Thinking about taxes when investing

I've always known that you need to be careful of mutual funds that are actively traded -- i.e., the more the manager buys and sells, the more taxes you might have to pay.

But there's more to taxes than that. In The Wall Street Journal, Carolyn Geer shows how you need to consider your mix of investment funds in light of future taxes. Here's one scenario to illustrate the point.

Say you and your spouse retire at 65 with $1 million—your entire savings—in a traditional IRA. Assume, too, you need $80,000 a year to live on, and together you receive $40,000 a year in Social Security benefits. Dean Barber, a financial adviser in Lenexa, Kan., says you would have to withdraw not just $40,000 a year but $70,000 a year from the IRA to meet living expenses. Why?

Not only would your IRA withdrawals be taxable, but they also would get included in your so-called "provisional income," which is used to figure what, if any, taxes you owe on your Social Security benefits. In this scenario, you would end up owing taxes on every dollar you took out of your IRA plus 85% of your Social Security benefits—the maximum percentage.

"That's really the current state of affairs for most people because they have piled most of their assets into the tax-deferred accounts," says Mr. Barber.

If instead you had $600,000 in the IRA and $400,000 in a taxable brokerage account, you could withdraw from the brokerage account just $40,000 a year in securities on which you don't have a net capital gain. That money wouldn't be taxable because it has already been taxed, and it wouldn't be included in your provisional income, so none of your Social Security benefits would be taxable either. In effect, you let the principal from the brokerage account feed your income needs for the first five years of retirement until you reach age 70½, when you are forced to start taking distributions from your IRA. This strategy would save you $150,000 in taxes over the five years.

Let's see, what could I do with $150k? Ms. Geer offers some advice (and I know the article is behind a paywall, if you're not a subscriber):

To get the most mileage out of your different accounts, fund them with investments that match their tax characteristics. For example, taxable accounts are a good place to hold tax-exempt municipal bonds and muni funds. Taxable bonds and bond funds work well in tax-deferred accounts. And actively traded stocks and actively managed stock funds make sense for Roth accounts where they can grow tax-free, especially if the top long-term capital-gains rate jumps from 15% to 20% next year as scheduled.

She suggests you may need professional advice on this. I know I do.