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Tax Strategies for Retirees
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.
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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). 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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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% |
| Tax-Exempt Rate | Taxable-Equivalent Yield | ||||
| 4% | 4.71% | 5.33% | 5.56% | 5.97% | 6.15% |
| 5% | 5.88% | 6.67% | 6.94% | 7.46% | 7.69% |
| 6% | 7.06% | 8% | 8.33% | 8.96% | 9.23% |
| 7% | 8.24% | 9.33% | 9.72% | 10.45% | 10.77% |
| 8% | 9.41% | 10.67% | 11.11% | 11.94% | 12.31% |
The yields shown above are for illustrative purposes only and are not intended to reflect the actual yields of any investment.
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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).
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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 70 1/2. 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 70 1/2 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 70 1/2. In fact, you're never required to take distributions
from your Roth IRA, and qualified withdrawals are tax free. 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.
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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, and the ability to transfer plan assets --
in most cases -- into a rollover IRA.
Also consider transferring assets into an irrevocable trust if you're
close to the threshold for owing estate taxes (in 2007, the taxable amount is
$2 million). Assets in this type of arrangement 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 70 1/2, when RMDs must
begin.
Finally, if you have a taxable estate, you can give up to $12,000 per individual
($24,000 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.
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Summary
- 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 70 1/2.
- 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.
Checklist
- Before selling appreciated investment assets, be sure that you have owned them for at least one year. That way, you'll qualify for lower capital gains taxes.
- If you're considering placing assets in a trust or custodial account, think carefully about which assets would be most appropriate to transfer.
- Schedule a meeting with a financial professional to review your tax management strategies.
- Remember to begin taking required minimum distributions from traditional IRAs and employer-sponsored retirement accounts after you reach age 70 1/2 in order to avoid costly penalties.
