Taxes are a necessary evil. The government might say everyone must pay taxes for the state to function accordingly, but when you are in your retirement and have limited income, every penny will matter. This is why you need a tax-efficient retirement plan.
What is a Tax-efficient Retirement Investment Plan?
A tax-efficient retirement investment plan is a financial plan that will ensure the minimizing of wealth loss in the form of less taxation. This doesn’t mean, in any capacity, that you will avoid paying the dues taxes.
For most people, retirement investments are crucial for the rest of their lives. And at this stage of their lives, they don’t want to take financial plans that will harm their pockets any more than they need to.
Generally, people who have retired have two main concerns regarding taxation. That is whether they will have to continue paying taxes in retirement and if there is any tax on their retirement income.
In short, the answer to both of these FAQs is the same, that is, yes they are obliged to pay taxes even after they have retired.
But with proper retirement tax planning, maximizing your investment by choosing options with better tax benefits is possible. In some cases, these plans might cut your taxes in half.
Also Read: Real Estate Investment Opportunities: What You Need to Look in Emerging Markets
Type of Taxes Active after Retirement
Before knowing the strategies for retirement tax planning it is important to understand all the taxes that will still apply to you.
1) Federal and State Income Tax
2) Sales Tax
3) Property Tax
4) Net Investment Income Tax
5) Social Security Benefits Tax
All these forms of taxes, although at lower rates, will accumulate and take a toll on your post-retirement life.
Effective Strategy for Tax-efficient Retirement Investment
The most popular tax-smart investment strategy is a combination of a couple of things. This includes selecting the right type of accounts, and the right investments.
1) The right type of account
It should be a no-brainer that, in your retirement, you should opt for the tax-advantaged accounts for your money. But while we are on the subject of money nothing is simple.
While accounts like IRAs offer advantages, they are not above shortcomings. These accounts come with contribution limitations. What you might not know is that there are two types of IRA accounts: traditional IRA and Roth IRA. Among these, the Roth IRA benefits in retirement are more desirable than traditional ones as it gives the best withdrawal rates.
In simple words, you can make some pre-tax contributions to a regular IRA. By doing this, you save money for retirement and lower your taxable income for the year. Hence, taxes will be required when you withdraw the funds. On the other hand, you can make post-tax contributions to a Roth IRA. While there aren’t any immediate tax advantages, both the amount you contributed and the interest are tax-free after you retire.
2) Choosing Tax-Efficient Investments
After choosing the right account, now it’s time to invest your hard-earned money. In the realm of investments, some are more tax-friendly than others. And finding out which ones are more tax-friendly is the key to a fool-proof post-retirement investment.
Firstly, stocks are some of the most popular types of investment for people after retirement. Exchange-traded funds (EFTs) in comparison to other types of stocks are much more tax-efficient. The EFTs ensure a seemingly tax-free retirement income because they have fewer capital gains. This is because EFT transactions are done in exchanges, bypassing frequent share redemptions that can increase taxes.
The second type of investment, ideal for retirement is the bonds. Among all types of bonds, municipal bonds are the most tax-efficient as the interest income of these bonds isn’t taxable at any level. Treasury bonds and Series I bonds are also good for retirement investment as they are not required to pay any sort of income taxes.
Things to Avoid for Minimizing Tax Liabilities
Tax liability is the total amount of money that you need to pay to the government. In your retirement, there are some simple steps you can take to avoid these tax liabilities.
1) Overcontributing to IRAs and 401(k)s
Yes, the IRAs and 401(k)s are both tax-advantaged accounts. But if you think on these accounts can you keep an indefinite amount of money then you are wrong. Depositing more than the limit will make you eligible for taxes.
For instance, in the year 2023, one could have only contributed a total of $6,500 to their IRAs and $23,000 to their 401(k)s.
2) Investing in mutual funds
The simple reason why a mutual fund is a big tax liability is because these funds aren’t controlled by any single individual. Furthermore, in some cases, the income of your mutual funds is considered as capital gains which then makes it subject to capital gain taxes.
3) Corporate Bonds
Corporate bonds are a must to avoid if you want to minimize your tax liability. Unlike municipal bonds, corporate bonds don’t have any tax-free provisions at any level. There are two reasons behind this. Firstly, corporate tax has one of the highest interest rates among any bonds. And secondly, these bonds also have the highest level of default risk.
For example, you can anticipate receiving $14,000 in taxable interest each year if you purchase 100 corporate bonds at $2,000 par value and they all yield 7% yearly.
Tips on Optimizing Tax Benefits in Retirement Planning
Besides these basics, consider the following tips to optimize tax benefits in your retirement.
1) Having a Spousal IRA
When one spouse has a source of income, open a spousal IRA to increase your contributions and save taxes. If the working spouse, for example, contributes the maximum amount to their IRA, they can form a second IRA for the non-working spouse, enabling them to increase the amount of their contributions. Take advantage of this tax-saving opportunity as many people overlook it.
2) Having a Universal life insurance
Maintain a universal life insurance policy as a tax-efficient asset in addition to serving as a safety net for loved ones. In addition to providing income tax-free death benefit payouts to beneficiaries, these plans have the potential to accrue tax-deferred cash value that can be accessed tax-free up to the amount borrowed or premiums paid in.
Before accessing assets early, speak with a tax expert or financial counselor to minimize any potential tax repercussions. Dividends are a flexible financial tool that may also be useful, however, they are not guaranteed.
3) Forming a Charitable Trust
Another way to enjoy tax benefits is by forming a trust. Through financing a trust, you can donate assets to charity and continue to receive income throughout your retirement life. And on these incomes, you will be able to claim a tax deduction.
Final Thoughts
Tax-efficient retirement investment plan might sound complex, but by following some simple strategies it is possible to maximize the tax benefits. To put it simply, you need to know what options offer the best tax returns. You can always consult a financial expert while planning your retirement plan. Just keep in mind that, managing and investing money in your retirement without proper planning might ruin the hard work that you have put to enjoy your retirement days.
