Nothing in life is certain except death and taxes. - Benjamin
That saying still rings true roughly 300 years after the former
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. Here are a few
suggestions for effective money management during your later
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.
Also, consider investing in tax-managed mutual funds. Managers of
these funds pursue tax efficiency by employing a number of
strategies. For instance, they might limit the number of times they
trade investments within a fund or sell securities at a loss to
offset portfolio gains. Equity index funds may also be more
tax-efficient than actively managed stock funds due to a
potentially lower investment turnover rate.
It's also important to review which types of securities are held
in taxable versus tax-deferred accounts. Why? Because in 2003,
Congress reduced the maximum federal tax rate on some
dividend-producing investments and long-term capital gains to 15%.
In light of these changes, many financial experts recommend keeping
real estate investment trusts (REITs), high-yield bonds, and
high-turnover stock mutual funds in tax-deferred accounts.
Low-turnover stock funds, municipal bonds, and growth or value
stocks may be more appropriate for 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? Compare the yields to see. For instance,
if you were in the 25% federal tax bracket, a taxable bond would
need to earn a yield of 6.67% to equal a 5% tax-exempt municipal
|Federal Tax Rate
|The yields shown above are for illustrative
purposes only and are not intended to reflect the actual yields of
Which Securities to Tap First?
Another major 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
On the other hand, you'll need to consider that qualified
withdrawals from tax-deferred investments are taxed at ordinary
federal income tax rates of up to 35%, while distributions - in the
form of capital gains or dividends - from investments in taxable
accounts are taxed at a maximum 15%. (Capital gains on investments
held for less than a year are taxed at regular income tax
For this reason, it's beneficial to hold securities in taxable
accounts long enough to qualify for the 15% tax rate. And, when
choosing between tapping capital gains versus dividends, long-term
capital gains are more attractive from an estate planning
perspective because you get a step-up in basis on appreciated
assets at death.
It also makes sense to take a long view with regard to tapping
tax-deferred accounts. Keep in mind, however, the deadline for
taking annual required minimum distributions (RMDs).
The Ins and Outs of RMDs
The IRS mandates that you begin taking an annual RMD from
traditional IRAs and employer-sponsored retirement plans after you
reach age 70½. The premise behind the 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 now based on a uniform table, which takes into
consideration the participant's and beneficiary's lifetimes, based
on the participant's age. Failure to take the RMD can result in a
tax penalty equal to 50% of the required amount. TIP: If you'll be
pushed into a higher tax bracket at age 70½ due to the RMD
rule, it may pay to begin taking withdrawals during your
Unlike traditional IRAs, Roth IRAs do not require you to begin
taking distributions by age 70½.2 In fact, you're
never required to take distributions from your Roth IRA, and
qualified withdrawals are tax free.2 For this reason,
you may wish to liquidate investments in a Roth IRA after you've
exhausted other sources of income. Be aware, however, that your
beneficiaries will be required to take RMDs 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 of
your money accounts 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 aren't available to other
beneficiaries, including the marital deduction for the federal
Also, consider transferring assets into an irrevocable trust if
you're close to the threshold for owing estate taxes. Currently,
the federal estate tax applies to all estate assets over $5
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 70½, when RMDs must
Finally, if you have a taxable estate, you can give up to $13,000
per individual ($26,000 per married couple) each year to anyone tax
free. Also, consider making gifts to children over age 14, as
dividends may be taxed - or gains tapped - at much lower tax rates
than those that apply to adults. TIP: Some people choose to
transfer appreciated securities to custodial accounts (UTMAs and
UGMAs) to help save for a grandchild's higher education
Strategies for making the most of your money and reducing taxes
are complex. Your best recourse? Plan ahead and consider meeting
with a competent tax advisor, an estate attorney, and a financial
professional to help you sort through your options.
Points to Remember
- Formulating a tax-efficient investment and distribution
strategy may allow you to keep more assets for you and your
- Consider tax-efficient investments, such as municipal bonds and
index funds, to help reduce exposure to taxes.
- Tax-deferred investments compound on a before-tax basis and
therefore have greater earning potential than their taxable
counterparts. However, qualified withdrawals from tax-deferred
investments are taxed at income tax rates up to 35%, whereas
distributions from taxable investments held for more than 12 months
are taxed at a maximum 15%.
- You must begin taking an annual amount of money (known as a
required minimum distribution) from some tax-deferred accounts
after you reach age 70½.
- Review how your assets fit into a comprehensive estate plan to
make the most of your money while you're alive and to maximize the
amount you'll pass along to your heirs.
1Capital gains from municipal bonds are taxable and
may be subject to the alternative minimum tax.
2Withdrawals prior to age 59½ are subject to a
© 2011 McGraw-Hill Financial Communications. All rights