Understanding Tax Jargon

Tax time is sure to bring out certain things, such as confusion, anxiety, and shoe boxes of records and receipts to name a few.  It also invariably invokes financial articles, providing advise such as “last minute tax saving tips” that are either irrelevant to the average reader or not really helpful.    Susannah Snider, of US News & World Report, took a refreshing twist in her piece, Making Sense of 10 Confusing Tax Phrases, where she asked financial professionals to list tax jargon that they would like to see disappear.  

I submitted “Tax Diversification,” because it mixes and blends tax planning with investing.   Even so, I don’t necessarily want it to disappear from our financial terminology.  While I’m not able to offer a better term, I proposed the phrase “don’t put all of your investments into one tax basket” as a better way to describe a confusing, yet worthwhile idea.  

That said, there is a notably different tax treatment for different types of investments, which means that having more than one type can help with tax planning.   Many people have all of their investments in a 401(k) or an IRA which is exclusively pre-tax dollars.  If you are lucky enough to also have investments in after-tax accounts, you can choose between the two types when it’s time to withdraw funds for spending.    In this way, you can exercise some control over the taxation of your income.   For example, if you are near the top of a tax bracket and need supplemental income, you could take a distribution from an after-tax account and incur no additional taxable income.  However, if limited to only pre-tax investments, you would generate taxable income and a portion could be at your highest tax rate.

Even though withdrawals of principal from after-tax accounts are tax-free, the accounts still generate taxable income.   A Roth IRA is comprised of after-tax dollars and the gains are tax free, creating a third type of taxable account and even more tax diversification.   Many people who qualify for a Roth IRA never take advantage of this opportunity.

Annuities are a mix of pre-tax and post-tax dollars, but the gains are tax deferred and not tax free.  This creates another category from a tax perspective.  While I don’t recommend annuities for many reasons, they can increase tax diversification for some investors.

The disparate tax treatment of assets also lends itself to more diversification of investments in a given portfolio.   Since they are inherently tax inefficient, most advisors would suggest holding real estate funds only in a tax-sheltered account.  Someone without such an account would probably not wish to invest in real estate funds.   Conversely for someone with only tax-sheltered accounts, tax free bond funds would not be an appropriate investment.      

Deciding which investments go into which accounts is called “Asset Location”.   This term would have been another good candidate for the tax jargon article as well    While a confusing terminology, it highlights the great disparity in tax treatment between types of assets.  For instance, interest income from CDs or bonds is taxed at ordinary rates, which could be as high as 39.6%. Meanwhile capital gains and dividends are taxed at a maximum of 20%, but are often only 15% or lower.  In fact, taxpayers in the 15% normal tax bracket (or below) receive a zero tax rate for capital gains and qualified dividends.   I have many clients with a high net worth, but who also have a modest income.  Therefore, for such people, a well-crafted portfolio can generate little or no taxable income!

Current tax laws clearly favor certain types of assets and income groups.   Therefore, having dissimilar buckets of money when it comes to tax treatment can have advantages.  The terms tax diversification and asset location might be confusing, but they represent strategies that can have a positive effect on after-tax investment returns.   Jargon or not, these are useful concepts to employ when building and maintaining a tax-efficient investment portfolio.