A: “In this world nothing is certain except death and taxes.” — Benjamin Franklin
That saying still rings true centuries after the 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.
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).1 The higher your tax bracket, the more you may benefit from investing in munis.
It is also important to review which types of securities are held in taxable versus tax-deferred accounts. Why? Because at least through the end of 2012, the maximum federal tax rate on some dividend-producing investments and long-term capital gains is 15 percent. Work with your financial advisor to review your overall investment holdings and determine which investments might be best suited for tax-deferred accounts versus taxable accounts.
The tax-exempt advantage: When less may yield more
Would a tax-free bond be a better investment for you than a taxable bond? To find out, compare the yields. For instance, if you were in the 25-percent federal tax bracket, a taxable bond would need to earn a yield of 6.67 percent to equal a 5 percent 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%
This hypothetical example is used for illustrative purposes only and does not reflect the performance of any specific investment. State, capital gains and alternative minimum taxes are not considered. This formula is only one factor that should be considered when purchasing securities and is meant to be used only as a general guideline when calculating the taxable equivalent yields on municipal securities.
Which securities to tap first?
Another 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 need to consider that qualified withdrawals from tax-deferred investments are taxed at ordinary federal income tax rates of up to 35 percent, while distributions — in the form of capital gains or dividends — from investments in taxable accounts are taxed at a maximum of 15 percent. (Capital gains on investments held for less than one year are taxed at regular income tax rates.) For this reason, it may be beneficial to hold securities in taxable accounts long enough to qualify for the 15-percent tax rate.
The ins and outs of RMDs
The IRS mandates that you begin taking an annual distribution from traditional IRAs and employer-sponsored retirement plans after you reach age 70-and-a-half. The premise behind the required minimum distribution (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 calculated using a Uniform Lifetime Table, which takes into consideration the participant’s life expectancy based on his or her age. Failure to take the RMD can result in a tax penalty equal to 50 percent of the required amount.
TIP: If you will be pushed into a higher tax bracket at age 70-and-a-half due to the RMD rule, it may pay to begin taking withdrawals during your 60s.
Unlike traditional IRAs, Roth IRAs do not require you to take distributions at all during your lifetime and qualified withdrawals are tax free.2 For this reason, you may choose to begin withdrawing assets held in a Roth IRA after you have exhausted other sources of income. Be aware, however, that any named beneficiaries of a Roth IRA will be required to take RMDs following the rules that govern traditional IRAs after your death.
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 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 are not available to other beneficiaries, including the marital deduction for the federal estate tax. As you likely know, LGBT partners are not considered spouses under federal law, and therefore are treated differently as a beneficiary. It’s important to understand the distinction and plan for it appropriately.
Also, consider transferring assets into an irrevocable trust if you are close to the threshold for owing estate taxes. In 2012, the federal estate tax applies to all estate assets over $5.12 million, but this threshold is scheduled to revert to $1 million in 2013, unless Congress elects to extend it. Assets in an irrevocable trust 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-and-a-half, when RMDs must begin.
Finally, if you have a taxable estate, you can give up to $13,000 per individual each year to anyone tax-free.
Strategies for making the most of your money and reducing taxes are complex. Please meet with an estate attorney and/or a financial advisor to help you sort through your options. For specific tax advice, please see a tax professional.
1. Capital gains from municipal bonds are taxable and may be subject to the alternative minimum tax.
2. Withdrawals prior to age 59-and-a-half are subject to a 10-percent penalty.
Jeremy R. Gussick is a financial advisor with LPL Financial, the nation’s largest independent broker-dealer.* Out Money appears monthly. If you have a question for him, email email@example.com. *As reported by Financial Planning magazine, 1996-2011, based on total revenues. This article was prepared by McGraw-Hill Financial Communications and is not intended to provide specific investment advice or recommendations for any individual. Consult your financial advisor, or me, if you have any questions. Because of the possibility of human or mechanical error by McGraw-Hill Financial Communications or its sources, neither McGraw-Hill Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall McGraw-Hill Financial Communications be liable for any indirect, special or consequential damages in connection with subscribers’ or others’ use of the content.