When retirement arrives, it would be nice to know that you won’t have to pay over-the-odds for tax on your life’s savings. After working so hard for so many years, surely you have done your bit already? The trouble is, without sensible planning and investment, your retirement income could take a major hit. In today’s guide, I’m going to walk you through some of the tools and vehicles you need to ensure an (almost) tax-free retirement.
First of all, we need to look at the way your accounts exist under the current law. In simple terms, we can boil this down to three separate categories: taxable, deferred, or exempt. Taxable accounts are your investment income as you receive it – just as you would treat your salary, for example. They are things like your bank and savings accounts, and also money market mutual funds.
Deferred accounts are slightly different, however. They allow you to shield your investments from taxes, as long as they stay in the account. So, these will be vehicles such as your 401(k), Roth IRA, or any self-directed IRA plans. Exempt accounts are those which you don’t have to pay any tax at all, even after you start withdrawing funds.
The aim of the game
So, what about your investments – where should you put them? In simple terms, if an investment is tax-efficient, you should make them in your taxable account. On the other hand, if they are not tax efficient, you should put them in your deferred or exempt accounts.
However, your path to a tax-free retirement will also be based on your marginal tax bracket.
Let’s say you are a high tax bracket investor. Exploring tax-efficiencies will be more worthwhile than if you were a low-bracket investor. You will also need to understand the cause and effect of capital gains taxes, and how they differ from income taxes.
Let’s say you have an investment with short-term capital gain rates. You would need to look at whether your rates will be more preferable than generating funds through a longer-term rate.
It can be complicated, but there is plenty of help out there. So, whether you use a personal financial advisor or read online sites like The Fortunate Investor, keep up to date with expert advice. You will gain essential knowledge and give your retirement savings a nice boost.
Plan for tax efficient investments
Some investments are far more tax-efficient than others. For example, convertible bonds tend to have lower yields so you won’t pay as many taxes on them. On the other hand, preferred stocks can end up costing you a lot in taxes if they aren’t in tax-deferred accounts. Investment grade corporate bonds are another safe, tax efficient addition to make to your portfolio. You can put these into your deferred accounts, too, which will significantly reduce their tax profile.
The general idea is to start moving your investments into the tax-efficient arena before you reach retirement. Junk bonds, preferred stocks, and common stock are all highly taxable – and will end up costing you money. If you want to keep more of your investment earnings, it’s critical to choose products that offer the lowest tax burdens possible. Hope this has helped – stay tuned for more ways of improving your retirement fund!