Weekly Tax Tip

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One of the basics when considering how to fund your retirement is to be as tax efficient with your income as possible. In 2022, income tax rates range from 0 to 37 percent, plus a potential 3.8 percent net investment tax. Understanding how these progressive tax rates apply to ordinary income creates a tremendous retirement planning opportunity.
Retirement Basics – Tax Efficiency

Whether you’re planning for retirement or already have it, the key is knowing what to invest in for tax efficiency. If you have not figured out how to invest in the most tax-efficient way, read this article. It will give you an overview of the different types of IRAs, including Roth, SEP, and Traditional IRAs. You’ll also learn about how to choose the best investment options for your individual situation.

Tax-efficient investments

For those looking for the most efficient investments for retirement, exchange-traded funds (ETFs) are a good option. They offer greater flexibility and lower fees than mutual funds. The tax benefit is dependent on the bonds held, with some U.S. government bonds, for example, being tax-free. Other types, however, can be subject to federal and local taxes. ETFs are available from many providers and may be right for your retirement goals.

Roth IRAs

If you’re interested in saving for retirement, you may want to consider Roth IRAs. While taxable investments aren’t taxed until you sell them, the step-up in tax basis can make gains tax-free during your lifetime for your heirs. In order to determine which retirement account is the best option for your current situation, consider these four things. First, you’ll want to understand how to calculate the break-even cost basis percentage. This means dividing the cost basis of your taxable investment by the current value. Compare this to the first chart below.

SEP IRAs

When you set up a SEP IRA, the primary purpose of the account is to provide tax-deferred income for yourself and your spouse. In most cases, the amount of retirement contributions you make will depend on your age and marital status. Unless you are self-employed, your SEP IRA account may not be fully tax-deductible. However, there are many ways to avoid these penalties and still enjoy tax-efficient retirement savings.

Traditional IRAs

When it comes to retirement accounts, it is best to look at tax efficiency as well as the size of your traditional IRA. A traditional IRA offers double tax advantages – you can contribute as much as you want and reduce your current taxable income while the money grows tax-deferred. But after you reach age 70 1/2, you must begin to take distributions or risk having to pay taxes to Social Security or Medicare. If you choose to spend down your traditional IRA accounts first, it is likely that you will pay a higher tax rate.

401(k)s

A 401(k) is a tax-advantaged retirement account where your employer contributes a certain percentage of your salary. Depending on the type of plan, you may choose between a variety of mutual funds. Traditional 401(k)s require you to fund the account with pre-tax dollars. The money you put in your account grows tax-free and is not taxed until you withdraw it.

Capital gains

As people age, they rely heavily on investments and savings for their income. Therefore, working tax efficient strategies into your financial plan is important to maximize your future financial health. Here are three ways to lower your taxes when you retire:

RMDs

Taking required minimum distributions (RMDs) from your retirement account is an important part of your annual financial housekeeping, as missed RMDs can cost you more than 50% in penalties. In addition to your yearly tax liability, you may incur higher Medicare Part B premiums if you wait until the following year to take your distribution. There are three basic steps for calculating your RMD:

Liquidating investment accounts

Before you can properly liquidate investment accounts in retirement, you must know the basics of tax efficiency. There is a rule of thumb for retirement accounts: withdraw the least tax-efficient portion first. This way, you will preserve the tax-deferred compound growth. The conventional approach is to liquidate the pre-tax brokerage accounts first, and then withdraw the retirement accounts. In reality, you can use this strategy for both IRAs and taxable accounts.

Published August 15, 2022