Enjoy a Satisfying Tax Life! (Part 2)

In Part 1, we went over the hidden trap of making a pretax account like a 401(k) your primary retirement vehicle. Here, I want to give you some ideas on what you can do to avoid that trap. But instead of providing an abstract list of different possibilities, I figured it would be more helpful to describe in plain language what my wife and I are doing. Think of it as a “case study”.

(Photo by Matheus Bertelli from Pexels)

For amassing wealth that we’ll be able to tap into in the future, we’re using a combination of accounts in which profits can be tapped tax-free, and accounts that are unsheltered from taxes. The tax-free accounts are for trades & investments that would otherwise add to our tax bill each year, while the unsheltered accounts are for investments that will expose us to little or no taxation until we sell them (or a piece of them), which might not be for years to come.

It would be great if all of our assets earmarked for amassing wealth could be placed in a tax-free account, but alas, the government places caps on how much one can contribute to such accounts. So for us, the next best thing is to complement our tax-free accounts with unsheltered accounts. By “unsheltered”, I mean an account that, in and of itself, doesn’t offer any respite from taxes. The type of account where, if you own stock in a company and that company shares some of its profits with you each year, those profits are added to your tax bill each year. The type of account where, if you sell an investment for more than you paid for it, that profit is added to your tax bill for that same year (even if you let that profit just sit there in the account instead of it reinvesting it or cashing it out). But here’s the key: although the account itself doesn’t shield you from taxes at any point, it does come with the freedom to populate it with tax-efficient investments! For example, we’re populating ours with investments that we might not sell for years to come and will likely have to pay little or no tax on until then. This makes the account feel almost like a pretax account, except without the headaches of yearly contribution limits, a 10% penalty tax for withdrawing money before we turn 59½, or a 50% penalty for failing to comply with RMDs later in life. And if we hold an investment in the account long enough (a year minus a day), the profit will be taxed at a lower rate than if we’d held the investment in a pretax account. (If the investment were in a pretax account, the profit from selling it wouldn’t be taxed until it was cashed out of the account, which could be years after the sale took place, but it would be taxed at a higher rate than in an unsheltered account). Now, to be fair, I should note that we don’t get an upfront tax break for contributing to our unsheltered accounts, the way we would with a pretax account. But on the flipside, we do get a tax break for any losses we incur, which isn’t true of pretax (or even tax-free) accounts.

As for pretax accounts, we used to have some, but then we decided it made sense for us to convert them into tax-free accounts (a process known as “Roth conversion”; I’ll discuss that in a future post). As our situation evolves, we might find it worthwhile to open new pretax accounts. But we’ll be mindful of how much of our money we’re putting in the line of fire of RMDs!

To using knowledge wisely,

Ben