The Tax-Efficiency of your Retirement Portfolio Can Save you Thousands

It official the 2016 Tax Season has started! I’m sure you’re busy gathering your tax documents to complete your return this year. However, in order to get the most tax saving “bang for your buck” you should be smart with your investments and retirement assets throughout the year to get the most benefit. Below is are some tax saving tips that all retirement savers should be doing in 2016 and every year for that matter.

There are a lot of laws in the US related to investing and taxes. Because of this complexity many investors pay a lot more tax than they need to be. On the flip side this is a huge opportunity for smart investors to take advantage of the current system for their benefit just by managing your portfolio to minimize your tax burden.

What we are really talking about is tax efficiency. This is basically looking at your after-tax return. This is one of the best return numbers to consider because it is what you are actually getting once taxes are paid. For example, would you rather have an investment that pays you 20% but 50% is taxable or an investment that pays you 15% but is only 15% taxable. This could very well be the case when you consider state and federal ordinary income taxes versus long term capital gains rates. In general, the more investment income that you receive from an investment (like interest and dividends) the investment is LESS tax efficient. This is when compared to capital appreciation ie. the price going up. This is because of different tax rates on this type of income, taxed at ordinary income tax rates versus long-term capital gains rates. Ok so now that you know that let’s explore how we can save you some money on taxes!

Different Account Types – Taxable, Tax Deferred, and Tax Exempt Accounts

Before you, the investor, can do anything to improve the tax efficiency of your investing you need to know and understand how your accounts are structured and how they operate under the law. In general, accounts can be either taxable, tax-deferred, or tax-exempt. Taxable accounts include individual and joint brokerage accounts, bank accounts, money market among other accounts. These accounts require the investor to pay taxes on their investment income in the year it’s received. This means if you sell a stock for a gain you have to report the gain in that year. Likewise, if you receive interest or dividends, you need to report that income on your tax return that year. Get it? Ok, the next account types are tax-deferred. These accounts are Traditional IRAs and 401ks (there are others but these are the most common). These accounts you have to pay tax on every dollar that comes out of the account at ordinary income tax rates. Money goes in these accounts pre-tax so you either get a deduction on your tax return (as in the case of a traditional IRA) or it’s never included in income (as in the case of 401ks). Finally, we have tax-free accounts. The most common of this type of account is the Roth IRA. (Note you can also have a Roth 401k). The contributions to these accounts were made with after tax money which means when it comes time to take the money out you are not taxed again. All of these accounts have pros and cons and it’s good to have money in all of these different accounts (which you’ll see why a little later) but in general tax-efficient investments should be made in the taxable accounts, and more tax inefficient investments should be made in the tax-deferred or tax-exempt accounts.

Make Sure You Know and Understand your Tax Bracket

Now that we have a good understanding of all the different account types you should learn how to best use them based on your tax bracket. You need to determine your marginal income tax bracket. You should be able to do this by looking at your tax return or by asking your Maple Grove Tax Preparer. The higher your marginal tax rate the better tax efficient investing will be for you. This means that someone who is in the 39.6% tax bracket will gain more benefit from tax efficient investing than someone who is in the 15% bracket.

2016 US Income Tax Schedule

Ok, so you have your bracket, now you need to be aware of the difference between taxes on your income and taxes on your capital gains. Your income is taxed as ordinary income tax rates which is where you bracket comes in. If you make $450k in income per year, every dollar you earn over that will be taxes at 39.6% federally. That’s a lot of money going to the government. Alternatively, capital gains taxes, as long as they are long-term (over a year). Capital gains tax rates are 0%, 15%, or 20% depending on your marginal tax rate.

2016 Capital Gains Tax Rates

In general, short-term capital gains (less than a year) are taxed the taxpayers ordinary income tax rates while long-term capital gains are taxed at the marginal rates mentioned above. So, one of the goals is to make sure to generate gains at the long-term preferred tax rates.

Now we have to look at different asset classes like stocks and bonds and examine how they are taxed and the roles they play within an investor’s portfolio. Historically speaking bonds produce income and are in general lower risk than stocks (although there are some bonds that can be just as risky as stocks). The interest income generated from these bonds are tax in-efficient because as we said the income generated is taxed at the higher ordinary income tax rates. However, there are special bonds such as municipal bonds which are not taxed at the Federal level or at the state level (as long as you live in the same state where your bonds are purchased from). Also, in today’s low interest rate environment you actually are not receiving a lot of income on your bonds, and therefore the argument could be made to hold them in a taxable account. In a more “normal” interest rate environment you should consider holding your bonds in a tax-deferred account. Note that they could also be held in a tax-free account and avoid tax on the income but since they are not very highly appreciating assets you should save the room in your tax-free accounts for other assets.

If you are looking for a rule-of-thumb, your tax-inefficient investments should go in tax-deferred accounts and tax-efficient investments should go in taxable accounts. Tax efficiency is always a relative concept. Just like how we said above, bonds are more tax-efficient when interest rates are low and less tax-efficient when interest rates are high. And more so, you need to compare one investment to another when determining which account to hold it in. The next part of this article will discuss the different types of investments on a tax-efficiency scale going from less efficient to more tax efficient. For more information about bonds keep reading below or check out this post – The Role of Bonds in your Portfolio

Tax Inefficient and Tax Efficient Investments

High Yield (Junk Bonds)

You may have already guessed based on the previous text of this article that junk bonds are some of the least tax efficient investments out there. They generally pay a much higher interest rate than other bonds (because of their high credit risk) which means they are paying you out more income which then means more taxes at ordinary income tax rates.

Preferred Stocks

Next up are preferred stocks. They also tend to be relatively tax inefficient. Preferred stocks are a combination of a stock and a bond. They are similar to a stock in that they do not have a maturity date and you can share in the good fortunes of the company through price appreciation. They are like bonds in that they pay a fixed rate based on a stated interest rate. This may seem like a best of both worlds type of situation however, you are limited in the upside potential of price appreciation. So, because of a large part of the income from these investments are paid out as income they tend to be more tax-inefficient.

Convertible Bonds

In the same family as preferred stocks there are convertible bonds. They tend to be a little more tax efficient. This is because they generally have lower yields, and therefore incur less tax from ordinary income rates. Not only that, these bonds can be converted to the issuer’s common stock and achieve improved taxability of capital gains.

Common Stocks

Some of the most tax-efficient investments are common stocks. But it depends on the holding period because, as discussed, they need to be held for at least a year to achieve the favorable long term capital gains tax rates. Also since they generally appreciate much more over time when compared to bond type investments they are a perfect fit for tax-free accounts. If you a buy and hold type of investor you could build up a lot of capital gains over the years all of which are tax free when coming out of a Roth IRA.

Municipal Bonds

Municipal bonds are bonds issued from a specific state or municipality. They are privileged investments as they are not taxed on the federal level and if you live in the state of the issuer they are also not taxed at your state tax rate (making them even more beneficial if you live in a high state-income tax state).

Conclusion

Tax efficiency is something all investors and do-it-yourself retirees should be paying attention to. Using some of these simple concepts you could save yourself thousands of dollars that would otherwise go the IRS. Use your tax bracket wisely to take money out for retirement. And make sure you are putting the right investments in the right accounts. These two simple things are worth their weight in gold (or at least tax-savings).

Resources used in this Article

PJF Tax

Go Banking Rates

Forbes

Retirement in Minnesota – Is it a good idea in 2016?

We all complain about Minnesota weather but if that’s not enough to make you move maybe the taxes are. Let’s take a look at the retirement environment heading into 2016 for all of us Minnesotans.

Minnesota Best Places to Invest and Retire
Minnesota Best Places to Invest and Retire

So despite the weather should you stick around? Well once you look around you’ll see some things you might like as a retiree. We are usually a very friendly bunch, we have wildlife galore, and a plethora of outdoor activities, year round. Plenty for the Minnesota retiree to keep active. If you really hate the cold and snow you could always be a snowbird for 3 months of the year.

Everyone Loves Water and other Hobbies

Oh and talk about water. We have 10,000 lakes so you have plenty of options when it comes to a cabin or even your primary residence being on water. And because of the ample supply of water you should be able to move there for less. Remember more supply will mean lower prices. Oh and I haven’t even mentioned fishing yet. Prime retiree pastime. We have some of the best Crappie, Walleye, and Northern Pike fishing in the US.

Do it all in MN. Lots to do for Retirees
Do it all in MN. Lots to do for Retirees

Fishing not your thing. How about Golf? We have over 400 golf courses and plenty of time to use them. Spring, summer, and Fall provide plenty of opportunities to get in a round. We also have hunting, snow-mobiling, skiing, hiking, camping, and a huge variety of other hobbies to keep you occupied. Remember, you’ll want to have plenty of activities for your grandkids as well. Even if you don’t enjoy an activity, in order to get your family to visit you’ll have to have something for them to do on their vacation.

Let’s Get Down to the Numbers

While it’s not all about cost of living, taxes, and other financial matters this should be a consideration. First off, income taxes are as high as 9.85% for taxpayers earning more than $150,000 if you are single and $250,000 if you are married filing jointly. The cost of living is 3.2% higher than the national average – this is according to Sperling’s Best Places index. However, for your later years, average assisted living expenses are lower than the rest of the US but nursing home costs are slightly above average. This is based on a 2014 study by Genworth, a large provider of insurance including Long-Term Care. Unemployment is at 4.5% so if you want to transition into retirement with part-time work you shouldn’t have a problem finding a job. If you need good tax preparation help in minnesota check out PJF Tax.

Yeah, but where exactly in Minnesota should I Retire?

Great Cities to Retire in MN. Northfield, Maple Grove, Plymouth, Minnetonka.
Great Cities to Retire in MN. Northfield, Maple Grove, Plymouth, Minnetonka.

Ok so you still want to stick around for retirement. Then where in Minnesota should you settle down for the golden years? How about Northfield. Forbes voted Northfield as one of the top places to retire in the US. They call it the best place for a “Well Rounded Retirement.” You can check out their reasoning here. All the above info we discussed above really applies to all of Minnesota so don’t feel like you have move out of your hometown.

Or Maybe Not.

Everyone has their own opinions. Daily Finance ranked Minnesota as the 7th worse state to retire in 2012. The cited the following reasons.

“With no income tax exemptions for pensions or Social Security, Minnesota puts a heavy tax burden on retirees — the nation’s fourth highest levy.”

Overall there are a lot of considerations when deciding where to retire. We think Minnesota is a very viable option whether you are a transplant or a lived here your entire life. Personally, we love it here and while not retired yet don’t anticipate moving when the time comes. With the winter we are having right now (40 degrees in September), the cold is not a reason leave the state.

Remember to always consult your Maple Grove Financial Advisor for more info on when, how, and even where to retire.

Retirement Blueprint – Easy to Follow Steps for a Successful Retirement

blueprint-rectangle

How do I get Help with my Retirement Plan?

Well you’re off to a good start by being at our website, Retirement Planning Minnesota. 🙂 Seriously, there are a lot, and I mean a lot, of places to find help with your retirement not all of them good. Many of them downright awful. What this blueprint aims to do is provide you with the resources and other information you need to get a good head start on your retirement planning. Follow along, ask questions, and let us know if we missed something that you would like to see discussed.

When Should I Start Savings for Retirement?

Easy answer….as soon as possible. Ok, so maybe we didn’t all start in our 20s right after we got our first job but that’s ok. The next beset time to start is now. If you have any savings and investments so far good, if you have nothing that’s fine too, you just have a little more work to do. The right mindset is to not compare yourself to other but instead determine what you want your retirement to look like. What are you trying to accomplish in terms of goals such as travel, buying a second home, and sending the children (or grandkids) to college. This is on top of providing for your basic needs during retirement.

Where should I save my retirement Money?

This could be different for every person because of varying tax situations but in general you want to invest using tax deferred accounts. These are accounts like IRAs, Roth IRAs, 401(k)s etc. These type of accounts protect your money from taxes either through tax deferral and tax-free growth. The goal is to get as much money into these types of accounts as possible. As a rule of thumb contribute to your 401(k) up to the employer match (if they provide this), then invest outside your employer in a Roth IRA or Traditional IRA. Then if you have additional capacity to save you can go back to your 401(k) and max that out. Once you have exhausted all your retirement account options you can save into a taxable brokerage account. It is a good idea to have some money in each of these type of accounts. In doing so you will be able to draw from different sources at different periods during your retirement. For example, when you retire there may be a period of time before drawing social security, that your income is lower. In this scenario you may want to pull from your tax deferred accounts like your traditional IRA because the tax will be paid in your lower tax brackets. This type of planning ahead can save you a lot of money over time.

How Much Do I Need to Invest for Retirement?

need-for-retirement-780x439

This again is different for everyone. This is because your goals are different from other people’s financial goals. For example if you live on $200,000/year in annual spending and want to sustain your lifestyle during retirement you are going to need a lot more than someone who only spends $50,000/year. Get it? Ok so the best way to determine what you need to save is run a time-value of money calculation factoring in inflation and stock market returns projections. Combine this with a Monte Carlo simulation for the best results. Sounds like a lot? It can be. Try a simple retirement calculator like the one over a Kiplingers. That might be enough information to make you comfortable. If it’s not then you might want to seek the help of a professional fee-only financial advisor.

What Should I Invest In?

Stocks are still one of the best ways to build wealth. The stock market on average returns about 10% every year. There is, of course, quite a bit of volatility with this as stock market returns can fluctuate greatly from year to year but in general you should get about 10% by investing in the stock market over a long period of time. Use this number in your calculations in determining how much you should be saving. Don’t get too fancy with your investments as your investment expenses can go way up. Stick with Index funds like Vanguard and Schwab. If you work with a financial advisor, then you might have access to DFA Funds managed by Dimensional Fund Advisors. These funds take investing to the next level utilizing academic research to increase the efficiency and returns of standard passive indexing. A mix of both is probably best. Then as you get closer to retirement you will want to shift some of your portfolio to bonds. Stick with high grade, short term bonds and use them to preserve your cash flows. Again, do some work ahead of time to determine our proper allocation.

What If I can’t Save and Invest Enough?

There are opportunity costs to everything. Anything you spend now cannot be saved and spent in the future. So consider that if you don’t think you will have enough. Would you rather keep your $200/month cable package and retire a couple years later? Or would you rather cut your expenses and retire a little earlier. Remember it is up to you. You make choices today that will affect your future self. If you don’t want to just live off social security income then you had better save some money now. By investing it will be worth even more in the future which is why the earlier you can start the better. I believe it was the great Doctor Brown that said, “Your Future is whatever you make it so make it a good one.”

I’m confused, what do I do now?

Well you can just google it. Too lazy? Here I’ll do it for you.  Ok seriously, you can either spend the time to learn more about investments, retirement planning, financial planning, and the myriad of other topics until you are comfortable with your retirement situation or you can hire someone to help. You should look for a local independent fee-only financial advisor in your area. This will give you the best chance having a successful retirement. So either do it yourself or hire someone to do it for you. Remember, in the words of Heed the words of Winston Churchill, “Failing to plan is planning to fail.”

 

How to Create your Own Financial Retirement Plan

Self-Help for Retirement Planning

retirement planning, help with retirement

Relatively few people are prepared financially for retirement. One study has reported that more than half of American adults planned to depend entirely on Social Security for retirement income. Another reported that most Americans do not save regularly at all.

To make retirement years enjoyable, planning must start early. With longer life expectancies and a growing senior population, planning and saving for retirement should begin by the 30s. With adequate planning seniors will not outlive their savings and become financially dependent.

There are three steps to retirement planning:

  • Estimating retirement income
  • Estimating retirement needs
  • Deciding on investments

Estimating Retirement Income

Most people have three available sources of retirement income: (1) Social Security, (2) pension payments, and (3) savings and investments. Determination of income from savings and investments is doable after estimation of income from Social Security and pension plans.

Social Security

A planner can estimate how much to expect from Social Security retirement income by filing a “Request for Earnings and Benefits Estimate” with the Social Security Administration (SSA). Request this form on the SSA website or with the SSA toll-free phone number 800–772–1213–FREE.

The amount of Social Security benefits depends on time worked, age at which benefits start, and total earnings. Waiting until full retirement at age 65 to 67 to start receiving benefits maximizes the monthly amount payable.

Planners should be aware that Social Security benefits may be subject to income tax. The basic rule is that if adjusted gross income plus tax-exempt interest plus one half of Social Security benefits exceed $25,000 for an individual or $32,000 for a couple, some portion of the benefit will be taxable and will increase as the adjusted gross income level rises.

Pension Plans

Estimate how much to expect from a traditional pension or other retirement plan. Ask for a projection of what to expect from continued work until retirement age or from an earlier termination. Estimate any lump sum available from a 401(k), profit-sharing, or Keogh plan or a simplified employee pension at retirement age. The employer or plan administrator should be able to help with this estimate.

Estimating Retirement Needs

retirement planning, how to retire

Determine how much income will suffice after retirement, then calculate how much to set aside for a fund large enough for a desired income level. Many people don’t realize that retirement can last as long as a career, 35 years or longer. The fund may have to last much longer than might be expected, and the earlier the retirement, the more money it will need. Retirement at age 55 costs much more than at age 65.

A general guideline is to have at least 70 percent of the preretirement income stream. For special needs or desires the percentage is greater. The 70-percent figure is no substitute for a thorough analysis of future income needs, only a general guideline.

Suggestions for estimating an income stream needed after retirement:

  • Consider current annual expenses. From checkbook, credit card, and bank records over a year, add up payments for insurance, mortgage or rent, food, household expenses, and so on.
  • Consider how expenses may change after retirement. Will the mortgage be retired? Will commuting expenses continue? How much will health insurance cost? Will life insurance coverage increase or decrease? How much will travel expenses be? Will hobbies cost more or less after retirement? Will children be financially independent by retirement time? Will income taxes be lower, higher, or the same?

The answers to these questions indicate estimated annual expenses post-retirement. Then subtract from this estimate annual income anticipated from already-established sources. The difference is the anticipated annual deficit to be financed.

How much to save each year to accumulate a sufficient fund by retirement age? Assuming an after-tax return of five percent per year, multiply the accumulation required by a savings rate multiplier for the number of years until retirement:

Years until Retirement Savings Rate Growth Rate

5

18.0%

128%

10

8.0%

163%

15

4.6%

208%

20

3.0%

265%

25

2.1%

339%

30

1.5%

432%

Example: A planner 40 years old who wants to retire at age 65 needs $350,000 to fund an anticipated annual deficit. To find out how much to save each year, multiply $350,000 by the 25-year savings rate of 2.1 percent, which indicates a need to save $7,350 every year for 25 years.

Subtract from this amount any lump sums anticipated at retirement. To project the value at retirement of a present asset, multiply its current value by the growth rate for the number of years until retirement.

Example: The current value of a 401(k) plan is $75,000. To project how much that amount will grow in 25 years, apply the 339-percent growth rate, which indicates $254,250 to subtract from the $350,000 needed to fund the anticipated post-retirement deficit. Multiply this $95,750 difference by the 25-year savings rate to see that, after factoring in the projected 401(k) lump sum, the planner still needs to save $2,010.75 per year to accumulate $95,750.

Investments

Generally, the more time until retirement, the more savings the planner should invest in vehicles with growth potential. If very close to or at retirement age, low-risk investments may be best, but this rule is subject to individual financial profiles in risk tolerance, income level, other retirement income sources, and unique individual needs.

Advantages and disadvantages of retirement-savings investments:

  • Tax-Deferred Retirement Investments. Deposit as much as possible in a 401(k), individual retirement account, Keogh, or some other form of tax-deferred savings plan. This money grows tax-deferred, and, if deposits are deductible, they reduce the planner’s income tax base.
  • Low-Risk Investments. Money market funds, certificates of deposit, and treasury bills are all conservative investments, but only the treasury bills offer rates that adjust to economic inflation. Most individuals saving for retirement should invest only small portions of their savings in them.
  • Bonds. The fixed-income rate from corporate and government bonds is higher than that from treasury bills. Bonds fluctuate in value with interest rates and so are riskier investments. For conservative investing, short-term may be preferable to long-term bonds to minimize value fluctuation.
  • Stocks. Corporate common stock is riskier still but offers potentially greater returns.
  • Mutual Funds. Mutual funds are good retirement savings devices. A balanced mutual fund portfolio can achieve a high return but not entirely without risk. The prospectus, the fund’s selling document, offers information about fund costs, risks, performance history, and investment goals. Planners should read the prospectus and exercise judgment carefully.

For more information or help with your own retirement planning check out Certified Financial Planner Maple Grove. They are a fee-only financial advisor that can help you achieve your retirement goals.