Not coordinating your retirement accounts with your outside investments is a mistake that can cost you greatly.
Allow me to illustrate with a true story:
My client (at that time they weren’t yet a client) took me up on my free consultation offer. One of the points we discussed was maximizing their investments. They showed me their investment portfolio totaling about $1 million.
Pay attention to the following details of their portfolio:
- Their $1 million was split between two accounts; $500k in TSP and $500k in the non-qualified account (the technical term for “regular” account is “non-qualified”).
- Each account had the same stock/bond mix which was pretty much exactly 50% stock and 50% bond.
I usually need to know a ton of info about a person before I can make any investment recommendation. However, in this case, I didn’t need to know much at all and I could already tell there was something wrong with their portfolio.
Can you spot the problem?
This is tricky to the untrained eye, but here’s what i can see…
They have stock in their TSP. The stock in the TSP can grow and provide long-term capital gains. Long-term capital gains are taxed at a much lower rate than regular income. However, long-term capital gains inside the TSP do NOT get the lower tax treatment but instead get taxed as regular income, which is a higher tax hit than necessary!
What could this client do?
Here’s what I proposed. She should reallocate both her TSP and non-qualified accounts so that her stock exposure in the TSP is now in her non-qualified account, while her bond exposure in her non-qualified account are now in the TSP.
How would that help her?
By exchanging the TSP stock portion with the non-qualified bond portion, she now would be able to get the favorable long-term capital gains tax treatment on that stock portion of her portfolio. Before she came to me, half of her non-qualified portfolio was being taxed more than it should have been; that’s poor taxation of $250k!!! By doing my switch she would have her entire non-qualified portfolio benefiting from better tax treatment.
While I was basking in my brilliance she looked at me like I was from Mars. She thought I was crazy because the result of my recommendation would mean the following:
- Her TSP would become 100% bonds. Isn’t that super-conservative?
- Her non-qualified account would become 100% stock. Isn’t that super-aggressive?
I had to draw it out for her that her combined portfolio (TSP & non-qualified TOGETHER) would still remain 50%/50% which is exactly how she was currently invested!
In the above example ,this mistake was causing an over-taxation of $250k.
But there’s even more inefficiency than what I pointed out. Here are three other issues she didn’t consider:
- Unnecessary taxation of bond interest: The bond portion of their non-qualified portfolio was issuing taxable interest payments every year. They weren’t using the income, so there really was no point to generating all that interest. Had they adjusted their portfolio as I recommended, their bonds would be in the TSP, and would not be taxed until they withdrew it from the TSP. Their non-qualified account would consist of stock, which wouldn’t be taxed until they realized any gains.
- Required Minimum Distributions (RMDs) from an unstable account: Taking RMDs from a stable account is safer than from an unstable account. Why? Because unstable accounts are more prone to loss, and if a distribution (which is a type of loss) is taken when the account has already suffered a loss, the distribution compounds that loss. TSP accounts are required to take RMDs; non-qualified accounts are not required. If they’d listen to me, their TSP would be bond heavy thus making it more stable and better to draw RMDs.
- Realizing Capital Losses: Capital losses in a non-qualified account can be used to offset capital gains, as well as used to reduce taxable income. Capital losses in the TSP are not usable to offset anything. If this prospect would use my advice and make their non-qualified account more stock heavy, they would have greater chances to harvest capital losses which would help them minimize their tax liability.
These are mistakes the stunt your growth and prevent you from MAXIMIZING your overall portfolio. It’s easy to notice the individual accounts and lose sight of the overall portfolio. Each account in a vacuum may be “good” or “bad” but when you look at them in relation to each other you may see how they complement each other, or perhaps stifle each other.
If you need help with this, just let me know!
Stephen Zelcer is part of the GovLoop Featured Blogger program, where we feature blog posts by government voices from all across the country (and world!). To see more Featured Blogger posts, click here.
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