Tax-Smart Investing: How Optometrists Can Maximize After-Tax Wealth
Two optometrists invest nearly the same way. Same amount of stocks and bonds. Same risk level. Roughly the same pre-tax returns over their careers.
Yet one ends up with more wealth to spend in retirement.
What's the difference? In this case - taxes.
The investments you own and the accounts you hold them in can have a massive impact on your after-tax wealth over time. This has nothing to do with market timing or picking hot stocks - it's simply about being strategic with which investments go into which accounts.
Two Layers of Tax-Smart Investing
Layer 1: Your Account Types
Each account has different tax characteristics.
Pre-tax retirement accounts (401ks, traditional IRAs) give you a deduction now, you don't pay tax on any income as it grows, and withdrawals are taxed in retirement.
Roth account deposits are after-tax, but the funds grow and are withdrawn tax-free if the rules are followed. HSAs offer triple tax advantages (federally) if used for healthcare expenses. Some states treat them a bit differently...looking at you CA...
Taxable accounts (individual, joint, living trust accounts) are super flexible, but don't give you upfront tax benefits - all the investment income shows up on your tax return each year.
Layer 2: Your Investments
Different investments create different types of taxable income.
๐ Stocks kick off dividends.
๐ Bonds are tax-inefficient, kicking off interest ordinary income. The exceptions being municipal bonds (free from federal tax) and US Treasuries (free from state tax).
๐ REITs throw off large distributions usually taxed at ordinary rates.
๐ Mutual funds and ETFs simply pass on income matching whatever is inside of them. E.g., stock mutual funds will pass on dividends to you, the fund owner. Bond funds pass on the interest income.
How funds are managed also matters - passive index funds and ETFs tend to be more tax-efficient than actively managed mutual funds. The higher amount of trading in active funds can create more capital gains, which the funds pass on to you.
And for all of these, when you sell something for higher amounts than you buy them, you're creating capital gains. Either more favorable long-term gains if you've owned it longer than a year, or less favorable short-term gains if a year or less.
The Strategy: Asset Location
Here's the core idea: put the most appropriate investments in the most appropriate account, based on how they're taxed.
Prioritize tax-inefficient investments (the yucky stuff) in tax-sheltered accounts, and more tax-efficient investments in taxable accounts.
When I work with clients, I treat all their investment accounts working toward the same goal as one coordinated household portfolio. Then we strategically place investments:
Pre-tax accounts (401(k), traditional IRA): Bonds and REITs often go here. You're already paying ordinary income rates on withdrawals, so this is the perfect home for investments that generate ordinary income.
Roth accounts and HSAs: Prioritize highest-growth stocks. These are tax-free dollars - don't waste that potential on bonds.
Taxable accounts: Tax-efficient stock index funds with low turnover. Avoid high-dividend strategies, REITs, and taxable bonds when possible.
The Most Common Mistake
I see this constantly with new clients: each account managed separately with the same investment mix across all of them. Often it's the same stocks/bonds split (80/20, 60/40, etc) in every account - the Roth IRA, Traditional IRA, and the taxable account. And the 401(k)s tend to be ignored altogether.
The result? Bonds sitting in Roth IRAs where they waste tax-free growth potential. Tax-inefficient investments in taxable accounts creating unnecessary tax bills. And now we have to unwind the mess.
When you coordinate your accounts as one household portfolio and place investments strategically, you can often improve after-tax returns without changing your overall risk level or investment approach at all.
Don't Let the Tax Tail Wag the Dog
The goal isn't to avoid taxes at all costs - it's to maximize after-tax wealth over your lifetime. Don't jump on poor investments just because of the touted tax benefits.
Start with good, prudent, evidence-based investments. Then optimize which accounts you own them in to minimize taxes along the way.
Too many investment pitches market tax savings but aren't actually good investments in the first place. We see this with certain insurance products, real estate deals, and opportunity zone funds. Don't fall for it.
Take Action
I've created a free Tax Location Review Checklist that walks you through how to inventory your accounts, identify tax-inefficient holdings, and evaluate whether your investments are in the right places.
๐ฅ Click HERE to download your guide.
And if you'd like a second set of eyes on your setup, reach out (or click here) for a no-pressure conversation.
Have a great weekend!
Evon Mendrin, CFPยฎ, CSLPยฎ
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