The Best Account of All

Americans love to rank things: from restaurants to movies to sports teams, if there is a list, we can rank it. Best to worst, worst to best, it doesn’t matter—we are fascinated with this pastime.

Well, we at Bragg Financial decided to create our own ranking. However, instead of debating whether Rosemont in Elizabeth is better than Matador in Southend or Providence Road Sundries in Myers Park (my vote!), we will focus on tools from our wealth management world: The Best Investment Account of All.

As we create our ranking, we will examine three types of accounts:

• A taxable account,
• a 401(k)/Traditional IRA,
• and Roth IRA/Roth 401(k).

We will consider the tax characteristics of these accounts and how investors can utilize them to manage their taxable income in retirement. Lastly, we’ll discuss asset location and its impact on tax efficiency and estate planning.

Taxes by Account Type

The tax characteristics of different types of investment accounts vary, often depending on the owner’s income and stage in life, with some more favorable than others. Pre-tax accounts allow owners to invest money before it is taxed, deferring the tax obligation until the funds are distributed. Conversely, after-tax accounts do not provide income tax deductions on the front end but typically provide more tax-friendly distributions.

A Closer Look

Clients Joe and Jane Smith are married-filing-jointly taxpayers and will have $500,000 in taxable income in 2024. Over time, they have invested $600,000 in each of the three accounts described below, and each account is now worth $1,000,000. They plan to withdraw $100,000 from one of these accounts in 2024. Based on the Smith’s current situation, let’s review how a distribution from each account type is taxed.

Taxable Accounts

Taxable accounts, including individual, joint, and transfer-on-death accounts and revocable trusts, are funded with after-tax dollars. As such, investors do not defer taxes on the front end. Moreover, activity within these accounts is taxable. For example, interest, dividends, and capital gains are passed along to the owner in the year they are generated, not deferred, as they may be in a 401(k) or IRA.

However, distributions from these accounts tend to be more favorable than other account types because a portion of each withdrawal represents the account owner’s cost basis—what they initially invested—which is taxed on the front end. The growth or gain portion of the account is taxable but at the typically more favorable (lower) capital gains rate, not the typically less favorable (higher) ordinary income rates.

Because a portion of each withdrawal represents the account owner’s cost basis—what they initially invested—which is not taxed, distributions from these accounts tend to be more favorable than from other account types. The growth or gain portion of the account is taxable, but at the typically more favorable capital gains rate, not the typically higher ordinary income rates.

Distribution: If $400,000 of the $1,000,000 investment account is growth/unrealized gain, then let’s oversimplify and assume that a withdrawal has that same pro-rata percentage of capital gain. Therefore, $40,000 of a $100,000 distribution would be capital gain, while $60,000 would represent the Smith’s original after-tax investment (cost basis) and would not be taxed. Because the Smiths are in the 15% capital gains tax bracket, they would pay $6,000 in capital gains taxes on this $100,000 withdrawal. This amount compares quite favorably to their ordinary income tax rate of 35%.

Note: while not insignificant, we have ignored the additional Net Investment Income Tax (NIIT) and state income tax in all scenarios for simplicity.

401(k)/Traditional IRA

Funded with pre-tax dollars, these accounts allow owners to defer income tax when the funds are invested in the account. Annual account activity such as dividends, interest, and capital gains do not flow through to a year-end 1099 because they occur under the tax-deferred umbrella of a qualified retirement plan or IRA. However, unlike the taxable account above, each dollar that is ultimately distributed from a pre-tax account is taxable and at the generally less favorable ordinary income tax rates. Said another way, the owner of a Traditional IRA will pay income tax on every dollar distributed from the account, based on their marginal tax rate at the time of withdrawal.

Distribution: While this account may have the same capital gain over time as the taxable account above, it is irrelevant for this exercise because every dollar distributed from a Traditional IRA is taxable and at ordinary income tax rates, not the generally preferable capital gains rates. Specifically for the Smiths, who find themselves in the 35% marginal income tax bracket, this $100,000 distribution generates another $35,000 in income tax owed for 2024. Compare this to the $6,000 in taxes owed from the taxable account withdrawal—much less favorable!

Roth IRA / Roth 401(k)

Like taxable accounts, Roth accounts are funded with after-tax dollars and do not defer taxes on the front end. However, unlike taxable accounts, income generated within the account—dividends, interest, capital gains—is not taxable to the owner. Most importantly, when money is withdrawn, it comes out tax-free. That’s right—funds in Roth  accounts grow tax-free and can be distributed tax-free!

Distribution: While this account may have the same unrealized gain over time as the taxable account above, that gain is irrelevant as it relates to taxes. However, for tax purposes, the gain in the Roth IRA is irrelevant for very different reasons than the gain in the Traditional IRA. Unlike a Traditional IRA, where every dollar distributed is taxed at ordinary income rates, every dollar distributed from a Roth IRA is distributed tax-free. In the case of the Smiths, who would pay $35,000 in tax on a $100,000 withdrawal from their Traditional IRA, they would pay no taxes on a $100,000 distribution from their Roth IRA—zero!

Why not put all our money in a Roth account, investors may ask? Unfortunately, there are annual funding limits as well as income thresholds that restrict what high-net-worth investors can deposit into Roth accounts. While there are ways for high-net-worth investors to contribute to Roth accounts, such as backdoor Roth contributions and Roth conversions, those methods are beyond the scope of this article. Please see our Roth account-related articles for information on these topics.

Control Your Retirement Income

As we discuss in Roth IRAs for Everyone, we would like our clients to have diversified pots of money to pull from in retirement. Our retired clients know that we think it is desirable to be able to manipulate your taxable income in retirement (legally, of course!). Retirement cash flow is not the same thing as taxable income. Wouldn’t it be nice to have a lot of retirement cash flow but very little taxable income? As mentioned above, retirement cash flow drawn from a pre-tax IRA is 100% taxable as ordinary income. Retirement cash flow drawn from your joint account or other non-IRA may be lightly taxed (perhaps a little capital gain and some dividends). Retirement cash flow drawn from a Roth account is 100% tax-free.

After-tax retirement savings options—Roth IRA and Roth 401(k)—were introduced into tax law¹ much later than pre-tax vehicles—IRA and 401(k). Therefore, most folks retiring now have large pre-tax IRAs, so achieving a retirement cash flow that is completely tax-free is often very difficult. But if we can manage the growth of our various account types, then the more tax-favorable pots of money grow more than the less favorable pots.

In an ideal world, most growth would occur in Roth accounts, followed by taxable accounts, and, lastly, in Traditional IRAs. As a result, we do our best to manage your portfolio growth, and hence, your retirement withdrawal tax efficiency, by implementing asset location as part of Bragg Financial’s ongoing investment management process.

Asset Location

Understanding asset location is extremely instructive when it comes to managing growth within the various account types. Firm president Benton Bragg previously wrote an article about asset location, which we have excerpted in this section.

Many investors spend more time worrying about what securities to own and relatively little time considering where to own those securities. Specifically, they haven’t considered whether the security should be held in their IRA (or other pre-tax account) or if it should be held in their taxable account (after-tax account). This can be an expensive mistake given today’s tax environment.

High-net-worth investors with large portfolios should locate more of their growth-oriented securities (stocks) in after-tax accounts and more of their income-oriented securities (bonds) in pre-tax accounts. The goal is to slow the growth of the IRA and ramp up the growth of the after-tax account. Here are three reasons why this makes sense:

1. Tax-Friendly Withdrawals: For most investors, withdrawals from after-tax accounts are much more tax-friendly than from pre-tax accounts. Recall that withdrawals from pre-tax IRAs/401(k)s are taxed as ordinary income. In contrast, withdrawals from after-tax accounts are not taxed, per se. Rather the activity inside the after-tax account may be taxable. Stock sales may generate taxable capital gains and most dividends are also taxable. In most cases, however, when transactions in after-tax accounts create a tax bill, the applicable tax rate is more favorable than ordinary income tax rates.
    
   In an after-tax account, investors can also engage in tax-loss harvesting to offset gains and of course, municipal bonds can be owned for tax-free or partially tax-free income. In short, an after-tax account is a more favorable place to have money; it spends more tax-efficiently. Said another way, a dollar taken from an after-tax account nets you more than a dollar taken from a pre-tax account.
2. Step-up at Death: Given a choice, one should choose to die with a large after-tax account and a small IRA rather than the opposite configuration (note we said IRA, not Roth IRA. As previously noted, Roth IRAs are an extremely attractive account type). Under current law, one’s heirs receive a step-up in the cost basis on all securities in an after-tax account. Heirs can inherit a stock portfolio today, sell all the stocks the next day, and pay no capital gain tax.
    
   In contrast, if one’s heirs inherit an IRA, there is no getting around the eventual income tax that will be due as the money is withdrawn from the IRA. And the IRA withdrawals are taxed at ordinary income rates. Compounding this forced and often unwanted distribution, the IRS now makes most non-spousal IRA beneficiaries fully distribute an inherited IRA within a 10-year window beginning the year after an IRA account owner dies. So we want a small IRA and a large after-tax account if we have a choice.
3. Required Distributions: After we reach age 72 (age 73 if born between 1951 and 1959, or age 75 if born in 1960 or later), the government requires that we take a distribution from our IRA each year. For married couples, the amount of the required draw in the first year is approximately 1/27th of the account balance. The fraction grows larger as we age. Owners of large IRAs are therefore facing a significant amount of unavoidable income in retirement and this unstoppable income will be taxed as ordinary income.
    
   For example, the required distribution on an IRA worth $4 million is about $150,000 for someone aged 72. That income plus social security, dividends, etc. will almost guarantee that the taxpayer is in one of the higher tax brackets. The larger the IRA, the larger this required distribution. So our goal should be to slow the growth of the IRA, thus minimizing the amount of the required distribution. Wouldn’t it be nice to take large, lightly-taxed withdrawals from our growing after-tax account and small, heavily-taxed required distributions from our shrinking IRA?

In short, asset location considers account type and underlying holdings to maximize a portfolio’s tax efficiency, especially as the investor prepares for retirement distributions and estate transfers. To review, investors should locate more of their growth assets (stocks) in after-tax accounts and more of their income assets (bonds) in IRAs. Note that the goal is not to slow the growth of the overall portfolio. We want the overall portfolio to grow at the same rate. We simply want that growth to occur in our after-tax account and not in our IRA.

Summary

Account types have different tax treatments, and these differences matter. By now, you have likely deduced that Roth accounts are often considered the Best Investment Account of All by financial planners, especially regarding retirement distributions and taxable income in retirement.

Taxable accounts follow in our preferred account rankings, as withdrawals from after-tax accounts are much more tax-friendly than withdrawals from pre-tax accounts. While great vehicles for deferring income taxes for high earners while working, pre-tax accounts are last on our list of favorite account types. Forgive us for being redundant: dollars withdrawn from pre-tax accounts spend less tax efficiently. A dollar taken from an after-tax account nets you more than a dollar taken from a pre-tax account. Generally, investors should own growth assets (stocks) in after-tax accounts and income assets (bonds) in pre-tax accounts.

Take a moment to think about your own situation:

• Is my retirement income plan tax-efficient and sustainable?
• Should I consider Roth conversions?
• Is the portfolio allocation among my various accounts—taxable account, IRA, Roth account—structured to maximize family wealth after taxes?

Asset location is integral to tax-efficient retirement distributions and is a key component of our portfolio management. Please let us know if you would like to discuss asset location, Roth conversions, or any of the issues raised in this article. As always, thank you for choosing Bragg Financial Advisors.

Retirement Savings Options: A Timeline

• 1974—The IRA was introduced in 1974 as part of the Employee Retirement Income Security Act (ERISA) of 1974.
• 1978—The 401(k) was introduced in 1978 as part of the Revenue Act of 1978.
• 1998—The Roth IRA was introduced in 1998 as part of the Taxpayer Relief Act of 1997.
• 2006—The Roth 401(k) was introduced in 2006 as part of the Economic Growth and Tax Relief Reconciliation Act of 2001.

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This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.