Three buckets (taxable, tax-deferred and tax-free) many methods to reduce tax / Deferral among tools to trim liability over earning years

Joel Steele for the Courier-Post writes: How do you want to pay tax on your investments?
It is nice to have a choice. However, many don’t realize it is up to you in part how you pay tax on this money. In general, there are three tax buckets you can have your money in. They are taxable, tax-deferred and tax-free. Inside of these three buckets can be many types of investment products. An account in a taxable bucket is one you pay tax on whether or not you take the interest. This is non-IRA money and can apply to interest earned on CDs, mutual funds, etc.

If interest for the year is $10 or more, you get a 1099 tax document on all interest and dividends. The good and bad news on these accounts is that the interest rates are so low on CDs that you’re probably not having much taxable income to report. If you depend on the interest from these accounts for income, then that is a bigger issue you may need to address.



The tax-deferred bucket includes traditional IRAs, deferred annuities, 401(k)s, etc. Tax deferred simply means you defer paying tax on it now, but you or your heirs will pay tax on the money later. You can move taxable money into a tax-deferred account if that makes sense for you.
If you are paying more tax than you prefer now, you can defer taxes until a time when you feel you will be in a lower tax bracket. A common use of a tax deferred strategy is using a deferred annuity, either fixed or variable, to postpone the taxable event until later. If your goal is to have more money go to your heirs, you should keep in mind the taxes they may pay on your money. Here is an example.  You have a $100,000 deferred, nonqualified account and $50,000 of it is accumulated interest. When you take withdrawals you’ll pay tax on the built up interest first. If you pass away and your beneficiaries cash it in, they’ll pay tax on the whole $50,000 of interest all at once. This would likely result in a chunk of your hard-earned money going out the window in taxes.


However, you may have the ability to strategically reduce the tax liability over time. If you have tax-deferred accounts, I highly suggest you see what you can do to possibly reduce your tax liability so the tax bubble doesn’t burst one day. Additionally, there are a couple account types that are tax-deferred to you and tax-free to your heirs. They are Roth IRAs and single premium life insurance policies.

The tax-free bucket can be a good place for some of your taxable money. When you take money out of a tax deferred account like an IRA, you have to pay tax on it now. Once you start taking a required minimum distribution at 70½, you now have more taxable income than you may need or want.  If you have some of your other taxable money move into a tax-free account, that may help to keep your tax bite down. There are a few good strategies to use when it comes to tax-free investments. Each strategy is best left to each individual’s situation.

I do recommend that you meet with your financial services professional to see if and how using the tax-free bucket can help you retain more of your money in your lifetime and after.
Regardless of which of the three tax buckets you are using, it doesn’t hurt to see if you have too much in one bucket or not enough in another.
Your accountant may be able to shed some light on this. He or she can tell you if you have a big tax bite, but your financial services professional can help you design a strategy to possibly reduce it.