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Know the Tax Position of Your Money :: Retirement Success :: THE RETIREMENT SOURCE®
Know the Tax Position of Your Money

Understand Tax Treatment Differences

In my opinion most people having high income and/or high net worth are overpaying taxes now or will be in the future. Different types of asset ownership may have dramatic differences in the tax treatment of cash flows, income and profits. In the process of accumulating wealth most people think about the taxes going in, but few consider the tax costs of getting money out. For example, virtually everybody has been advised to put as much as they can into deferred accounts so it can grow “tax free”. Because they ultimately must take distributions, they unknowingly take the IRS and other tax agencies on as partners in their growth.

I call this the “Reverse Rumpelstiltskin Effect” because it spins gold into straw (taxes). As an example, high growth assets outside deferred accounts could be taxed at capital gains rates, or not at all if passed through an estate with a stepped-up basis. When the gains are withdrawn from a deferred account, they are taxed as ordinary income at perhaps twice the capital gains rate. Rumpelstiltskin!

I
No Tax Now
No Tax Later
II
No Tax Now
Tax Later
III
Tax Now
No Tax Later
IV
Tax Now
Tax Later

We developed a method of analyzing many of the important features of various assets and strategies through a series of GRIDs. These GRIDs enable a simplified classification of certain features into quadrants making ranking the degree of desirability easy. We use four different estate and tax planning GRIDs to sort out the effectiveness of our plans and the potential for improvement.

In this system, Quadrant I always being best with Quadrant IV being worst. Quadrants II and III are frequently nearly equal and are a matter of personal choice. Once you are familiar with this system, then you should be able to make up your own GRID analysis sheets on plain pieces of paper to evaluate your own plans.

As you review your assets and strategies, it is important to know where each is in the respective GRIDs. Intelligent planning can often result in shifting some assets to more favorable positions.

Certain deferred accounts can be veritable “tax traps” for some people. On the other hand, there are ownership forms that may offer benefits of both income and estate tax advantage.

In fact, over the long-term, the efficient tax position of a given asset may mean more to your bottom line than your raw rate of return.

One example is the Traditional IRA versus the Roth IRA. Traditional IRAs are in Quadrant II, which is not all bad unless a large proportion of your assets are in that quadrant. This can result in substantial income taxes and, in some cases estate tax problems. Roth IRAs, on the other hand, are one of the few ownership forms that are in Quadrant I—no income tax on contributed after-tax dollars or earnings ever during the owner’s lifetime (for owners over age 59 ½, after the account has been active for five years). If Roth IRAs are left to beneficiaries after death, they will be required to withdraw funds based upon their life expectancy, but will never have to pay income taxes.

You can plot the Tax Position of Your Money by using an Income Tax GRID. In some cases, you can change the characteristics of ownership by reregistration to improve your income tax status as in a Roth IRA Conversion.

 

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