Lessen your Tax Bite in Retirement

The Tax BiteKeep More – Setting Ground Rules for a Tax Smart Retirement

Nearly all business owners, high income earners and retirement savers are interested in reducing income taxes. This is understandable as income taxes are generally the highest-rate tax business owners and high income earners will pay during their lifetimes.

Part of a successful investment plan is comprehensive tax planning, and one must also consider the tax impact on assets which will be relied upon in retirement. Without some awareness and organized planning, the tax bite on long-term investments can be significant. In fact, a study Lipper, a mutual fund tracker, showed that from 1997 to 2007, the typical equity fund investor had their returns reduced by 16 percent to 44 percent as a result of taxes. Poof! Left unchecked, tax consequences can dramatically change long-term financial planning. This is why reducing retirement asset taxes through proper tax diversification is a critical element to financial success.

Most investors will rely on the following asset types during retirement:

  • qualified employer or individual retirement plans (QRPs)
  • securities and investment funds
  • real estate and other personally owned assets

With the exception of Roth 401(k) and Roth IRAs, QRPs are subject to income taxes when they are distributed. Due to the high marginal tax rates in the past, many retirees may be losing 40 percent to 50 percent of their QRP funds to taxes (state and federal). Ouch.

A personally or jointly owned investment portfolio may be subject to a host of tax treatments as it grows or when it is converted to cash. Long-term capital gains taxes will be assessed on the appreciation of portfolio assets. Qualifying dividends earned in the portfolio will also be taxed at the long-term capital gains tax rate. Short-term gains, interest income, and foreign dividends will be taxed at ordinary income tax rates.

Most real estate and other investments are subject to federal capital gains taxes and state income taxes when they are turned into retirement cash. Depending on the state of residence, today’s long-term rates may range from 20 percent to 33 percent and have been higher in the past. In addition, a portion of the gain may be subject to ordinary income tax rates due to depreciation recapture.

Understand fees, but focus on taxes Many investors spend little time on tax planning, but instead focus on investment-related fees rather than investment-related taxes. Although it is important to ask about fee schedules, other issues should also be considered when selecting a financial advisor.

No one wants to overpay for investment advice, but focusing solely on the fee to the exclusion of tax considerations is worth of pause for consideration. For example, if one assumes an 8 percent average gain (even if it seems a bit optimistic based on the past 80 years), taxes could be an expense of up to 4 percent. Focusing on a 1 percent investment fee and ignoring a 1.5 percent to 4 percent potential tax liability expense seems counterintuitive.

Tax planning for retirement is a critical element in building financial prosperity and long lasting legacy wealth. Here’s what you can do:

  • Maximize account types that help minimize tax drag under current law
  • Use the right asset classes within in QRPs in conjunction with other taxable securities and account types
  • Coordinate with your advisor to managing taxation of transactions. That is, harvest gains or losses in a given year depending on your tax situation
  • Understand how to select the best QRP for your unique needs
  • Incorporate tax-advantaged investments (such as municipal bonds) to limit current taxable income if you are in a high tax bracket
  • incorporate charitable planning for current and future deductions and income streams
  • Explore appropriate solutions in coordination with your tax professional to identify other tax deduction or tax credit strategies to meet your financial, social and or legacy goals.

Conclusion Investors may not have their eye on the right place when it comes to investment returns. Ultimately, it is important what you keep, not what you earn. There are many tax efficient strategies in coordination with retirement planning that can help increase after tax returns. Having awareness and an approach to address how taxes impact your investments can lead to higher after tax returns, and long term wealth building that takes steps to liberate you from financial and tax worries.

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