Tax deferral means postponing the payment of tax on income, interest, dividends, and capital gains until the investor takes possession of them. The simplest form of tax deferral is by putting money in your 401k or IRA. You put a portion of your income away before taxes so that you can use that income later in retirement. That’s the basic form of tax deferral. But did you know that there are advanced forms of tax deferral?
How it worksAdvance Tax Deferral involves placing highly taxable investments in your tax deferral accounts and placing your less taxable investments in your taxable accounts. Confused? This one is best explained with an example. For simplicity, we’ll use round figures.
Suppose your a millionaire. You have a one million dollar portfolio exactly and your asset allocation is 50% equity and 50% bonds. The bond fund pays 4%.
Your portfolio is divided into two accounts: an IRA, and a taxable joint account with your wife. Each account has $500,000 in it.
Most people would put 50% bonds and 50% equity in both IRA and joint account. This would mean that $250,000 is invested in bonds in a taxable account. At 4% interest, the bonds would generate $10,000 of interest that is added to your tax return at the end of the year. Someone in the 25% tax bracket would owe $2,500 extra in taxes that year. More importantly, after taxes you’d only make $7,500 on your bond fund, which is equivalent to a real after tax return of 3%, NOT 4%.
Using an advanced tax deferral strategy you’d allocate all of your fixed portion of your investments in your IRA account. This would equal $500,000 which would pay dividends of $20,000 ($500,000 x 4%), none of which would be added to your taxes this year. Your real after tax return is the FULL 4%.
You can further lower your tax bill by Tax Loss Harvesting, and investing in low turnover index funds in your taxable account.