Retirement Planning and Taxes
Retirement tax planning is a moving target. Very few of us can accurately predict what our income will be in retirement and none of us can predict what future tax rates will be. Therefore, retirement tax planning is more about removing as many variables as possible by focusing on what can be controlled now, rather than what we can't control in the future.
Saving as much as possible in tax-deferred accounts, utilizing tax-efficient investments, and understanding how tax liabilities impact the amount of money you'll have available will help to take some of the sting out of taxes that will be due. Protecting as much of your retirement income as possible should be the goal of tax planning.
When to Contribute to a Traditional and a Roth IRA
Depending on your income, the amount you contribute to a traditional IRA is tax-deductible. And, all contributions grow tax-deferred. Even if your contribution isn't deductible, it still grows tax-deferred. Tax-deferred growth provides numerous advantages over taxable accounts. First, accounts typically grow faster because money isn't removed to pay taxes. Second, current year tax liability can be reduced, which leaves more money for investing in other areas. And third, if income is less once distributions begin, less tax will be paid on the earnings and the investment.
For most investors, however, the biggest draw of the traditional IRA is the current year tax deduction. If a contribution to a traditional IRA, combined with your other deductions, puts you in a lower marginal tax rate and significantly reduces your tax liability, then choose this type of retirement fund. If your current year tax liability is not significantly reduced, consider contributing to a Roth IRA.
While almost anyone will benefit from a Roth IRA, those who are under the age of 35 and over the age of 65 typically benefit most. Young people usually earn less than the modified gross adjusted income limit (currently $107,000 for 2011) and don't earn enough to benefit from the tax deduction of a traditional IRA. Older folks who continue to work in their 60s and 70s can continue to contribute to a Roth IRA as long as they have earned income. Contributions can be made to a Roth IRA regardless of age, whereas contributions to a traditional IRA cannot be made past age 70 ½. With a Roth IRA you'll lose the current year tax deduction, but the distributions are paid out tax-free. If you suspect that you'll be in the same tax bracket in retirement, or even a higher tax bracket, a Roth IRA is the best bet.
If you're in the "sandwich" generation, meaning you're between the ages of 35 and 60 and financially responsible for children and ageing parents, you'll want to do the calculations to see which type of IRA is the right choice. While a Roth IRA will provide tax-free income once distributions begin, you may be better off taking the deduction that comes with a traditional IRA. Regardless of your financial obligations to others, make sure you establish at least one or the other type of retirement savings account.
How to Choose Tax-Efficient Non-Qualified Investments
When choosing non-qualified investments, you want to focus on those that are tax-efficient. Whether you're retired or not, you want to choose investments that provide adequate growth without being subject to high tax rates. The key is to earn and keep the return rather than giving it up to taxes. Examples of tax-efficient investments are index funds, stock mutual funds and ETFs with low turnover rates, individual stocks that you hold longer than one year, municipal bonds, and savings bonds.
Index funds are highly tax-efficient because the stocks within them don't turn over very often. For example, the last time stocks were added to the Dow was in June of 2009 when Cisco Systems and Travelers joined this prestigious group. (General Electric has been part of the Dow since 1907.) Stock mutual funds and ETFs with low turnover rates are also tax-efficient because stocks aren't bought and sold as frequently, which means fewer capital gains taxes and dividend distributions are passed along to shareholders. Because these types of funds and ETFs aren't actively managed, the administration fees are also lower, which means more of your money will be available for the investment.
Individual stocks that are held for more than one year are subject to long-term capital gains taxes instead of short-term gains taxes. The difference between the two can be a staggering 15% to 20% if you're in one of the highest tax brackets. If you enjoy trading stocks for short-term gains, trade them in a tax-qualified account such as a traditional or Roth IRA. While the long-term capital gains rate is always subject to change, it is currently lower than the marginal tax rate for most taxpayers.
Finally, municipal bonds almost always provide income that is free from federal, state, and local income taxes. Muni bonds should be considered if you're in a high tax bracket, live in a state that has high income tax rates, or if you need the income.
Taxes on Retirement Income: Annuities, Pensions, and Social Security
The earnings on annuities and pensions funded with after-tax dollars are taxed at ordinary income rates. Note that only the earnings are taxable, as the balance of the payout is considered to be the return of principal. In other words, if you purchase an annuity for $300,000 and receive $350,000 at the end of the contract, you will only owe taxes on $50,000. If, however, your pension or annuity was completely funded by your employer and you did not contribute to it, or if the amount you contributed was made up of pre-tax dollars, the entire payout amount is taxable. While you can't avoid federal taxes on a pension, you can avoid state taxes. By moving to a state that does not collect income tax, you will avoid paying at least some tax on your pension or annuity income.
Some retirees pay federal income tax on their Social Security benefits and some do not. The highest percentage of the benefit that is taxed is currently 85%. For example, if you're single and have combined income between $25,000 and $34,000, you could pay tax on up to 50% of your benefit. If you have income above $34,000, 85% of your benefit could be taxable. While it may not seem fair that Social Security income is taxable, it is at least only partially taxable.
Taking Steps to Reduce Your Taxable Income in Retirement
While most of us assume our tax liability will be lower after retirement, for some this might not be true. If you sell a business, a valuable piece of property, or inherit substantial assets, your tax liability could actually increase. And, if you inherit an IRA or other retirement account from someone who is not your spouse, you will have to begin taking distributions immediately based on your life expectancy, which could significantly change your tax status. Further, the amount of your retirement account distributions are also based on your life expectancy at the time they begin. If you delay these until age 70 ½, you'll be taking more money each year than if you had started at age 59 ½ or even at age 65. If you begin taking distributions earlier, take only what you need.
Taxes can't be avoided completely, but they can be reduced. Five of the most effective tax strategies include moving to a state that does not have income tax, transferring assets to children or grandchildren through tax-deductible gifts, converting traditional retirement account assets to Roth IRAs, donating to charity or charitable causes, and diversifying assets into those that are more tax-efficient.
Taxes are complicated enough during our working years. We shouldn't really expect that they would be any less challenging in retirement. But once we're retired, we have less room for missteps. By starting your retirement tax planning early, you'll reduce the risk of being caught unprepared.
While we've covered the basics of retirement planning here, there is much more to securing a great retirement. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Retirement Planning Guidance
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- Retirement Planning FAQ — Frequently asked questions about retirement planning.