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 When the gains are withdrawn from a deferred account, they are taxed as ordinary income at perhaps twice the capital gains rate.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!

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.