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- Some assets can have tax savings—which may be important to your retirement income strategy
- Depending on your investments and accounts, you may be able to employ some tax-saving strategies
- Don’t let potential tax benefits distract you from sticking to an investment strategy that is best suited to your long-term retirement goals and needs
Your retirement portfolio might consist of different assets, such as savings bonds, mutual funds, stocks, annuities, or real estate. Each category of investments may have some specific taxation nuances. You might be tempted to pursue tax-saving investments whenever possible. However, remember that although tax efficiency can be an important consideration when investing, over-focusing on tax savings could lead you to pursue a strategy that is not appropriate for your retirement needs.
Here we briefly describe different asset categories and their tax benefits and treatment, and instances which may or may not present tax advantages. Please note this is general tax information only. Please speak with a tax professional for specific advice on tax savings.*
Tax Treatments of Assets
- Municipal bonds: A local authority or municipality may issue municipal bonds. You may not have to pay federal income tax for interest received from municipal bonds. And if you buy them in your state of residence, you may not face state and local taxes.
- Government bonds: The U.S. Treasury issues several types of debt securities—U.S. Savings Bonds, Treasury notes, bills, and bonds. Among these potentially tax-saving investment vehicles, savings bonds are popular among retirees. You may need to pay federal income tax on any interest these savings bonds generate. But at the state and local level, savings bonds may not be taxable.
- Corporate bonds: Interest earned from corporate bonds may be subject to federal and state income tax.
- Capital gains: When you sell an investment for a profit (capital gain), you will likely have to pay tax on the profit if it is held in a taxable account. Capital gains taxes vary depending on how long you held the asset. Typically, when you hold an asset for less than a year, it is subject to short-term capital gains tax at your ordinary income tax rate. If you have held the asset for more than a year, it will be taxed at a potentially lower long-term gains rate.
- Profits from mutual funds in a taxable account may be subject to capital gains tax. You have no control over when or what the mutual fund sells or when it distributes those capital gains to you. Since these capital gains are distributed to each mutual fund shareholder, you may end up paying tax on these gains even if you don’t sell any shares yourself. Mutual fund turnovers could cost you and potentially increase your capital gains.
Exchange-traded funds (ETFs)
- Investors may realize capital gains on an ETF only after the entire investment is sold. ETF dividends, however, are taxed differently—depending on how long you’ve held the ETF, you may pay tax at your normal income rate (unqualified dividend) or a different rate (qualified dividend).
- Tax-deferred growth of funds: You may have to pay tax on interest and gains when you start taking withdrawals.
- Investment gains: These are taxed at your ordinary income tax rate.
- Death benefit payouts: They may or may not be taxable. Your heirs may have to pay taxes on the gain at their ordinary income tax rate.
- Penalty for withdrawals: If you withdraw from your annuity before age 59½ you may be subject to an additional 10% tax on early distributions, unless it qualifies for an exception.
Real estate investment trusts (REITs)
- Taxation of REITs can differ depending on how the REIT returns income to the shareholders.[i]
- Dividend income may be taxed at your ordinary income tax rate.
- Shareholders are responsible for any capital gains associated with the REIT investment.
Master Limited Partnerships (MLPs)
- Some of the income from MLPs may be tax-deferred until you sell the interest in the MLP.[ii] Investors may have to pay federal, state and local income tax even if they don’t receive cash distributions from the MLP. And if the MLP operates in a state the investor doesn’t reside in, the investor may have to file a state tax return in that state.
Tax Treatment of Different Accounts
You may have different assets in different account types. Here’s a brief synopsis of how different account types are taxed.
Tax-deferred accounts: These include traditional 401(k)s, and traditional IRAs.
- Since your contributions are made pre-tax, you may be able to reduce your taxable income for the year you contribute.
- Distributions from tax-deferred accounts are taxed in the future as ordinary income.
Tax-exempt accounts: These may include Roth IRAs and Roth 401(k)s.
- Contributions are made with after-tax money. Your contributions then grow tax-free, and when you reach retirement age, you can make tax-free withdrawals.
Taxable investment accounts:
- When you sell a security at a gain in a taxable account, you will pay capital gains tax—whether or not you decide to withdraw the money, let it sit as cash in the account, or invest into a different asset.
- If you sell securities at a loss in a taxable account, you may be able to offset your capital gains or parts of your ordinary income.
529 Plans or qualified tuition plans:
- There may be tax benefits for contributions to a 529 plan.[iii] If withdrawals are used for higher education expenses or tuition for elementary and secondary schools, earnings may not be subject to federal or even state income tax. If the withdrawals aren’t used for qualified educational expenses, you may be subject to state and federal income tax plus a 10% federal tax penalty.
Health Savings Accounts (HSAs):
- If you are enrolled in a High Deductible Health Plan, you might be eligible to contribute to an HSA-eligible plan, pre-tax, for qualified medical expenses.[iv] You may be able to take a tax deduction for your contributions. Additionally, distributions applied to qualified medical expenses may be tax-free.
Create a Tax Saving Retirement Investing Strategy
Now that you have some idea of how certain categories and accounts are taxed, the next step is to determine what assets go into what account.
What assets should go in what account?
- Depending on the asset, you may wish to hold it in a tax-advantaged account or have no preference. As an example, there is no need to hold tax-deferred annuities in accounts that are already tax-deferred, such as an IRA.
Income versus cash flow
- Interest and dividend income may be taxed at your ordinary income tax rate, which could be higher than long-term capital gains tax.
- Think about how much you may have to pay for short-term capital gains versus long-term.
- Some assets, such as mutual funds, may not offer total control over capital gain distributions.
- Don’t overlook the benefits of a tax-loss harvesting strategy if applicable.
Tax savings can be an important part of your investments strategy, but don’t overlook the importance of aligning your investment plan with long-term retirement goals. If you want to learn more about how to align your retirement strategy with your long-term goals, call Fisher Investments today.
*The contents of this webpage should not be construed as tax advice. Please contact your tax professional.
[i] Source: U.S. Securities and Exchange Commission, as of 2/20/2019. https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/real-estate-investment-trusts-reits
[ii] Source: U.S. Securities and Exchange Commission, as of 2/20/2019. https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/updated-investor-bulletin-master-limited
[iii] Source: U.S. Securities and Exchange Commission, as of 2/20/2019. https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-introduction-529-plans
[iv] Source: Internal Revenue Service, as of 2/20/2019. https://www.irs.gov/publications/p969