Tax Planning Strategies for Retirement Investments

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 paycheck but how to handle income taxes in retirement, too. While income taxes can be complex, you may be able to lower your tax burden during retirement 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

Retirement taxes are 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. (For related reading, see: 5 Ways to Reduce Taxes When You Are in Retirement.)

Investments With Lower or No Taxes

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 of helping investors save on taxes and offsetting 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 home state. The higher your income tax bracket the more you can potentially benefit from investing in munis. (For related reading, see: Avoid Tricky Tax Issues on Municipal Bonds.)

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. Mangers 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 Within Investment Accounts

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 accounts 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. (For related reading, see: Not All Retirement Accounts Should Be Tax-Deferred.)

The Retirement 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 too much taxable income into those buckets will give you a surprise at tax time. (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 are 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 checkbook. (For more from this author, see: A Roth IRA or 529 Plan for a Grandchild's College?)