Today, we’re wrapping up a series by guest author Ed Garrison on “Tax Considerations in Retirement Investing.” Ed is the Executive Director of AAFR, the American Association of Future Retirees. If you missed Part 1 of the article, you can catch it here.
Enjoy!
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Asset Allocation Is Key
So how do you know where to put what investments for the lowest possible tax burden? For best results, you should start off by examining your asset allocation. According to an old rule of thumb, percentually, you should have about 100 minus your age invested in stocks and stock mutual funds. So if you’re 45 years old, you should have 100-45 or 55% of your total portfolio in stock-based investments. The rest should be in fixed-income (e.g. bonds, Ginnie Maes) and/or a money market fund.
Once you’ve come up with an asset allocation that you’re comfortable with–say, 50% stocks, 40% bonds and 10% money market–take a look at your total investment portfolio: in other words, the sum total of all accounts regardless of whether they’re tax-favored or not. If you’re allocation is out of whack, you’re going to have to do some rejiggering.
This is where the tax considerations come in. As a general rule, you should try to keep lightly taxed investments (stocks, stock mutual funds) in your ordinary accounts, and highly taxed investments (bonds) in tax-deferred accounts. Money market accounts are fully taxable, but currently yield so little that taxation on them is a secondary concern. This will change if short term interest rates rise.
Note that you can freely buy and sell assets in your tax-deferred account without tax consequences as long as you fully reinvest the proceeds within the account. If you sell an asset in an ordinary account, capital gains taxes may come due. Be sure to factor this possibility in when reallocating non-tax-deferred assets.
An Ongoing Process
With time, the parameters of your asset allocation will change. You’ll gradually want to increase the percentage of fixed income investments. And, of course, some assets will go up, others will go down. At least once per year, you should do a portfolio check-up along the lines described above, and re-allocate if necessary.
One final thought: while everyone wants to minimize taxes, it’s important not to let the tax tail wag the investment dog. Your primary goal should be to invest prudently in vehicles that promise reasonable return and safety. Once you have determined the right mix of the right assets, then, and only then, should you try to “game” the tax-deferral system for maximum tax savings. That’s the best way to ensure that your “golden years” will truly be golden.
For more on Tax Considerations in Retirement Planning, stop by Ed’s blog.
Tax is a pretty broad area of the law. I don’t profess to know it all. Okay, my brothers may say that I think I do, but that’s just for their benefit (and to keep them in their place). I really don’t.
One of the subjects which I will freely admit is one of my weaknesses is retirement planning and tax. I know enough to be dangerous but clearly, I’m no expert. Fortunately, I’ve always surrounded myself with other folks who know what they’re talking about (hey lawyer newbies, this is key!).
One of those experts, Ed Garrison, has been kind enough to pen a guest post for taxgirl on “Tax Considerations in Retirement Investing.” Ed is the Executive Director of AAFR, the American Association of Future Retirees. His article will appear today and tomorrow as part of a series.
So enjoy…
Tax Considerations in Retirement Planning
Many people consider the tax side of retirement investing to be a no-brainer: invest as much as you can in tax-deferred accounts (like 401k’s or IRAs), and your money will compound tax-free. Period.
Believe it or not, however, a tax-deferred account is not always the ideal place for retirement investments. In some cases, it can even end up increasing your tax burden!
Some Investments Are Already Tax-Favored
What possible reason can there be not to use a tax-deferred account (other than the fact that you generally can’t withdraw your money without penalty until you’re 59 1/2 years old)? The problem lies in the tax treatment of the withdrawals. These are generally treated as ordinary income (Roth IRAs are an exception). Because of this, they incur the maximum possible income tax. That’s not a problem if the income generated by your investments would have been ordinary income anyway. But if not, you’ll lose the tax advantages you would otherwise have had, and instead end up paying the top tax rate.
The two most common examples of this are long-term capital gains and dividends. In most cases, these forms of income are taxed at a maximum of 15%. By contrast, the highest marginal tax rate on ordinary income is 35%, or more than double the reduced rate. Like other income, the dividends and capital gains you rack up in your tax-deferred account won’t be taxed when you receive them. But when you go to withdraw your money, if you’re in the top tax bracket, you’ll pay 35%. Investments that generate most of their returns through capital gains and dividends, therefore, may be more profitable if you keep them in an ordinary, taxable account.
Also, any investment vehicle that’s already tax-free or tax-deferred absolutely, positively, does not belong in a tax-deferred account. If you hold, for example, municipal bonds or variable annuities in your IRA, you’ll eventually pay taxes you otherwise wouldn’t have owed at all!
Why do people do this? Some do it out of ignorance; but in most cases, they’ve been talked into such absurd investments by unscrupulous investment advisors. Variable annuities–especially those sold by salespersons–are loaded down with all kinds of fees and commissions, making them very lucrative for the sellers. Some salespeople can’t resist the easy money, and (unethically) push them even for tax-favored accounts. If this happens to you, you should find another advisor immediately, and probably lodge a complaint with your state’s regulatory authorities.
For more on Tax Considerations in Retirement Planning, check out Part 2 tomorrow – and stop by Ed’s blog.
