How IRAs can have a role in tax-efficient investing

What constitutes the ‘perfect portfolio’ is a matter of debate. It can depend on a variety of factors such as the right exposure to different asset classes, the right sectors of the economy, social impact, liquidity and the investor’s own tolerance for risk. However, whether or not said ‘perfect portfolio’ can be structured for tax-efficiency, is beyond question. 

Structuring your investments for tax-efficiency is a logical process that requires little to no guesswork and is essentially about applying math to tax rules. Here, we look at how IRAs can play a role in investing tax-efficiently for the future. 

What are the obstacles to structuring investments tax-efficiently?

People can face several constraints when first faced with the prospect of tax-efficient investing. It could be that some people have assets that cannot be changed at a given point of time, others may have different proportions of their net worth invested in retirement accounts versus taxable accounts, while others might be starting from scratch with accumulating in their retirement accounts. Regardless of the starting point, it is possible to work within virtually any individual investor’s limitations to start exercising tax-efficiency while investing.

Things to be aware of when trying to invest more tax-efficiently

Short-term gains- Some investments produce short-term gains, that is, returns received from an investment that’s been held for less than 12 months. After you deduct any capital losses from these gains, they are taxed at the marginal tax rate, which is the same as your income tax rate. This is the least tax-efficient way to earn income. The government adds short-term gains from investments to ordinary income and then taxes it on a progressive tax scale that caps out at 37%. 

Interest income- Income generated from interest is treated the same way. Any income made by earning interest on investments is added to an individual’s ordinary income and can even cause them to be taxed in the next marginal tax bracket with no deductions against it. 

Long-term gains- Assets that are to be held long-term or for more than 12 months and do not generate income may be better off being held in a taxable account. 

Tax-efficient investing with an IRA

There are two kinds of IRAs, traditional and Roth. Traditional IRAs give investors a tax deduction in the year the contribution was made and also potentially allow for tax-deferred growth of the earnings. Taxes are then paid once the individual begins withdrawing from the IRA, with the required minimum distributions, or RMDs, starting at age 72. Conversely, with Roth IRAs, individuals pay taxes beforehand and so all the income earned from investments held in the IRA comes out tax-free, no matter what it grows to. 

Individuals may find themselves in a lower marginal tax bracket upon retiring as they are no longer earning a salary.  Those investing with a traditional IRA may strategize and take their taxable distributions upon retirement. This is better than having paid income taxes on that amount when they were earning a salary and were in a higher tax bracket. They would also stand to benefit from the capital gains earned from their IRA investments rather than using them to pay taxes. 

In this simple example, let’s compare how an investment of $10,000 in a taxable account would fare vs that same investment in a traditional IRA where you would earn 10% interest over 15 years. 

This example is based on the tax inflation adjustments provided by the IRS for tax year 2020

As you can see, the after-tax benefit to the investor for taxable investment would be $28,651, while the IRA investment would be $36,927.  

This particular example assumes that the marginal tax bracket for the taxable investor was 32% and the IRA distributions were made at 12%. The reason for this difference is that instead of paying taxes each year on the investment gains, that money stays invested and compounds in an IRA account.

As it is possible to invest in more than one type of IRA account, having some money in both Roth IRAs and Traditional IRAs could make sense for some people. By having both types of IRAs, investors are able to choose which type of IRA to take distributions from based on their marginal tax bracket in that particular year of retirement. During the years the investor is in a high marginal tax bracket and needs to take a distribution to sustain their lifestyle, they might choose to withdraw from their Roth IRA, while in a year that they are in a low marginal tax bracket, they might want to choose to withdraw from the Traditional IRA so as to pay lower taxes on the RMDs. 

In the event that an IRA owner is below the income threshold to pay any income taxes at all, they could take distributions from their Traditional IRA each year up to the point where they would have to start paying taxes, even though they may not need the money. This way, they could be in for a tax-free ride on that amount.

It is also important to remember that while individuals participating in an employee-sponsored 401(K) plan are able to contribute to an IRA, they will not be able to have a current year deduction against their income. 

Investors can begin tax-efficient investing from any point in their journey to save for retirement. Please note, however, that Yieldstreet cannot provide tax advice, you should consult a tax professional for advice specific to your situation.

Yieldstreet now gives our investors the option to open a Yieldstreet IRA. When you invest with your IRA at Yieldstreet, you don’t pay any income taxes on the returns made by your Yieldstreet investments. You only pay taxes on your IRA investments when you take a taxable distribution down the road. The income produced by your Yieldstreet investments is reinvested and you can take advantage of compounded interest income, which has the potential to be significantly beneficial over time. 

You can explore setting up your Yieldstreet IRA in-depth and get answers to some of the most Frequently Asked Questions about the Yieldstreet IRA. If you have any additional questions about how to set up and get started with a Yieldstreet IRA, please reach out to [email protected]. 

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