*This post highlights Chapter 6 from Mike’s book, Achieving Financial Fulfillment.
In 1789 Benjamin Franklin famously said, “Our new Constitution is now established, everything seems to promise it will be durable; but, in this world, nothing is certain except death and taxes.” Taxes continue to this day to be a certainty of life, so you’d better learn how best to live with them!
Any amount or method of saving money for retirement will help, right? Well, you are on the right track if you are delaying gratification by saving money for the future. Also, many people focus on trying to select investments that will produce the greatest returns over time, which makes sense, of course. However, the asset allocation you choose (the mix of aggressive and/or conservative investments) will likely have the greatest impact on your results. So, if the specific investments you chose won’t have as large of an impact as you might expect, what else might? The answer lies in trying to maximize your after-tax returns. Would you rather have a 10% return that is reduced to 7% after taxes or an 8% tax-free return? I think the answer is obvious.
There are three major types of investment accounts, and they all have different tax treatment.
Tax-Deferred Accounts
As the name implies, typically the tax on these accounts is deferred until later when withdrawals are made. IRAs, 401(k) s, 403(b)s, and most company retirement accounts fall into this category. In most cases an income tax deduction is allowed for the year of the contribution, and there are annual limits as to how much can be added to these accounts.
Taxable Accounts
These are non-retirement investment accounts where what you earn is generally taxable each year. Common strategies for minimizing income taxes include passive investments, such as index funds or ETFs, and municipal bonds whose income is typically tax-exempt. Taxable accounts can be opened as a brokerage account, held directly with a mutual fund company, or as a transfer agent for buying individual stocks. A brokerage account is the most flexible, as it allows you to buy and sell a wide range of investment products.
Tax-Free Accounts
Your investment growth in these accounts, Roth IRAs and Roth 401(k)s, is generally tax-free over the years and also when withdrawn. There is no income tax deduction allowed in the year of the contribution, and there are annual limits on how much can be added to these accounts. You can also convert some tax-deferred accounts into Roth accounts, which includes paying the tax in the year of the conversion. This could make sense if you are in a low tax bracket now and expect to be in a higher one in retirement when the funds are used.
It is very common for people to simply save money in their company’s tax-deferred savings plan and spend everything else, thinking they have done enough. The problem with this approach manifests itself at retirement. Every dollar distributed from a tax-deferred account is usually taxable. If you instead have money saved in a taxable account or a Roth IRA, you should have more flexibility and may have better control over how much tax you will pay on withdrawals by choosing which account is best.
Here are a few other common tax-saving strategies:
1. Long-term capital gains – Hold investments a year or longer and gains are given favorable tax treatment over short-term gains (held less than 1 year), which are taxed as ordinary income.
2. Qualified dividends – Many investors like to hold dividend paying stocks or mutual funds. Pay close attention to the type of income your investment generates. Qualified dividends are taxed at a lower rate
than ordinary dividends. For example, many REITs and partnerships pay ordinary dividends, which are taxed at your marginal (highest) tax bracket.
3. Municipal bonds – Over the years I have seen money managers invest in bonds that pay taxable interest without any regard for taxes, when there may be tax-free alternatives.
4. Index funds and/or exchange traded funds (ETFs) – Many index funds and ETFs have low turnover and as a result don’t typically pass on as many capital gains distributions to shareholders as traditional mutual funds.
5. Look Ahead at Your Income for Tax Bracket Changes – Low income years may be good for intentionally taking on more income (ex: would you pay 12% now to avoid a 22% tax later?). High-income years should be planned around by taking losses or deductions or deferring income to other years.
Let’s look at an example of Roth IRA conversions that shows the importance of planning ahead and understanding the impact of taxes, specifically to consider converting IRA assets to a Roth IRA before drawing Social Security. Back in 2010, Roth IRA conversions became available to everyone because limits based on income and filing status were lifted. A conversion is typically a shift of pre-tax IRA (or 401(k)) money to a Roth IRA (or Roth 401(k)). The main benefit of a Roth conversion is that the money grows tax-free once inside the Roth IRA. The cost of the conversion is that the amount moved is taxed in the current year as income. It will take time to recover from the initial tax bill, but the savings over time can be substantial.
Real-Life Example
Let’s say you retire at 58, and your new taxable income is $49,450 from pensions, investment earnings, and/ or part-time work. You could convert $40,000 from a traditional IRA to a Roth IRA and stay within the 12% tax bracket (up to $89,450 ($49,450 + $40,000) of taxable income in 2023 for Married Filing Jointly). If you take advantage of this over the next four years you can convert a total of $160,000 ($40,000 x 4) into a Roth IRA. You have to pay taxes on the conversions, but remember that you would eventually pay tax on this money at RMD (Required Minimum Distribution) age AND anything it earns if left in your traditional IRA.
Here’s the savings: the $160,000 now in the Roth IRA would earn about $450,000 over 20 years if invested at 7%. Not having to pay taxes on the $450,000 of growth at 12% tax saves you $54,000 ($450,000 x 12%)! This could be even more savings if your tax rate is higher in the future.
So why did we stop after 4 years? If you plan to draw Social Security at 62, the additional income from the Roth IRA conversion may cause your Social Security benefits to become taxable, thus reducing the savings of conversion. Currently, no one pays Federal income tax on more than 85% of his or her Social Security benefits. For example, if you file a joint return, and your combined income is between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits. If more than $44,000, up to 85% of your benefits may be taxable.
Once again, you may be able to move a substantial portion of your IRA to a Roth IRA. As a great side benefit, lowering your IRA balance could lower your future RMDs. This could mean less tax on Social Security income in the future and less total taxes paid. As you can see it is important to be aware of this window of opportunity and all the specifics in order to take full advantage.
Remember, saving money on taxes has the effect of compounding, giving you more to invest. As you can see, understanding the impact of taxes is very important to your finances!
Cunningham, Cathryn. (4 Jan 2021). “Start the New Year with a Look at the Roth IRA”. Albuquerque Journal. Retrieved 23 Oct 2023 from https://www.abqjournal.com/business/startthe-new-year-with-a-look-at-the-roth-ira/article_2ca7b3ad-2c2a-5d01-8aaf-3da67269beae.html