Tax Efficient Investing For Retirement

by Todd Smith on 2012-02-0612

Are you saving for retirement? Consider the tax ramifications.

It’s painfully obvious that we have officially entered into a period in which many people work far past the age of retirement — whether it’s because they actually want to or because they have to. With people living to be much older nowadays, “retirement” tends to last much longer — and with no guarantee of ever seeing a penny of Social Security. The employee has suddenly become responsible for making sure they have money to live on once they reach that golden age.

Therefore, having an effective savings plan and a strong investment portfolio is not just attractive — it’s also just common sense. But is your retirement savings plan tax efficient? With so many retired folks spending twenty-five years or more in retirement, taxes can absolutely cripple your hard-earned savings!

So we’d like to bring up the idea of handling our investments in such a way as to minimize our tax obligations. After all, we all want to keep more of our money to better support our retirement. You should invest your money with tax efficiency in mind. Taking advantage of tax-efficient investments will allow you to build a bigger nest egg and enjoy your retirement without the anxiety of wondering how you’ll make ends meet. So how do you make tax-efficient investments a reality?

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How To Make Your Retirement Investment Portfolio Tax Efficient

There are three critical factors to retirement fund success: your philosophy on spending, diversification of tax accounts and asset allocation. These can affect whether or not you achieve tax efficiency in your investments. Let’s go through each of these factors in more detail:

1. Asset Location
When we talk about asset location (no, that’s not a typo…), we are referring to the ability to maximize our overall portfolio’s expected, after-tax return by positioning assets between taxable and tax-advantaged accounts. This is sometimes also referred to as “preferred domain”. This approach can be most beneficial for people who have a mix of taxable and tax-advantaged accounts and who have a long enough time horizon. To accomplish the optimal mix, you need to place your least tax efficient investments (bonds, high turnover stock funds, etc.) into tax-deferred accounts, and your tax efficient investments (municipal bonds, index funds, etc.) into taxable accounts.

2. Your Personal Spending Philosophy
Most retirees favor “income” and are typically looking for assets that have the best yield. But this approach generally results in a portfolio that is geared towards income generation (via taxable bonds, high-yield bonds, cash/cash equivalents such as online savings accounts, bank cds or high yield checking accounts), and that tends to focus on dividends rather than long-term gains, which can have favorable tax treatment. Also, many try to minimize taxes by investing in municipal bonds, even when their tax bracket does not warrant them, which produces a lower yield than taxable bonds.

So what’s the alternative? You may want to consider a “total return” spending approach (here’s a writeup from Vanguard about this). Instead of opting for a pure income portfolio to accommodate your spending, you would opt for a diversified portfolio and spend from both income and principal. In this way, you would be reducing ordinary income (and, therefore, taxes) and favoring long-term gains in your overall portfolio; it would steer your portfolio allocation away from an “income tilt” thus allowing a better alignment with risk tolerance and other investment considerations.

Thus when we spend, we would not be drawing yield necessarily, but the amount we need from the appropriate accounts. In doing so, our spending order would be as follows:

  • First, taxable assets;
  • Second, non-qualified annuities;
  • Third, qualified retirement plans and Traditional IRAs;
  • and finally, Roth IRA’s, Roth 401(k)s/403(b)s and other employee sponsored retirement accounts.

3. The Mapping And Diversification Of Your Tax Managed Accounts
It’s not uncommon for people to be in a higher tax bracket during retirement as compared to when they are working. Tax rates are dynamic and future rates are fundamentally unpredictable. You are doing yourself, and your portfolio, a disservice by assuming you will be in a lower tax bracket when you stop working. So, just as it is prudent to diversify between stocks and bonds, you shouldn’t really put your entire nest egg into one tax bracket. That is — don’t bet 100% on one tax bracket since you can’t really predict what the future will bring, in terms of your tax situation. To accomplish this, it makes good sense to hold after-tax investment accounts and Roth IRAs to complement the pre-tax accounts you may have (i.e. Traditional IRAs, SEP IRAs, 401(k)s, 403(b)s, etc.).

Remember that there are limits to the amount you can contribute across certain retirement vehicles, but you can own multiple retirement accounts of various types. For instance, if you are eligible, you can take advantage of both a Roth IRA and a traditional IRA, but you must keep your total contributions to both under the IRA contribution limits for a given tax year. Check out this post on Roth IRA rules and tips for additional information as well.

The Bottom Line On Tax Efficient Investing

Most long term investment and savings goals boil down to achieving a comfortable retirement or reaching financial freedom. It’s not just “here’s the watch; have a nice life” anymore. The fact is that these days, we expect to have longer lifespans, and therefore, possibly more time spent in the retirement phase. For these reasons, it not only makes sense to have a very good savings and investment plan in place, but also to do it in the most tax efficient way possible, because taxes, like costs, can take a big bite out of our returns and ultimately our nest eggs. Take a peek at your portfolio gains and realize that not all of what you see there is yours to keep — a portion of that is going to the tax man!

Therefore, think about creating a tax-efficient portfolio with a little planning. Accomplishing a tax-efficient portfolio and ultimately, a retirement nest egg, may take a little forethought. It may also require looking at things a bit differently from a spending perspective. But all this is worth it if you are paying less taxes over the duration of your retirement, which can make a big difference in maintaining your lifestyle and possibly passing assets onto your heirs.

Created September 9, 2010. Updated February 6, 2012. Copyright © 2012 The Digerati Life. All Rights Reserved.

{ 12 comments… read them below or add one }

Jerry September 10, 2010 at 12:12 am

I’d never thought of stock funds and bonds as tax efficient investments but you’re absolutely right there. In my line of work, planning for the future is incredibly crucial. Here in Maryland, the economy can have its dips and rises so making sure the family is taken care of is job number one. Thanks for sharing your tips. September 10, 2010 at 4:03 am

This article discusses some good points which I tend to agree with. I think the most important is the ROTH IRA. It can be withdrawn tax free, you cannot beat that.

Also, there are tax free bonds out there. Bonds are not sexy, but then how has your stock portfolio done the last 10 years?

Kosmo @ The Soap Boxers September 10, 2010 at 8:03 am

I wrote an article contrasting Roth and 401K a while ago. I break down a few scenarios. The gist is that there is no silver bullet – a lot depends on your individual situation.

Ken September 10, 2010 at 9:16 am

I’ve never given much thought to what investments one should tap first when entering retirement. I’m all for avoiding paying any more tax than I absolutely have to. Great info.

Paul Petillo of September 10, 2010 at 7:04 pm

I have been focusing on this aspect of retirement building but have been suggesting a way to do it gradually over time, assuming you are beginning young(ish).

Get 5% into your company’s 401(k). At this rate, there is a sort of no-pain threshold where this tax deferred deduction doesn’t impact the net pay – great for those fresh into the workforce. Then, once you do that and understand the concept, fully fund a Roth IRA. This works out to about $100 a week but the benefits of this particular investment tool are numerous – as long as you keep your hands off it. (Roth IRAs are already financed with money you paid taxes on so the temptation to withdraw in times of emergencies is high).

If you have been successful with the 5% 401(k) and the maxed-out Roth IRA, go back to your 401(k) and begin to inch your contributions up. Keep index funds in your Roth (because they are tax efficient) and riskier funds in your 401(k) (because they aren’t so much, usually).

Hope this helps!

20smoney September 11, 2010 at 8:24 am

Awesome information here.

Credit Girl September 11, 2010 at 6:39 pm

Thanks for the information. I don’t know too much about investment portfolios but it’s always nice to learn new things.

Tom September 12, 2010 at 2:53 pm

Annuities are a great choice as there are different types to choose from and they come with options. they’ve proven to be a safe investment through a recession, but don’t let that be your deciding factor. Each person has different needs so each person should do their homework and find something that best suits them.

Consumermiser September 15, 2010 at 9:58 am

Whoa, that was a lot to digest. I do worry slightly about being in a higher income bracket during retirement than when I am actually working, but it will be a good problem to have. I actually hope that I do generate more income during retirement than now.

@ Paul Petillo. I like your simple approach which is similar to mine. I look for the tax friendly vehicles such as the 401K and IRAs. I am trying to get more sophisticated, but simple is good.

Stacey September 16, 2010 at 7:40 am

Great post! We’ve split our retirement savings between Roth and Traditional IRAs. If you look at how current income is taxed, the standard deduction and exemptions mean that the first ~$18,000 of a couple’s “real” (not AGI) income is taxed at 0%. Why not aim to get at least a portion of your retirement income from pre-tax accounts and enjoy the tax deduction now? Besides, who says that we won’t move to a consumption-based tax system in the future — which means that Roths will be taxed at the same rate as Traditional IRAs and even non-retirement savings. Diversification should go well beyond your stock & bond investments.

Silicon Valley Blogger February 5, 2012 at 2:54 pm

I think it’s important to remember that although we may be saving for shorter term goals such as a new car, house, or vacation, or investing for our children’s 529 college savings plans, ultimately we seek financial freedom where our income and our lifestyle are not linked to a job. Unfortunately, most people are simply busy with life and trying to save for retirement that there is little forethought to future tax efficiency in retirement. Hopefully this piece will give us something to think about.

EMHpe February 10, 2012 at 12:05 pm

I think you are bang on the concept of having a diversified approach to building a portfolio of dividend paying stocks, fixed income, and capital appreciation to be tax efficient. Dividend paying stocks are an asset class that should be considered in detail, and for a rundown of this asset class see this link.

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