Understanding Taxes for Corporate Executives: Tax Treatment of Accounts

In Part 3, we discuss how the most common account types available to corporate executives are taxed. In Part 1 and Part 2, the focus was on how various types of income are taxed, but Part 3 will explain how utilizing tax-advantaged accounts can help you reduce taxable income in your high tax rate years.

Similar to most corporate professionals, corporate executives have access to an array of accounts with varying tax treatment. The difference is that corporate executives typically have the cash flow to contribute to most, if not all, of these accounts to take advantage of the favorable tax treatment. On top of that, corporate executives typically have a significant amount of income subject to the highest tax rates which amplifies the benefit of these tax-advantaged accounts. The tax treatment of investment accounts can be divided into three categories: Tax Deferred, Tax Free and Taxable.

Tax Deferred Accounts

Tax Deferred Accounts are funded with pre-tax dollars. This means that the dollars that you contribute to a tax deferred account are deducted from your taxable income. These dollars continue to grow tax free until you ultimately withdraw the dollars and pay income taxes on the distribution. The potential benefit is that you have the opportunity to reduce taxable income during your high tax rate years and take taxable distributions when you are in a lower tax bracket. The benefit is twofold: 1.) You pay a lower tax rate on the dollars and 2.) You earn a return on the deferred taxes. The financial benefit to paying a lower tax rate is obvious, but the advantage of investing the deferred taxes over several years (basically, an interest free loan from the IRS) will have a huge impact on accelerating your retirement. The most common types of deferred tax accounts are 401(k), Traditional IRA, Non-Qualified Deferred Compensation Plans and Health Savings Accounts. For corporate executives, tax deferred accounts are typically the highest priority because executives are in high tax brackets.

Tax Free Accounts

While not as beneficial for corporate executives as Tax Deferred Accounts, Tax Free accounts have an important place in reducing lifetime taxes. Tax Free Accounts are funded with after tax dollars. This means that the dollars that you contribute to the Tax Free Account have already been taxed. The benefit of contributing to a Tax Free Account is that you will not pay taxes on these dollars again. In other words, the dollars will grow tax free via dividends, interest and capital appreciation. Then, when you take out the dollars you will not pay taxes on the investment income. The most common types of Tax Free Accounts for corporate executives are the ROTH IRA, ROTH 401(k), 529 Plans and certain life insurance products. Tax Free Accounts should be a priority for investors that are currently in a low tax bracket and expect to be in a higher tax bracket in the future.

Taxable Accounts

Taxable Accounts refer to your typical brokerage account that is funded with after tax dollars and pays taxes on dividends, interest and capital gains in the year they are generated. While taxable accounts are the least tax efficient account, they offer the most flexibility as they do not place any restrictions when you are able to withdraw funds or what you are allowed to invest in. The key is to place tax efficient investments (e.g. stocks that are held for more than a year with a low dividend yield) in the taxable accounts and vice versa - place highly taxed investments in tax efficient accounts. You can read more about this concept - known as asset location - in our Corporate Executive Guide to Paying Less Taxes. See the below illustration for a general idea of which investments and account types are tax efficient. At the end of the day, it is never a bad idea to have your assets spread across the various account types because you never know what future tax legislation will transpire.

Conclusion

The discussion on utilizing various accounts in a tax efficient way concludes the Understanding Taxes for Corporate Executives articles for now. Understanding the tax code is an ongoing endeavor and we expect to write additional articles in the future. We hope that you learned a few concepts and while taxes are inevitable, knowledge is the first step to creating a tax efficient strategy for your wealth.

Mark Chisenhall, CFA is the founder of Taurus Financial Planning, a wealth management firm specializing in helping high-earning corporate executives reduce taxes, optimize investments, and accelerate retirement. Check out other relevant posts that take a deeper dive into understanding tax topics such as income taxes and withholding, tax-advantaged accounts, and managing concentrated company stock positions. If you are interested in learning more about working with Taurus Financial Planning, you can schedule an introductory call here.

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