There is one major tax-planning principle that changes in retirement that is often overlooked by retirees and their advisors alike, which results in paying 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:
1. 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 retirement accounts.
2. 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.
3. 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.
4. Estate planning. From the perspective of your heirs, it’s far better for your non-retirement accounts to grow faster than your IRAs. Non-retirement 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 life expectancy.
5. Income tax control. Most importantly, directing non-retirement assets into tax-efficient equity investments 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.
Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.
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