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.
This is the standard formula for retirement that really needs to be updated due to the recent economic crisis and people loosing 30% to 40% of their retirment income. The stock market is too risky to put most of your retirment income into. Financial planners should change their thinking on this. This was a good strategy when the market was good but is no longer a good formula.