Taxes: Pay Now or Pay Later
A big part of protecting your 401(k) and IRA accounts takes place when you’re nearing retirement—planning for taxes. Arranging the investments in your accounts to balance the tax benefits both now while you’re working and after you retire is an important part of providing liquidity for nonmonthly expenses such as home repairs and car purchases, as well as making sure you don’t pay more than your fair share of taxes on your regular monthly withdrawals.
Playing the Brackets
Income tax and capital gains tax rates are likely to be the same or higher in the future, so you need to use the years before you retire to make sure you’ll have a tax-saving selection of options from which to draw income in retirement. Aim to arrive at retirement with as equal a balance as you can between the two basic types of accounts: tax-deferred retirement accounts and taxable or tax-free accounts. Tax-deferred retirement accounts, like your IRA and your 401(k), will cost you income taxes on the money you withdraw. Taxable accounts, like your regular mutual fund or brokerage account, and tax-free accounts, like your Roth IRA, give you access to withdrawals that cost you little or no extra tax when you are ready to tap them.
Capital gains rates are lower than income tax rates (and presumably still will be in the future), so start weighing your accounts so that the stock part of your asset allocation is more focused in your taxable investments accounts. Investments that are mostly taxed at income tax rates and offer lower capital gains, such as money market accounts and bond funds, should be concentrated in tax-sheltered retirement accounts like your 401(k) and Roth accounts.
For example, if you’re shooting to retire with an asset allocation of 60 percent stocks and 40 percent bonds and cash, ideally you’d have most of your stocks in taxable accounts where you can take advantage of the lower capital gains tax rates when you realize gains from them. Fixed-income investments like bonds and cash would be held in retirement accounts. Retirement accounts shelter the income until you withdraw it and then tax it at regular income tax rates. If you’re holding mostly stock in your retirement accounts, you’re missing out on the advantage of being able to realize some income at the lower capital gains tax rate. Follow these tips to make the adjustments you need in a tax-smart way.
• Pay attention to your tax bracket. One of the big advantages of investing in your 401(k), 403(b), or other employer plan is that your contribution reduces your taxable income. If your employer’s plan has a good list of investment choices, you can build your bond allocation in tax-deferred accounts by contributing to the bond funds in the account. If the plan doesn’t offer good bond funds, don’t miss the opportunity for tax savings by stopping your contributions. Instead, contribute enough to the best stock funds available to qualify for the employer match (if any) and enough to keep your income below the top of the income tax bracket you’re in. Review Chapter 3 for more information on how tax brackets work.
• Use your regular monthly investing to rebalance your accounts. Most people don’t have enough money in both their tax-deferred retirement plans and their taxable investment accounts to simply swap where they hold the different types of investments. For example, suppose your goal was to have 60 percent invested in stocks and 40 percent invested in bonds. If your retirement accounts and your taxable investment accounts were equal in value, you could simply invest your taxable account 100 percent in stocks and your retirement plans in bonds and stock to meet the 60/40 asset allocation overall. Most people have more money in their retirement plans than they do in taxable investments, especially when they’re 10 years away from retirement. Start to rebalance your accounts using your regular monthly investments. Buy the stock funds your asset allocation calls for in your taxable accounts and the fixed income in your retirement accounts.
The following tables show you how that would work. Suppose you have a $200,000 nest egg, divided equally between a retirement account and a taxable account and your target asset allocation is 60 percent stock and 40 percent bond.
Goal for the Whole Portfolio
To meet the asset allocation, you need to have $120,000 invested in stocks and $80,000 invested in bonds. It makes better tax sense to keep the bonds in the retirement account and the stocks in your taxable account, so your separate account allocations will look like this:
Goal for the Taxable Account
Goal for the Retirement Account
Notice how each portfolio has a different asset allocation from the overall goal of 60 percent stocks and 40 percent bonds, but when added together they meet the target of having $120,000 invested in stocks and $80,000 in bonds.
To quickly implement this strategy into your retirement plan, you could rebalance your current account to 20 percent stocks and 80 percent bonds by buying and selling funds (or transferring between funds, depending on how your retirement plan provider works it) until you have the right mix. If you’d rather make the change more gradually—something you might do if the stock market is losing value while you’re rebalancing—you could leave your current investments as they are but change how you direct new deposits. In this case, direct new deposits to 100 percent bonds. Check your asset allocation after a few months, and you’ll probably see that it is getting close to the 20/80 mix in your retirement account that you’re looking for.
Watch Out for the AMT
With all this attention being paid to what tax bracket you’re in and whether you’re investing in taxable or tax-deferred accounts, don’t let the AMT, or alternative minimum tax, fall off your radar screen.
The alternative minimum tax was created in 1969 to close loopholes that enabled some super-rich taxpayers to pay no or unfairly low taxes thanks to legal tax shelters. It worked well when it was first implemented, but lack of inflation-linked adjustments has subjected a very large number of middle-class families to this tax.
For many people, the AMT is an extra tax they have to pay on top of their regular income tax. Unfortunately, AMT can affect just about anyone regardless of whether or not they have a high income. Among other things, if you have dependents for whom you claim exemptions, take the standard deduction instead of itemizing, pay state or local taxes, have high medical expenses, or pay interest on a second mortgage that you didn’t use to buy or improve your home, you may find that you owe AMT. Check page 2 of your tax return Form 1040. A few lines down will be the line for AMT. If there’s a number on the line, that’s what you paid in AMT. IRS Form 6251, Alternative Minimum Tax—Individuals, details the AMT tax rules.
As you’re planning your strategy to level your asset allocation between taxable and tax-deferred accounts, be very wary of AMT. If you paid AMT or if you have any of the factors that might trigger it, it may be important for you to continue sheltering your current income by putting as much as you can into your deductible employer plan. Talk to your tax preparer for help in making a tax projection based on different work plan contribution amounts. Or make a tax projection yourself using online tax planning software like that available at www.CompleteTax.com.
Are Annuities a Good Idea?
Annuities usually are not a smart idea at this point in the retirement nest egg game. Your target asset allocation should still have quite a bit of stock assigned to it. You shouldn’t use an annuity to invest in the stock market, because you’ll lose the tax advantage of being able to take capital gains from stocks sales at the lower tax rate. All the growth in an annuity is taxed as income when it’s withdrawn.
You might understand the suggestion of investing in an annuity instead of a taxable investment account if you’ve maxed out the amount you can put in a tax-deductible plan at work and still need to put more away for retirement. But because annuities are tax-deferred investments, they wouldn’t help you create the balance of taxable and tax-deferred accounts in retirement that you need.
Nest Eggs
If you’re not sure you can live on the retirement income you’re planning for, set up a test run by depositing an amount equal to your monthly retirement budget into an account, then use the account for the expenses you expect in retirement. This practice cash flow while you’re working will help demonstrate what your retirement lifestyle will be like.
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