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Tax Knowledge Is Tax Power

When it comes to financial planning and investing, knowledge is power. The more you know, the more likely you are to recognize the benefits and consequences of making certain financial moves. 

This may be especially true with taxes. Most people would probably agree that if you can find a way to legally pay less in taxes than what you’re currently paying, then that’s a smart money move.  You don’t have to be an expert, but the more you know about taxes, tax rates, how the tax brackets work, and how certain accounts like your 401(k) or your personal brokerage account are taxable to you, the more power you have — and the less you may wind up having to pay. 

Let’s take stocks as an example. You can own a stock (or groups of stocks) in several different types of accounts. You can own them in your traditional IRA, your Roth IRA, in your 401k or other retirement plan at work, or you can own them personally through a brokerage house. When you ultimately sell some or all of those stocks and take possession of the money, if there’s any gain at all, that gain could either be 100% taxable at one rate, partially taxable at another rate, or not taxable to you at all. The amount of taxes you’ll pay depends on which account held the stock you sold and distributed the proceeds. 

This is where knowledge really is power. 

Suppose someone paid $5,000 for some stock many years ago. And let’s just say it was a good stock, and it managed to grow over the course of those years, and it’s now worth $25,000. Not bad, even if it is just a hypothetical example!   

If they sell that stock today, there would be a $20,000 gain. So the question is this: How much in taxes would they have to pay on that $20,000 gain? That all depends on which account had been holding that stock. If they had purchased it in their IRA or 401(k), and then removed the proceeds from the tax-deferred account, both the $20,000 gain and the original $5,000 they used to buy the stock will be 100% taxable at their ordinary income tax rate. That’s the entire $25,000. There’s also a 10% penalty assessed if the owner is under age 59 ½. If they’d owned it in a regular brokerage account, then just the $20,000 gain will be taxable today – and not at ordinary income rates, but at the lower capital gains tax rate. If the stock had been in a Roth IRA and the individual is over 59½, it will most likely be entirely tax free. 

So wait: does this mean that owning stocks in your 401(k) is a bad thing, or that having your equities in a Roth is always the best move? Not necessarily. Sometimes getting the up-front tax deduction with the 401k is worth more to you than paying ordinary income taxes on it later on. This is especially true if you deducted it when you were in a relatively high bracket, and then you take it out later on in a lower bracket. Not only that, but the contribution limits on a 401k are much higher than with a Roth IRA, so you’re potentially able to save more with the 401k. Your financial advisor can help you determine which way may be better for you to go. 

The point here is that knowing how assets located in different types of accounts are taxed may give you a real advantage once you’re in the withdrawal stages of retirement. By using what’s known as an “asset location” strategy, you may be able to dramatically decrease the amount you’ll ultimately pay in taxes.  In fact, there was an article in Forbes a few years ago that suggested this type of strategy could make as much as a 20% difference to your portfolio over the long run.

Tax management should be one the major priorities in your financial plan. The less you have to pay, the more you’re able to keep; and yes, that’s a good thing!  

We strategize with people on tax management and asset location every single day here at Lucia Capital Group, so if you want to find out how tax-efficient your portfolio is, just give us a call. How can we help you? Just let us know. 

Important Information:

The information provided should not be considered specific tax, legal, or investment advice and is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy (including the investments purchased and/or investment strategies devised by Lucia Capital Group (“LCG”)) will be either suitable or profitable for a client's or prospective client's portfolio, thus, investments may result in a loss of principal. Accordingly, no client or prospective client should assume that the presentation (or any component thereof) serves as the receipt of, or a substitute for, personalized advice from LCG or from any other investment professional.

You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.

IRA withdrawals will be taxed at ordinary income rates. Withdrawals prior to age 59½ may also be subject to a 10% penalty tax.

Roth IRA distributions of principal from a Roth IRA are tax-free; however, any earnings will be taxed at ordinary income rates and a 10% penalty tax will apply if withdrawn prior to age 59½ or within five years of the date the Roth IRA was established, whichever is longer.

Examples cited are hypothetical, are for illustrative purposes only, are not guaranteed and subject to potential federal and state law amendments. There is no guarantee that you will achieve the results discussed or illustrated.

Rick Plum is a registered representative with, and securities and advisory services offered through LPL Financial, a registered investment advisor and member FINRA/SIPC. The investment professionals are affiliated with LPL Financial and are conducting business using the name Lucia Capital Group, a separate entity from LPL Financial.

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