Few people enjoy paying taxes. So, if I told you that I could show you a way to reduce your taxes, would you be interested? Of course you would. Today, we’ll look at two scenarios involving couples who are about to retire. Each couple has a similar investment portfolio, but different needs and financial goals. I’ll analyze each couple’s situation and discuss what they can do to minimize the impact of taxes.

Two Couples, Two Different Situations

Imagine that we have two couples, both 66 years old and about to retire. Each couple has an investment portfolio worth $500,000. Of the $500,000, $300,000 is in an IRA rollover and $200,000 is in a taxable, jointly owned investment account.

The first couple (Jane and Tom) has an income need of $70,000 in retirement. Between pensions and Social Security, they are receiving $70,000. So, they have no need to generate income from their investment portfolio.

The second couple (Anne and Bill) also has a retirement income need of $70,000. Between their pensions and Social Security checks, however, their income is only $60,000. They need to generate income of $10,000 from their portfolio. Let’s assume that in each scenario, the couple wants to invest in traditional stocks and bonds.

Let’s also assume they wish to take on an appropriate amount of risk and that they have already adequate emergency reserves; therefore, they can fully invest in both stocks and bonds. We can also assume that they’d prefer not to dip into principal if possible. Typically, a bond or bond fund generates more income than a stock or stock fund, and the couple is comfortable with both. For these hypothetical situations, I’ll assume that the bond portfolio can generate a 4% yield and the stock portfolio a 1% yield.

Jane and Tom: Minimizing the Impact of Taxes on Earnings

Jane and Tom have decided they’d like to take on prudent investment risk. Even though they don’t need income from the portfolio, they still need to overcome inflation, and would like to take some trips and make some major purchases in the future. Therefore, they decided to invest in a portfolio that has a 50% allocation to bonds and 50% allocation to stocks.

The real question for Jane and Tom, since they don’t need to generate income, is what they can do to minimize the impact of taxes on their earnings and capital gains. The answer lies not in the specific investments they actually select, but in how those investments are held.

If we assume that the majority of the total return for a bond or bond fund is in the yield, then to reduce the impact of taxes on the yield it would be better to hold the majority of the bond portfolio inside their IRA. If they were to hold the bonds in the taxable account, all of the yield would be exposed to taxes—assuming they are taxable bonds. By owning these investments inside the IRA, they’ll pay less in taxes.

Assuming that the majority of the total return for a stock or stock fund is with the capital appreciation potential, it would be proper to own the majority of the stock portfolio in the taxable account. Typically, you would owe little or no tax on a stock or stock mutual fund unless you realized capital appreciation. Therefore, if all you did was hold the stock or stock fund, you could minimize the impact of taxes because you would have little in the way of realized capital gains.

Thus, to reduce the impact of taxes, Jane and Tom are better off holding the majority of the bond allocation inside their IRA and the majority of the stock allocation to their taxable account.

Anne and Bill: Generating Tax-Efficient Income

For Anne and Bill, the issue is different. They need to generate income from their portfolio. For them, the big question is, “How do I generate the income I need in a tax-efficient manner, and which account should it come from?” Understanding how to answer this question will not only help Anne and Bill match the investment portfolio with their retirement goals but also allow them to minimize tax exposure.

In this scenario, Anne and Bill should own the bond portfolio in the jointly held taxable account and the stocks in their IRA (the opposite of the first scenario). They could generate a 4% yield on $200,000 (the jointly held account), which would account for an additional $8,000 of income. This income would be taxed at favorable rates because this is dividend income. We would then need to make a distribution from the IRA of only $2,000, which would be considered ordinary income.

Know Where You Are On Your Investment Journey

Not only is it important to recognize what investments to own and how to coordinate them with your retirement goals, but also to understand what part of the investment journey you are on and how to own each investment properly in order to minimize tax exposure. Remember, it’s more important to know what your income need is, and to own the investments in the right accounts, than it is to own the right investments.

About Mark Singer

Mark Singer is a CERTIFIED FINANCIAL PLANNER™ professional and the author of The Changing Landscape of Retirement—What You Don't Know Could Hurt You. He has been The Retirement Guide to thousands of investors for close to 25 years and is the creator of the Retirement Roadmap, which contributes to a solution to investors' greatest concerns–properly coordinating their financial affairs. These systems have become a primary resource for the people who have worked with Mark over the years. You can download the first chapter of Mark's new book for free by Liking it on Facebook.