Ah, retirement! No more worries, right? But when your paycheck stops, you now have to figure out not only how to turn your nest egg into a ‘pay check’ but how to handle income taxes, too. Here are some tax strategies for retirees to consider. While income taxes can be complex, you may be able to lower your tax burden with good planning and some professional help.
Nothing in life is certain except death and taxes – Benjamin Franklin
Next to being shot at and missed, nothing is really quite as satisfying as an income tax refund. – F. J. Raymond, American Humorist
It’s not so much about how much you have but how much you keep. And retirees that have a tax-efficient investing and distribution plan in place may be able to keep more of their hard-earned wealth for themselves or their heirs. Consider the following tips to help you make smarter money management moves in retirement.
Less Taxing Investments
Retirees may want to consider a healthy dose of municipal bonds (also known as “munis”) in their taxable accounts. These types of investments have a long tradition helping investors save on taxes and offset stock market volatility. Interest paid on municipal bonds is exempt from federal taxes. And for residents in states with income taxes, you’ll also save on state income taxes by buying bonds issued by your tax-home state. And the higher your income tax bracket means the more you can potentially benefit from investing in munis.
The Tax-Exempt Advantage: When Less May Yield More
Would a tax-free bond be a better investment for you than a taxable bond? Compare the yields to see. For instance, if you were in the 25% federal tax bracket, a taxable bond would need to earn a yield of 6.67% to equal a 5% tax-exempt municipal bond yield.
| Federal Tax Rate | 15% | 25% | 28% | 33% | 35% | 39.6% |
| Tax-Exempt Rate | Taxable-Equivalent Yield | |||||
| 4% | 4.71% | 5.33% | 5.56% | 5.97% | 6.15% | 6.62% |
| 5% | 5.88% | 6.67% | 6.94% | 7.46% | 7.69% | 8.28% |
| 6% | 7.06% | 8% | 8.33% | 8.96% | 9.23% | 9.93% |
| 7% | 8.24% | 9.33% | 9.72% | 10.45% | 10.77% | 11.59% |
| 8% | 9.41% | 10.67% | 11.11% | 11.94% | 12.31% | 13.25% |
The yields shown above are for illustrative purposes only and are not intended to reflect the actual yields of any investment.
Courtesy of DST Systems, Inc.
Tax-managed mutual funds or investment platforms that offer tax-loss harvesting (like Betterment for Advisors) are other options. Managers of these funds as well as the algorithms used by the platforms focus on tax efficiency through many means. They may limit the ‘turnover’ or number of times they trade investments. Or they match capital gains with offsetting losses to minimize total taxable gains. At the very least, you should carefully look at a fund’s prospectus to determine its average ‘turnover’ ratio. The lower, the better as this will help limit trading fees and potential gains. Tax-managed funds are most appropriate for your taxable accounts though you may want to also consider them for your IRA accounts as well.
Asset Location
As important as diversification is to investing, you also need to consider where you should keep certain investments to ‘yield’ the optimum tax-efficient return.
Some types of investments are better suited for taxable accounts and others are more optimal when part of a tax-deferred account. Why? Blame the tax code. Certain investments are better suited for retirement account while others have better tax treatment in taxable accounts. This is why many financial and tax experts (including me) recommend keeping real estate investment trusts (REITs), high-yield bonds, and high-turnover stock mutual funds or ETFs in tax-deferred accounts. You won’t get hit with a tax bill from the dividends or gains as you would if these were in a taxable account. On the other hand, low-turnover stock funds (like index funds), municipal bonds and growth or value stocks may be more suited for taxable accounts.
The Tax Trap
The maximum federal tax rate on certain dividend-producing investments and long-term capital gains is 20%. And if your income is above a certain threshold, you may also be subject to an additional 3.8% Medicare tax. This applies to single-filer taxpayers with modified adjusted gross income (MAGI) over $200,000 and over $250,000 for joint filers. Without proper planning ahead of time, taking withdrawals from the ‘wrong’ buckets or having investments throw off too much taxable income into those buckets and you’ll get a surprise at tax time. (And another thing to consider is the potential impact that all this income may have on your Medicare premiums. If you have investments throwing off lots of capital gains, dividends and income, you may find that your MAGI is high enough to put you in a different tier where you may be paying the maximum amount for your Medicare Part B premium).
Taxes are never a favorite topic and less so for retirees. But with a little planning and guidance you may be able to keep more in your wallet. Skip the planning and you may just want to go straight for the aspirin … and your check book.
To see if you have the right investments that match up with your tax plan, call Steve Stanganelli at 617-398-7494.
