Taxable and Tax Deferred Investment Accounts

Taxable Investment Accounts

For taxable accounts, investors must pay taxes on their investment income in the year it was received. Taxable accounts include individual and joint investment accounts, bank accounts and money market mutual funds.

Tax Deferred Investment Accounts

On the other hand, tax-deferred accounts shelter investments from taxes as long as they remain in the account. Any kind of retirement account - 401(k), 403(b), 457, 529, Health Savings Account, IRA or Roth IRA - is a tax-deferred account. If you are self employed, you might consider a SEP IRA, Solo 401(k) or SIMPLE IRA. I will explain about these in more details later in “Different investment vehicles”.

Generally there are three types of tax deferred investments available

1. Employer-sponsored plans

One place to start investing for your retirement is an employer-sponsored plan such as a 401(k), 403(b) or 457. They typically allow both pre-tax contributions and tax-deferred compounding, and many employers offer a matching contribution.

2. Individual Retirement Accounts (IRAs) – Traditional and Roth

Traditional IRAs may allow you to contribute on a pre-tax basis, depending on your income level and some other factors. With a Roth IRA, you can’t make pre-tax contributions, but earnings could potentially be tax-free if certain conditions are met.

3. Annuities

These are contracts between you and life insurance companies that provide death benefits and may also include other guarantees. These benefits may help protect your beneficiaries if you die before the annuity’s proceeds have been distributed. Annuities do have limitations, and guarantees are subject to the claims-paying ability of the issuing insurance company.

Municipal Bonds

Usually municipal bonds are considered tax exempt investment as the interest on municipal bond is exempt from federal income tax and may also be exempt from state and local taxes if you reside in the state where the bond is issued but taxation on municipal bonds has some complications associated with it which I will cover in more details while explaining about the different investment vehicles.

In a taxable account, taxes are assessed each year on realized gains, but the maximum tax rate is 28%. In a deductible IRA, capital gains are tax deferred until withdrawal in retirement, but they are subject to the ordinary income tax rate that tops out at 39.6%. Power of tax deferred accounts  must not be under estimated. The following diagrams can show how it can be a really powerful way maximizing your wealth in long term:

Both types of accounts have their advantages and disadvantages. As a general rule of thumb, tax-efficient investments should be made in the taxable account, and investments that are not tax efficient should be made in a tax-deferred or tax-exempt account.

Ordinary Income, Capital Gains and Qualified Dividends

Before you learn about different types of investment vehicles and how to choose the investment vehicles that can best serve your need, you should be well acquainted with the following three things:

1. What are Ordinary Income and Capital Gains
2. How they are treated differently for tax purpose
3. What are Taxable and Tax Deferred Investment Accounts

Ordinary Income

Ordinary income is usually characterized as income other than (long-term) capital gain. Ordinary income can consist of income from wages, salaries, tips, commissions, bonuses, and other types of compensation from employment, interest, dividends, or net income from a sole proprietorship, partnership or LLC. It is categorized into two different categories- Earned Income and Business Income

Earned Income

Any money derived from a paid work comes under the category of earned income. If you work in a job- look at your pay stub and you will see that there are two types of taxes withheld from earned income (Social Security and Medicare) that are not taken against any other type of income. Self employed persons also pay these two taxes but it is labeled as self employment tax.

People with earned income may be eligible for Earned Income Tax Credit (EIC). IRS publication 596 explains the earned income credit and you can click here to see more details on EIC.

Business Income

Any residual profit (Gross profit - all expenses including your salary) comes under the category of business income. Business income is not subject to the self employment tax and that is where the people who own or are share holders in S corporation save taxes.

Unearned Income

Unearned income is money that you receive without doing “work” for it. Unearned income includes:

• Income from interest
• Dividends
• Capital gains
• Income from retirement account distributions
• Unemployment compensation (but you do pay taxes on unemployment benefits)
• Social Security benefits
• Debt forgiveness
• Money won from gambling
• Some real estate income
• Income from real estate
• Income from trust

Income from partnership or S corporation, without being an active part of the management (that might also be considered as capital gains)

Capital Gains

Long-term capital gains are taxed differently than short-term capital gains and earned income. This means that even if you are in a higher tax bracket, your long-term gains are often taxed at a lower rate (upto 20%). This can be very helpful to you — especially if you have a lot of investment income.


Similarly if a stock is sold within one year of purchase, the gain is short term and is taxed at the higher ordinary income rate. On the other hand, if you hold the stock for more than a year before selling, the gain is long term and is taxed at the lower capital gains rate.


Dividends

The amount of tax you'll pay on dividend income varies depending on the dividend tax rate associated with your overall income and whether or not dividends are ordinary dividends or qualified dividends.

Ordinary Dividends

Ordinary dividends are a share of a company's profits passed on to the shareholders on a periodic basis. Ordinary dividends are taxed as ordinary income and are reported on Line 9a of the Schedule B of the Form 1040. All dividends are considered ordinary unless they are specifically classified as qualified dividends.

Qualified Dividends

Qualified dividends, as defined by the United States Internal Revenue Code, are ordinary dividends that meet specific criteria to be taxed at the lower long-term capital gains tax rate rather than at higher tax rate for an individual's ordinary income.

Below is the table showing the tax rate on qualified dividends and long term capital gains:

Here are three important links I found on off-setting your capital gains in case of capital loss, including what can be off-set and what can not be off-set:

Capital Gains and Losses

Can a Short-Term Capital Loss Be a Tax Write-Off Against Ordinary Gains?

Rules for Capital Losses

Investment Strategies: Rebalancing

Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. In addition, if an investor's investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightings of each security or asset class in the portfolio to fulfill a newly devised asset allocation. It is the process of restoring your portfolio to your target allocation for it.

The rebalancing of investments (or Constant Mix) is the action / trading strategy of bringing a portfolio that has deviated away from one's target asset allocation back into line. This can be implemented by transferring assets, that is, selling investments of an asset class that is overweight and using the money to buy investments in a class that is underweight, but it also applies to adding or removing money from a portfolio, that is, putting new money into an underweight class, or making withdrawals from an overweight class.

 Here are three great article I found- One on FINRA.org about rebalancing your portfolio , another on Investopedia about consequences of imbalance and one on Marketwatch about right way to rebalance your portfolio.

Investment Strategies: Dollar Cost Averaging (DCA)

Dollar-cost averaging (DCA) is an investment technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. The investor purchases more shares when prices are low and fewer shares when prices are high. DCA reduces the impact of volatility on large purchases of financial assets such as equities. By dividing the total sum to be invested in the market (e.g. $100,000) into equal amounts put into the market at regular intervals (e.g. $1000 over 100 weeks), DCA reduces the risk of incurring a substantial loss resulting from investing the entire "lump sum" just before a fall in the market. Dollar cost averaging is not always the most profitable way to invest a large sum, but it minimizes downside risk.


In essence, the technique works in markets undergoing temporary declines because it exposes only part of the total sum to the decline. The technique is so-called because of its potential for reducing the average cost of shares bought. As the amount of shares that can be bought for a fixed amount of money varies inversely with their price, DCA effectively leads to more shares being purchased when their price is low and fewer when they are expensive. As a result, DCA can lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.

Here are two different examples of dollar-cost-averaging that will help you understand it better:

 

 

Here are three different web links, if you want some deeper details on - what is dollar cost averaging, why dollar cost averaging is a smart strategy and why dollar cost averaging works well with mutual funds.

Difference between Asset Allocation and Diversification

Asset Allocation refers to investing in different categories of investments, called asset classes. That is, we pick which assets we want to have in our portfolio. Generally, investors choose from stocks (equities), bonds (fixed income), cash, commodities and real estate.

Diversification, on the other hand, is the process of balancing these classes – and within these classes – so they offset one another amid ever-changing market conditions.

(Source: Stockcharts.com)

Your asset allocation may represent a diversified portfolio or a concentrated portfolio, if you are only using a couple of specific asset classes, then it is probably a concentrated portfolio. The goal of portfolio diversification is to generate the highest possible return for a given level of risk. A portfolio of all small company stocks may result in greater returns than a diversified portfolio of stocks, but it is unlikely to achieve that result without significantly more risk or volatility.

Asset allocation is a key element of diversification. No asset class is the top performer each year, so selecting asset classes that are not well correlated or do not move in the same direction, makes sense.

Here is an example of a portfolio with asset allocation and diversification:

You may also want to read this article on stockcharts.com for a better understanding of the difference between Asset Allocation and Diversification.

Here is another detailed article- Beginners' Guide to Asset Allocation, Diversification, and Rebalancing I found on SEC's website.

Investment Strategies: Diversification

Diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets.

The goal of diversification is not necessarily to boost performance—it won’t ensure gains or guarantee against losses. But once you choose to target a level of risk based on your goals, time horizon, and tolerance for volatility, diversification may provide the potential to improve returns for that level of risk.

To build a diversified portfolio, you should look for assets—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction, and to the same degree, and, ideally, assets whose returns typically move in opposite directions. This way, even if a portion of your portfolio is declining, the rest of your portfolio, hopefully, is growing. Thus, you can potentially offset some of the impact of a poorly performing asset class on your overall portfolio.

Within your individual stock holdings, beware of over-concentration in a single stock. For example, you may not want one stock to make up more than 5% of your stock portfolio. It would be smart to diversify across stocks by market capitalization (small, mid, and large caps), sectors, and geography.

Investment Strategies: Asset Allocation

Asset Allocation

Asset allocation is about not putting all your eggs in one basket. It's the ultimate protection should things go wrong in one investment class or sector, as is likely to be the case from time to time.

Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment time frame. Asset allocation is based on the principle that different assets perform differently in different market and economic conditions. Asset allocation is both the process of dividing an investment portfolio among different asset categories, as the resulting division over stocks, bonds, and cash. This process of determining which mix of assets to hold in a portfolio is a personal one. The asset allocation that works best at any given stage in an investor's life will depend largely on the need, ability and willingness of the investor to take risk. These depend on the investment time horizon and on both the investor's financial capacity and emotional capacity to tolerate risk and to stay the course.

A key reason for devising an asset allocation strategy is to help reduce the risk inherent in volatile equity asset classes that are expected to provide higher returns by combining these asset classes with more stable fixed-income assets. These balanced portfolios help reduce volatility and down-side risk, thus better enabling an investor to maintain investments over a long term period.

There is a nice article I found on the the website of American Association of Individual Investors about asset allocation. You MUST read this article to get some more detailed understanding on asset allocation. Click on this link to read this article.

You can also use this Asset Allocation Calculator on Bankrate.com website to determine how you should diversify your portfolio to allocate your assets.