Read this if you want to preserve more of your nest egg & lower your tax bill.
Location, location, location … It matters when it comes to real estate, and it also matters when it comes to the way you hold and invest your retirement savings.
You can’t control what happens with the tax code, but you can control how your savings are held. As various types of investments are taxed at varying rates, some investments are better held in taxable accounts and others in tax-deferred accounts.
*Funds that trade frequently (such as bond funds and money market funds) are better off in tax-deferred accounts, as much of their yields represent taxable income.
*Traditional IRAs are tax-inefficient (relatively speaking), and by holding a traditional IRA within a tax-deferred account, you can delay paying tax on those IRA assets until you withdraw them in retirement (when you will presumably be in a lower tax bracket than you are now).
*What kinds of investments are usually better off in taxable accounts? Think index funds, growth funds, tax-managed funds and ETFs that tend to generate capital gains (growth funds especially are prone to reinvesting profits). In light of long-term capital gains rates, keeping these types of investments in taxable accounts makes sense.1,2
Timing isn’t everything, but … The timing of withdrawals from retirement accounts can have a major impact on your income taxes – and the longevity of your savings.
You don’t want to outlive your money, and you want your income taxes to be as minimal as possible once you are retired. To that end, you want to withdraw from your retirement accounts in a tax-efficient way.
By drawing down taxable accounts first, you’ll face the capital gains tax rate instead of the ordinary income tax rate. Most retirees will see long-term capital gains taxed at 15%; for others, the long-term capital gains tax rate will be 0%.3 In taking money out of the taxable accounts to start, you are not only giving yourself a de facto tax break but also giving the retirement funds in the tax-advantaged accounts more time to grow and compound (and even a year or two of compounding and growth can be significant if you have held a tax-advantaged account for decades). Withdrawals from tax-deferred accounts – such as traditional IRAs and 401(k)s and 403(b)s – can follow, and then lastly withdrawals from Roth accounts.3
Following these asset location and distribution approaches may leave you with more retirement income – in fact, Morningstar estimates that in tandem, they can boost a retiree’s income by about 8%.1
If you receive a lump-sum payout, don’t put it in the bank. If you take direct control of that money, you are triggering a taxable event and your income taxes for that year could be staggering. An alternative outcome: make a direct rollover of the lump-sum payout (qualified distribution) into a traditional IRA. That move will exclude that money from your total taxable income for the year, and put you in position to take taxable annual Required Minimum Distributions (RMD), with the taxable RMDs being smaller than the taxable lump sum. (Alternately, you could directly roll the lump sum payout into a Roth IRA, which would leave you paying taxes on the conversion but set you up for tax-free withdrawals in retirement if Roth IRA rules and regulations have been followed).5,6
Lastly, consider living in a state where taxes bite a little less. Not everyone can afford to move, but in the long run, living in Florida, Nevada, Washington, Texas or other states that are relatively tax-friendly for retirees can help. Even moving to another town within your current state might result in some tax savings.6,7
Mark Lund provides 401k consulting for small businesses and Investment Advisory Services for select individuals. Visit StonecreekWealth.com for a free report titled, “9 Investing Mistakes To Avoid.” Investment advisory services through Stonecreek Wealth Advisors, Inc. a Registered Investment Advisor firm in Utah. Call 801-545-0696
Citations.
1 – money.cnn.com/2013/02/11/pf/expert/retirement-tax-plans.moneymag/ [2/11/13]
2 – biz.yahoo.com/edu/mf/vra.html [2/13/14]
3 – tinyurl.com/l6lkrfu [2/12/14]
4 – bankrate.com/finance/money-guides/capital-losses-can-help-cut-your-tax-bill-1.aspx [9/19/13]
5 – raymondjames.com/making_right_distribution.htm [2/13/14]
6 – wife.org/minimizing-tax-burden-in-retirement.htm [2/13/14]
7 – money.msn.com/tax-planning/retired-how-to-cut-your-taxes-mark-koba [2/6/12]
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