taxes.
Immediate Paydown Reducing Tax Strategy:
Move the entire taxable account to an account that compounds interest with no tax on the gains. While this option does have a positive impact on your tax liability it will probably impact your access to the money. You will need to weigh the benefits of each option before choosing this strategy.
Reduce Account Over a Period of Years
Take a portion of the principal and interest and move it into tax favored account over a period of years that best suits your financial circumstances. The taxable account decreases in value with every withdrawal and the tax favored account receiving funds continues to grow tax deferred and withdrawn tax free.
No matter which method is chosen, the balance in the account will be the same in the end. The difference, then, is the amount it cost along the way to achieve that balance. Taxes are one of the only sure things in life, but it doesn’t mean we should pay more than we have to.
Chris Jacob is a Registered Representative with Saxony Securities, Inc.. Securities offered through Saxony Securities Inc. (SSI). Member FINRA, SIPC. Non-security products and services or tax services are not offered through SSI. Cadeau is not affiliated with SSI.