Saving money for retirement can be a challenge since it involves so many factors that can't be controlled, such as market changes or how an investment will perform. However, one factor that is controllable are taxes. A tax-conscious investor will find the most tax-efficient investments to allocate his or her money in, lowering money spent on paying taxes and successfully saving for retirement.
Few people give thought to the tax consequences of their investments. Most clients trust their financial advisors to be knowledgeable of all aspects of investment management, and while many advisors are capable of designing successful investment portfolios, these portfolios must be created with attention to the tax consequences attached to each investment. Truth be told, it is a challenge for advisors to educate themselves on all the tax laws and procedures that affect investments and can cost an investor a hefty amount of retirement savings.
Thus, planning for taxes is complicated, naturally, and varies based on your individual financial plan. Nevertheless, it can be achieved through five key strategies outlined below.
Strategy 1: Choosing between taxable and tax-free
Investors may face a challenge when figuring out what type of account is best for retirement savings — taxable, tax-deferred (traditional 401(k) or IRAs), or tax-free (Roth IRAs). Yet it may be best for investors to go with a few accounts of each type, including taxable accounts as well.
For instance, during the course of a year, an investor or retiree could withdraw an amount of taxable income from their IRA that would allow them to remain in a lower tax bracket, using after-tax income from their Roth IRA to help with the rest of their monetary needs for the year.
Strategy 2: Understanding terms and their significance
It is important to understand terms commonly used in explaining the tax consequences of investments. For example, securities preserved for an entire year or more provide more favorable tax conditions and potential for financial gains in the long-term. These securities are known as long-term gains. Conversely, short term securities have fixed tax rates. Therefore, keeping money in a security without withdrawing before the end of a year, and preferably before the end of a few more years, helps to reduce taxes due by a considerable amount.
Understanding your investments is the first step to strategically allocating them.
Strategy 3: Allocating investments among taxable and tax-advantageous
The location of where investors allocate their money is crucial to successful financial planning.
Some advisors prefer to keep their clients' investments all in one location, such as tax-deferred accounts to delay the income tax on the interest. Other advisors suggest taxable accounts that way their clients can enjoy long-term capital gains on appreciated securities.
An appropriate balance of all types of accounts is what ensures successful retirement saving. Here are simplified strategies to follow:
- Allocate tax-efficient investments in taxable accounts
- Place tax-inefficient investments in tax-deferred accounts like 401(k)s and IRAs
- Keep investments with the highest potential for growth in tax-free accounts like Roth IRAs
All in all, what's best for you will depend on your tax bracket, how long you've owned the asset, and so forth.
Strategy 4: Taking advantage of low-income or low-tax years
When an investor changes a traditional IRA into a Roth IRA, tax due on the conversion amount is based on income for the year of the transition. Therefore, investors can take advantage of low-income years when they are moved down into a lower tax bracket, filling the tax bracket up with a Roth conversion. Not only that, but this strategy reduces retirees' total investments in taxable accounts, keeping taxes — possibly even on Social Security benefits — lower.
A low-income year also gives investors the chance to save money on taxes due by selling those long-term appreciated securities mentioned above. In addition, low-income or low-tax years are great for reviewing and focusing on tax efficiency to ensure that your financial design will be prepared for the years ahead.
Strategy 5: Continue to be mindful of tax consequences even after retirement has begun
Often times, new retirees immediately withdraw large amounts of money from their retirement accounts to use for helping a loved one with a big life event or maybe to pay off their mortgage. However, if the money withdrawn is taxable, then it could push them into an unfavorably higher tax bracket.
Looking at the long-term tax consequences of investments is vital to ensuring a successful retirement and financial future. Be a tax-conscious investor, and don't let your hard earned income go to waste by paying an unnecessarily high tax bill!
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