Managing taxes in retirement can be complex. Thoughtful
planning may help reduce the tax burden for you and your heirs.
Key Points
- Less Taxing Investments
- The Tax-Exempt Advantage: When Less May Yield More
- Which Securities to Tap First?
- The Ins and Outs of RMDs
- Estate Planning and Gifting
- Points to Remember
Nothing in life is certain except death and taxes. - Benjamin Franklin
That saying still rings true roughly 300 years after the
former statesman coined it. Yet, by formulating a tax-efficient investment and
distribution strategy, retirees may keep more of their hard-earned assets for
themselves and their heirs. Here are a few suggestions for effective money
management during your later years.
Less Taxing Investments
Municipal bonds, or "munis" have long been
appreciated by retirees seeking a haven from taxes and stock market volatility.
In general, the interest paid on municipal bonds is exempt from federal taxes
and sometimes state and local taxes as well (see table).1 The higher
your tax bracket, the more you may benefit from investing in munis.
Also, consider investing in tax-managed mutual funds. Managers of these funds
pursue tax efficiency by employing a number of strategies. For instance, they
might limit the number of times they trade investments within a fund or sell
securities at a loss to offset portfolio gains. Equity index funds may also be
more tax-efficient than actively managed stock funds due to a potentially lower
investment turnover rate.
It's also important to review which types of securities are held in taxable
versus tax-deferred accounts. Why? Because in 2003, Congress reduced the
maximum federal tax rate on some dividend-producing investments and long-term
capital gains to 15%. In light of these changes, many financial experts
recommend keeping real estate investment trusts (REITs), high-yield bonds, and
high-turnover stock mutual funds in tax-deferred accounts. Low-turnover stock
funds, municipal bonds, and growth or value stocks may be more appropriate for
taxable accounts.
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Which Securities to Tap First?
Another major decision facing retirees is when to liquidate
various types of assets. The advantage of holding on to tax-deferred investments
is that they compound on a before-tax basis and therefore have greater earning
potential than their taxable counterparts.
On the other hand, you'll need to consider that qualified withdrawals from
tax-deferred investments are taxed at ordinary federal income tax rates of up
to 35%, while distributions -- in the form of capital gains or dividends --
from investments in taxable accounts are taxed at a maximum 15%. (Capital gains
on investments held for less than a year are taxed at regular income tax
rates.)
For this reason, it's beneficial to hold securities in taxable
accounts long enough to qualify for the 15% tax rate. And, when choosing
between tapping capital gains versus dividends, long-term capital gains are
more attractive from an estate planning perspective because you get a step-up
in basis on appreciated assets at death.
It also makes sense to take a long view with regard to tapping
tax-deferred accounts. Keep in mind, however, the deadline for taking annual
required minimum distributions (RMDs).
The Ins and Outs of RMDs
The IRS mandates that you begin taking an annual RMD from
traditional IRAs and employer-sponsored retirement plans after you reach age
70½. The premise behind the RMD rule is simple - the longer you are expected to
live, the less the IRS requires you to withdraw (and pay taxes on) each year.
RMDs are now based on a uniform table, which takes into consideration the
participant's and beneficiary's lifetimes, based on the participant's age.
Failure to take the RMD can result in a tax penalty equal to 50% of the
required amount. TIP: If you'll be pushed into a higher tax bracket at age 70½
due to the RMD rule, it may pay to begin taking withdrawals during your
sixties.
Unlike traditional IRAs, Roth IRAs do not require you to begin taking
distributions by age 70½.2 In fact, you're never required to take
distributions from your Roth IRA, and qualified withdrawals are tax free.2
For this reason, you may wish to liquidate investments in a Roth IRA after
you've exhausted other sources of income. Be aware, however, that your
beneficiaries will be required to take RMDs after your death.
Estate Planning and Gifting
There are various ways to make the tax payments on your assets
easier for heirs to handle. Careful selection of beneficiaries of your money
accounts is one example. If you do not name a beneficiary, your assets could
end up in probate, and your beneficiaries could be taking distributions faster
than they expected. In most cases spousal beneficiaries are ideal, because they
have several options that aren't available to other beneficiaries, including
the marital deduction for the federal estate tax.
Also, consider transferring assets into an irrevocable trust if you're close to
the threshold for owing estate taxes. In 2012, the federal estate tax applies
to all estate assets over $5.12 million, but this threshold is scheduled to
revert to $1 million in 2013, unless Congress elects to extend it. Assets in an
irrevocable trust are passed on free of estate taxes, saving heirs thousands of
dollars. TIP: If you plan on moving assets from tax-deferred accounts, do so
before you reach age 70½, when RMDs must begin.
Finally, if you have a taxable estate, you can give up to $13,000 per
individual ($26,000 per married couple) each year to anyone tax free. Also,
consider making gifts to children over age 14, as dividends may be taxed - or
gains tapped - at much lower tax rates than those that apply to adults. TIP:
Some people choose to transfer appreciated securities to custodial accounts (UTMAs
and UGMAs) to help save for a grandchild's higher education expenses.
Strategies for making the most of your money and reducing taxes are complex.
Your best recourse? Plan ahead and consider meeting with a competent tax
advisor, an estate attorney, and a financial professional to help you sort
through your options.
Points to Remember
- Formulating a tax-efficient investment and
distribution strategy may allow you to keep more assets for you and your heirs. - Consider tax-efficient investments, such as municipal
bonds and index funds, to help reduce exposure to taxes. - Tax-deferred investments compound on a
before-tax basis and therefore have greater earning potential than their
taxable counterparts. However, qualified withdrawals from tax-deferred investments
are taxed at income tax rates up to 35%, whereas distributions from taxable
investments held for more than 12 months are taxed at a maximum 15%. - You must begin taking an annual amount of
money (known as a required minimum distribution) from some tax-deferred
accounts after you reach age 70½. - Review how your assets fit into a
comprehensive estate plan to make the most of your money while you're alive and
to maximize the amount you'll pass along to your heirs.
Source/Disclaimer:
1Capital gains from municipal bonds are taxable and may be
subject to the alternative minimum tax.
2Withdrawals prior to age 59½ are subject to a 10% penalty.
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February 2012 — This column is provided through the Financial
Planning Association, the membership organization for the financial planning
community, and is brought to you by Ronald J VanSurksum, CFP®, a local member
of FPA.
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