See if you can spot the flaw in this couple's plan:
A husband and wife are retiring next month at age 62,
with an equal amount saved in retirement and nonretirement
accounts (let's call it $500,000 each).
Like most, over their lifetimes they have emphasized
higher-growth assets in their retirement accounts
(IRAs, 401(k)s, etc.), which are invested almost
entirely in stocks. By contrast, their non-retirement
accounts are far more conservative, since they were
more likely to tap those over the years for expenses
like college, a home upgrade or an emergency. Those
accounts are more bond-heavy, with a particular
emphasis on tax-free municipal bonds.
Between the two sleeves of their portfolio, their
aggregate asset allocation is fairly well-balanced
going into retirement.
This couple has followed well-established financial
planning practices up to this point. However, there is
one major tax-planning principle that changes in
retirement that they have overlooked, and if they
continue down their current path, they will pay more
taxes than necessary.
Entering retirement, rather than emphasizing stocks in
your retirement accounts, consider overweighting
them in your non-retirement accounts instead. To
keep your overall allocation intact, simply do the
opposite with bonds. There are several reasons why
this is a superior approach in retirement:
Favorable tax treatment for stocks. In taxable
accounts, qualified dividends and long-term
capital gains are taxed at lower rates than
ordinary income. However, you lose this favorable
tax treatment when holding equities in your
Higher bond yields. Holding bonds in an IRA
eliminates the need for lower-yielding municipal
bonds. For an equivalent amount of risk, you can
purchase higher-yielding taxable bonds.
Minimization of required minimum
distributions (RMDs). Emphasizing fixed income
in your IRAs slows down the growth of that sleeve
of the portfolio, keeping RMDs in check.
Estate planning. From the perspective of your
heirs, it's far better for your non-retirement
accounts to grow faster than your IRAs. Nonretirement
accounts receive a step-up in basis,
so the beneficiary of an appreciated stock
account can immediately deploy the asset as
desired without triggering taxes. By contrast,
IRA beneficiaries pay ordinary income tax on
any withdrawals, and must navigate separate
RMD rules if they stretch distributions over their
Income tax control. Most importantly, directing
non-retirement assets into tax-efficient equity investments like ETFs or individual positions can
be the cornerstone of a comprehensive tax
mitigation plan, since you can control the timing
and amount of realized gains.
Several major retirement expenses are affected by
your level of reportable income:
Long-term capital gains tax rate
Tax rate on qualified dividends
Medicare Part B premiums
Taxation of Social Security benefits
Health insurance premiums prior to age.
Reducing taxes at every opportunity can minimize
your portfolio withdrawal rate in early retirement,
which is a key factor in determining whether your
money can last over your lifetime.
It's easy to understand why this couple fell into a
backward tax position entering retirement, since asset
location strategies (the process of deciding which
account type should hold various asset classes) are
so different from your working years.
Eventually, they saw the light and flip-flopped their
asset location. They moved their retirement accounts
mostly into bonds, and their non-retirement accounts
entirely into stocks.
Rather than reinvesting stock dividends, they now
sweep them to cash to fund their living expenses. The
rest of their expenses are covered by a combination
of IRA withdrawals and stock sales, all carefully
calibrated to keep them below the top of the 10%
federal income tax bracket. This not only keeps their
IRA withdrawals tax-efficient, but also allows them to
qualify for a 0% federal tax rate on their long-term
capital gains and qualified dividends.
In running the numbers, they found this strategy
significantly increased their spendable income, and
added years to the longevity of their portfolio.
The general principles here apply in most cases in
retirement, even if you are in a higher tax bracket. No
matter your income, long-term capital gains and
qualified dividends are always taxable at a lower rate
than ordinary income. For that reason, you should
strongly consider emphasizing stocks in your nonretirement
accounts at this stage in life.
One exception is if you employ high-turnover stock
strategies or mutual funds. Those are better suited for
your IRAs in order to avoid triggering short-term
capital gains taxes.
Minimizing income taxes is a powerful way to
potentially add years to your portfolio, with no need to
outguess the markets. If your portfolio is upside-down
from a tax perspective, turning it around it could
significantly strengthen your retirement.
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